One of the more interesting spectator sports, for those with an interest in the crypto playing fields, is watching the various teams do combat with the many hidden gremlins that traditional finance has spent centuries trying to ward off. All of those things that we generally do not worry about, because we assume that global financial regulators and financial institutions have it under control.

You know, subjects like leverage risk, liquidation contagion, counterparty trust, capital reserves, treasury diversification. 

Yawn.

Well, well. If the past couple of weeks have taught us anything, it is that pride comes before a fall. Or something like that. The young guns of crypto finance have been whumped upside the head by the very same stuff that has given rise to conservative lawyers and bureaucrats inscribing libraries worth of regulation and compliance requirements, for which financial institutions have teams of besuited employees to understand and implement.

This is the story, which, in retrospect, was bound to happen in this new unregulated space where hundreds of billions slosh around without oversight.

In the wake of Bitcoin came a fancy post-Bitcoin blockchain called Ethereum (in 2014), which allowed anyone to program any new application that struck their fancy. Unlike Satoshi’s Bitcoin, which was, well, not very programmable.

And one of the first industries to be targeted by warriors wielding this new Ethereum platform was the lumbering financial services industry, long-suffering participants in the aforementioned regulation and compliance dance embrace. 

This new challenge started slowly in about 2017 and exploded in 2020/21 with a firehouse of blockchain financial creatures – loans, deposits, derivatives, yield aggregators, exchanges and the like – a bacchanalian orgy of unregulated financial experiments.

Within the cloistered world of crypto, which lives largely outside the real world of rands and dollars (other than the onramp/offramp portals where dollars get exchanged for cryptocurrency), the big projects started to do business with each other. Borrowing here, lending there, doing a little arbitrage in that place, re-hypothecating in this place, offering loyalty rewards in the other.

Very incestuous. Everyone in everyone else’s pockets. Unmitigated reliance on everyone else’s financial prudence.

 Yes, well. A case of a poor judgement and even worse risk mitigation.

I recently wrote about a decentralised finance project called Terra/Luna. It was, at least in retrospect, a load of bollocks that was clearly unsound, and would collapse like the house of cards that it was at the first sign of a bear market.

Which is exactly what happened.

This might have passed relatively unnoticed, except that in a rising market they were able to promise (and deliver) returns of around 20% per annum without fixed-term deposit, in an old-world banking universe that was delivering low single-digit yields to its customers – which meant that depositors flocked in. Not only simple retail investors. But other crypto finance projects. And crypto investment companies in the real world. Who all rushed in enthusiastically.

Upwards of $40-billion disappeared in the Terra-Luna meltdown, which was built on the promise of lovely annual returns. And then it crashed on its flimsy foundations, taking with it everyone who had a stake. Like Celsius, which had in turn passed off those returns to others. Like Three Arrows Capital, a real-world investment company whose founders had long basked in the sunlight of alpha returns, and who took in retail investment and equity. 

Which has led to trouble at these many companies most of us have never heard of, but which have custody over tens of billions of dollars – Voyager Digital, Genesis Trading, BitMEX Nexo, Babel Finance, CoinFLEX, Ortho Trading, 8blockscapital, DeFianceCapital, Maple Finance, Finblox.

A long domino train of clackety-splat. This was crypto’s first major black eye, mostly because it was self-inflicted and avoidable.

Defi is sure to recover – it is a boiling cauldron of fabulous innovation, and the best will rise with the heat. But this crash is sure to bring with it much more than self-recrimination and introspection.

What is going to happen now is that the regulators are unsheathing their battle-scarred swords and wading in. On 23 June, crypto luminary Charles Hoskinson addressed a sitting of Congress (House of Representatives Committee on Agriculture), and tried to make a case for self-regulation, but I think that window has closed. 

We tend to forget that regulations work best in times of financial stress; it is nearly invisible otherwise. And now we have crypto under that exact financial stress.

In the wake of this value destruction, regulators now have political capital – and they intend to spend it.

A recent map of the crypto-regulated world by Statista shows regulations under way in about 50% of countries, primarily Western (but including Russia). Most of the Islamic world (with notable exceptions, such as the UAE) have tight constraints or outright bans. About half of Africa and South America have implicit bans or incomplete guidance. China has an outright ban.

In matters of financial regulation, there are four major drivers – to stop people cheating on taxes; to prevent money being transmitted to bad guys who want to drop bombs on you; to protect consumers from themselves; and to monitor the flow of capital through economy (to enable informed decisions on interest rates and money supply to be made).

In these matters, the world generally looks to the US for guidance. Even before the carnage of the past few weeks, US Representatives Cynthia Lummis and Kirsten Gillibrand on 7 June introduced a wide-ranging piece of legislation to Congress, called the Responsible Financial Innovation Act. It was surprising from two perspectives. 

The first was that after previously ham-fisted attempts at legislation, this one was well informed, carefully argued, cautious and quite wise, trying to balance innovation with oversight.

The second surprise was this was written by a cooperating Democrat and a Republican – a rare sight in the wild. 

And then on 28 June, Gary Gensler stated on a TV show that Bitcoin was a commodity. A throwaway line in an interview, but giving some clarity for the first time, and providing early handrails – at least for prospective investors in this one crypto asset. 

So, the rules are tightening. There will be more of this. 

Regulators seeing the sudden recent collapse are, well, energised and focused. Wild financial experiments will quickly start to fall under the gaze of conservatism and prudence. Crypto originalists and fundamentalists will chafe at their constraints. 

And so will continue the maturing of an important new industry. DM

Steven Boykey Sidley is Professor of Practice at The University of Johannesburg.