Towards the end of 2021, the cryptocurrency market reached record highs before collapsing in 2022. From $2.9 trillion in value in November 2021 to roughly $800 billion a year later, there was a significant decline in value. Leading crypto lenders and exchanges also failed as market value fell.
Many of these platforms are currently being sued and accused of serious wrongdoing, including fraud claims against Celsius. A class action lawsuit has been filed against Voyager Digital for deceiving customers and selling unregistered securities. BlockFi reached a settlement with the SEC and 32 states regarding related allegations, is still subject to a class action lawsuit, and ultimately declared bankruptcy. Two class-action lawsuits have been filed against the co-founder of Terraform Labs, the company that developed the algorithmic stablecoin TerraUSD, and an arrest warrant has been issued in South Korea. Now, the recently bankrupt centralized exchange FTX is being investigated for “serious fraud and mismanagement,” and its co-founder Sam Bankman-Fried is being closely examined by Congress, prosecutors, and civil lawsuits.
Some believe that the recent upheaval portends the demise of cryptocurrency. They perceive the series of collapses as evidence that cryptocurrency is nothing more than a house of cards.
These failures, however, did not affect the base of cryptocurrency. Instead, they represent a particular market sector that was dominated by secretive, centralized institutions that made it challenging for their clients to comprehend the risks they were taking. Additionally, the relative ease with which users could move their cryptocurrency assets between platforms fueled a fierce level of competition that forced platforms to continually offer deals that appeared to be better and better while carrying higher and higher levels of hidden risk.
In this sense, this type of financial meltdown isn’t particularly novel; fierce competition in markets with opaque products has frequently resulted in financial collapses. Ironically, while easier competition is typically a good thing in markets, it may have made the issues worse in this case.
But at the same time, the centralized institutions that failed stand in stark contrast to other crypto market segments, such as those built on decentralized protocols that run on fixed algorithms and have high levels of transparency. These platforms operated reasonably consistently despite being subject to the same market forces and the upheaval.
We describe some of the economic dynamics that drove this series of events in this article. Then we talk about how as decentralized finance develops, it might offer a way to harness the advantages of competitive crypto infrastructure with better consumer protection.
Web3 competition and opacity
You must comprehend why competition in the crypto/Web3 space behaves differently from many other traditional business contexts in order to comprehend how we ended up here.
Data and assets are locked inside “walled gardens” in both well-established Web 2.0 platforms and traditional financial institutions, necessitating considerable expense and effort to move them. Even content you have created yourself is difficult to extract from websites like Twitter and Facebook, and once it has been extracted, the content is delivered in a file format that is difficult to transfer to another website. People perceive significant switching costs in consumer banking, and as a result, very few people actually look for better banking products.
In contrast, because digital assets are managed and stored on open, interoperable blockchains, moving a user’s assets around is simple and intuitive. Users have control over their assets and frequently do not even need to notify a platform when they leave for a competitor, making the cost of switching platforms incredibly low. Platforms must therefore engage in fierce competition to retain users as well as attract new ones.
And in fact, we have observed these forces at work in a number of crypto markets. New platforms for trading both fungible and non-fungible crypto tokens have launched, and by providing innovative features and/or lower fees, they have successfully seized market share from incumbents by capitalizing on users’ low switching costs. Users can compare transaction opportunities frictionlessly between various platforms using aggregators, and the platforms frequently compete with one another by giving users larger shares of governance tokens and other benefits. Another illustration is “yield farming,” in which customers use open data about available options and low switching costs to algorithmically and instantly reallocate their capital to the products with the highest yield.
But there’s a problem: Right now, some crypto products and services are opaque and perhaps too complex for the typical user to understand. Intense competition can cause problems when customers don’t understand an offering, either because they lack the necessary expertise or because they aren’t being given crucial information. In particular, rival businesses can present consumers with increasingly alluring good deals while hiding potential pitfalls.
This dynamic is not specific to cryptocurrency. Markets for everything from used cars and wealth management to insurance and medical care experience it. But because the assets they deal with are novel and occasionally inherently complex, hiding potential issues can be particularly possible on some cryptocurrency platforms. Risk is increased by the fact that consumer protection and disclosure regulations are still in their infancy.
In situations like this, companies may increasingly offer alluring product features while concealing rising underlying costs and risks as competition heats up.
When Economic Forces Turn Negative
There is a lot of history behind the concoction of fierce competition, opaque financial products, and unsustainable yields.
For instance, in the banking industry, deregulation in the 1970s and 1980s increased competition, reduced profit margins, amplified risk-taking by banks, and increased bank failures. Recent studies have demonstrated that banks frequently design their financial products for households in a way that raises the headline interest rate while also raising the complexity and risk of the products. Of course, widespread fraud in the mortgage securitization sector was a hallmark of the 2008 financial crisis, and this behaviour was largely influenced by increased market competition as originators lowered credit standards and engaged in predatory lending to boost profits.
While competition can and should benefit consumers, history has repeatedly shown how intense competition in the financial markets fosters the growth of risky and complex products, albeit for a short time, by luring customers in with unbelievable bargains that will inevitably go bad.
This snowball dynamic is once again demonstrated in the context of several centralized platforms by the most recent collapse of the cryptocurrency market. Without fully disclosing the extreme leverage and risk they used to achieve those returns, Celsius and Voyager Digital, two significant centralized, retail-facing lending platforms that are currently in bankruptcy, offered incredibly attractive yields on customer deposits.
