The pyramid of cryptocurrencies

By Lionel Laurent

As the world’s most sparkling cryptocurrency figures join the elite of Davos every year – as investors sweep the market crashing through many sleepless nights – it’s time for regulators around the world to reflect on the real impact. of the next cycle of flourishing and collapse of cryptocurrencies.

Fintech and cryptocurrency applications are already rapidly expanding into digital cash, loans and complex products that may look as simple as a credit card in the form of an email. This has created financial channels much more complex than a simple bet on Bitcoin or Bored Apes: decentralized financial system (DeFi) platforms offer cryptocurrency returns of 8% -10% to investors. Some then fund start-ups around the world without ever passing by traditional banks. Tulipmania is meeting the real economy with speed… WhatsApp.

In these times of pressure in the wider markets, the rewards of being unsustainable have given way to a messy cascade of losses – underscoring the enormous challenge facing policymakers, some of whom admit to making big mistakes in the case of cryptocurrencies.

Flood

Currently, crypto funds are facing withdrawal from lending platforms, even those backed by real-world assets. A project that offered 8% returns on “cryptocurrency” debt of the French lender Bling has been hit by “huge” withdrawals of funds beyond its available cash and a line of credit received from its supporters from the venture capital area. For an investor I spoke to, this probably means that they will have to wait months to get their money back. His main motivation for the initial investment was the free token rewards on cryptocurrencies that have since evaporated in value.

Meanwhile, at the other end of the chain, lending to the final consumer has also hit a wall. Bling suspended its cash advance service in April as regulators cracked down on the industry. A consumer advocacy team estimated the cost of Bling’s one-month direct deposit to be equivalent to an annual interest rate of 128%, including commissions.

A low-security project like the one that is now running to sell assets is obviously nothing compared to the scale of the $ 60 billion Terra collapse that drove desperate Koreans to the door of its founder, Do Kwon. But it shows why regulators are particularly concerned about future risks to the wider financial system.

These free rewards and high returns attract people who may find themselves in an extremely difficult position when faced with losses. European Central Bank figures show that crypto ownership is a U-shaped case, with very high and correspondingly very low-income households more likely to own cryptocurrencies or related assets than mid-income households. .

Interconnection

Links to the traditional financial system are growing as venture capitalists and banks seek to capitalize on the subversive potential of cryptocurrencies – Societe Generale has been involved in DeFi loans, while others are launching stablecoins. “There is a very broad sense in the investing community that one has to dip one’s toes in space,” says economist Eswar Prasad, author of The Future of Money.

Crypto markets today are medium-sized – the current total value locked into DeFi is about $ 100 billion, or about one-sixth of the total venture capital investment last year – but what would 10 or 12 look like? parallel collapses of credit schemes in the industry in the future if this space continues to grow?

A fight for the rapid sale of assets to cover losses in cryptocurrencies could have huge side effects, especially if managed algorithmically through “smart contracts”. Parallels with the high-risk mortgage market that caused a global financial collapse in 2008 are becoming more common.

“Although the risks are small at the moment, they could increase significantly if the platforms started offering services to the real economy, rather than being confined to the cryptocurrency universe,” the ECB said last week.

The setting is coming

The founders and financiers behind DeFi platforms such as Centrifuge or Goldfinch say that serving real business is still good news for cryptocurrencies. Algorithmic project management and reducing “paperwork” means unlocking efficiency gains and access to capital, they argue, while building useful infrastructure in the way previous market bubbles have built railways and the internet.

Maybe. But these are also banking activities that they could do with more banking supervision. They often involve complex financial structures that combine many Delaware-based EIAs, with little chance of legal action against them and high counterparty risk. They are part of a wider explosive spread of fintech lending, which has not yet really been tested in a recession. Instead of a high-speed train, it may look more like “shadow square banking,” says fintech investor Peter Lugli.

Expect some of this activity to come to light as a result of institutional and regulatory focus: perhaps the next step is that the various Blinges will begin to behave more like regular banks and DeFi lending platforms will have more concentrated branded funds that will go through the ordeal. of due diligence.

However, given the way in which animal instincts tend to return, regulators should be aware that risk management will become even more difficult from now on.