In an effort to boost interest in Terraform Labs’ stablecoin, TerraUSD, which crashed later in the year, Anchor, a lending platform built and controlled by Terraform Labs, offered depositors unsustainable yields. One of the biggest centralized cryptocurrency exchanges, FTX, reportedly used customer funds to cover the losses of its sister company, the hedge fund Alameda Research, while enticing users with discounts on crypto asset trades.
Small changes in yield promises can result in significant capital movements in a highly competitive industry where customers can easily switch financial providers. Such actions increase the incentives to artificially improve customer terms, especially when the financial products themselves are complicated and opaque.
Unproductive businesses should be driven out of the market by competitive markets. However, due to the lack of transparency in centralized crypto finance, unproductive companies were able to compete by offering products that appeared appealing in the short run but were unsustainable in the long run. Unfortunately, as we’ve seen, such companies can amass substantial assets before their business models collapse.
What Makes DeFi Unique?
A natural experiment has been running for several years: Along with centralized crypto platforms like Celsius, Voyager Digital, and FTX, various decentralized finance (DeFi) protocols have emerged, and DeFi has held up in the midst of the broader crypto market turmoil.
Through protocols that are simultaneously stored on thousands of computers and use the blockchain to agree on the same results each time the code runs, DeFi platforms manage cryptocurrency and other assets. Smart contracts, a type of computer program that automatically executes protocols, guarantee that they will function as intended. Similar to centralized platforms, DeFi protocols make it possible to conduct markets, settle trades, process payments, and disburse loans. These platforms’ operations are consistent, completely auditable, and their transactions are all visible because they are supported by infrastructure that is public, open, and decentralized.
For instance, the decentralized protocols Aave and Compound enable lending and borrowing with excessive collateral. Based on real-time supply and demand, these protocols automatically set interest rates to reflect the state of the market. They are essentially in the same line of work as Celsius, for instance—crypto lending—but their activities can always be made public. Additionally, Aave and Compound run independently. Since all borrowing, lending, and interest-earning are automatic processes, there is no one in charge of managing assets or choosing which investments to make. As a result, there is no room for human intervention in the risk-taking process.
In fact, while Celsius boasted of offering stablecoin deposits at interest rates of 12% (significantly higher than the loans they offered, which started at 4.95%), Aave and Compound were unable to match those numbers because their interest rates were set mechanically based on supply and demand in the market. As a result, even as Celsius exploded, Aave and Compound continued to function effectively.
Although DeFi is subject to the same competitive forces as the centralized platforms, moving assets between DeFi lenders is actually even simpler for users than moving them in and out of centralized crypto finance platforms. However, DeFi is not designed to respond to competition by taking the kinds of opaque risks that have doomed Celsius and other centralized platforms.
More broadly, decentralized finance promises unprecedented levels of transparency in the financial system. Users on DeFi platforms can view publicly verifiable transaction information on the blockchain ledger and confirm their balances, orderly transaction execution, and other state changes. Furthermore, because these rules are explicitly written into open-source code, users can examine the precise software rules that govern the platforms’ operation and assets. Furthermore, because platform operations are managed by software, their behaviour is predictable even when market conditions change.
This contrasts sharply with much existing financial infrastructure, both inside and outside of crypto markets, which is based on private and unobservable ledgers. Many centralized finance platforms make decisions and moves that are hidden from the public eye, potentially leading to risky but unobservable changes in their financial products. For example, FTX allegedly loaned out customers’ deposits without their knowledge or permission — whereas this would be impossible in DeFi exchanges because there is no human control over deposits; rather, all transactions are managed mechanically by a pre-specified algorithm.
However, before DeFi can fulfil its potential, much more work needs to be done. Not all DeFi protocols are currently based on open-source software, and even among those that are, the code and underlying data are frequently difficult for anyone other than skilled power users to access and parse. Additional tools are required to guarantee regular software audits, real-time analysis of on-chain data, and simple, readable disclosures that will enable common consumers to evaluate the reliability of these products in a way that is not currently possible.
Of course, the underlying software must be strengthened as well. While DeFi protocols are designed to always work as intended, this makes them vulnerable to hacks that take advantage of subtle economic or security flaws in their algorithms. While decentralized governance helps to align platform incentives with the best interests of their users, it can also expose platforms to attacks in which a small number of users collect governance tokens and then try to force system changes, similar to a hostile takeover of a publicly traded company.
Finally, we must encourage the development and use of DeFi. Radical transparency may be a challenging strategy in the short term in highly competitive markets like crypto finance, as we’ve already seen, because it prevents platforms from offering deals that appear to be appealing but are unsustainable. However, transparency has long-term benefits, and there’s a chance that DeFi platforms could be more valuable overall, including for creators. In fact, the value proposition for consumers can be higher, which has the potential to spur further growth, especially to the extent that these platforms share some ownership with their users.
DeFi may therefore be bigger and more valuable than even the most prosperous centralized platforms when operating at scale. However, centralized actors in the space must be prevented from acting in an opaque manner because decentralized platforms still cannot defeat outright fraud.
More generally, regulation can be a significant addition to DeFi because it can set transparency standards that level the playing field compared to centralized platforms and give direction and structure regarding the best kinds of protocols. Similarly, data and modelling platforms can assist DeFi protocols in making the best choices possible. Gauntlet, for instance, conducts real-time analysis to counsel DeFi governance bodies on how to modify collateral and collateralization ratios to address shifting market risk.
