Winds of change in the crypto winter?

March 2023 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

March 2023 Issue

Cryptoassets have been a hot topic for over a decade. Starting as a niche interest understood by few and dismissed by some, they have developed into a headline-grabbing topic of mainstream conversation and a sector that has attracted a huge amount of capital. Crypto businesses have seen dramatic expansions in their user base and their valuations. Over the past five or so years, Coinbase, Tether, Binance and FTX (to name but a few) became household names at times worth billions of dollars each.

For some of these businesses, however, things have started to unravel. A catalogue of failures across the entire ecosystem, including hedge funds, coin projects, lenders and exchanges, culminating in the dramatic collapse of FTX in November 2022, have been a key focus for not only cryptoasset speculators, but also institutional investors, and increasingly, for politicians, regulators and central banks.

In a sector that has consistently surprised, disrupted and innovated in the face of substantial criticism, will 2023 wreak more havoc on the cryptoasset industry, or will the survivors of 2022’s ‘crypto winter’ thrive? While it is impossible to predict with certainty, it is informative to consider past crypto failures to understand their root causes and what this may mean for the future of this still nascent industry. Whatever happens, the era of light-touch regulation of cryptoasset business appears to be approaching its end.

2022 was not the only year to see cryptoasset corporate failures. In the early evolution of the cryptoasset space, many of the most notable failures could be blamed on hacks or frauds. Mt Gox, a Japanese exchange which at one point was responsible for around 70 percent of all Bitcoin transactions worldwide, abruptly closed its doors in 2014 after a hack which resulted in a loss equivalent to 7 percent of all Bitcoins at the time. It never opened its doors again and its Japanese bankruptcy process is still ongoing, with creditors likely to be finally repaid this year.

Bitconnect, which ran between 2016 and 2018, was a cryptoasset lending platform where owners could earn astounding rates of interest. It collapsed after various US state regulators issued cease and desist orders against it for operating as a ‘textbook’ Ponzi scheme. In 2022, the US Department of Justice charged the founder (whose whereabouts remain unknown) with fraud and sentenced its main US promoter to three years in prison and restitution of millions of dollars. The looming spectre of Ponzi schemes in the crypto world has notably still not entirely disappeared. A team member of crypto lender Celsius, as revealed in a recently published Bankruptcy Court examiners report, is noted to have said “that his title should have been Ponzi Consultant”.

While criminal interference still plagues the cryptoasset world, in recent years, as the industry has started to mature, the failures of some undertakings have more closely resembled those of traditional struggling businesses. There are of course a number of factors that may contribute to the ‘regular’ failure of a cryptoasset firm. These could include: (i) a failure to gain widespread adoption of a product or a coin resulting in a tapering of demand; (ii) unsustainable business models where a product or concept turns out to be unviable or the company was unable to generate sufficient revenue; (iii) technical challenges with the company’s underlying product; or (iv) simple mismanagement, where inexperience, overconfidence or naivety bring an otherwise perhaps viable company to its demise.

These factors are likely all too familiar to anyone who has contemplated a struggling business’ viability, particularly in fast-scaling sectors. In the cryptoasset world, however, these issues may be exacerbated by exposure to famously volatile cryptoasset markets, either through a company’s investment in cryptoassets, its position as an intermediary in the market ecosystem or through fluctuations in the value of its own coin or token.

These weaknesses can be further compounded by the interconnected nature of many cryptoasset businesses, particularly in the cryptoasset lending and yield-farming space, where many businesses lend or borrow to one another, and also by the ‘move fast and break things’ approach that may see risk management shunned in favour of rapid innovation. Certain commentators argue that it is inherent in the mindset of crypto industry participants to be wary of systems and controls. Regulation is (or at least was) in many ways the antithesis of the decentralised, disintermediated system the crypto world was designed around.

These exacerbating issues have played out again and again in recent failures, most notably that of the once-dominant darling of tech investors, FTX. The spark that lit the flame in the FTX collapse was likely the collapse of Terra/Luna in May 2022 and the subsequent decline in cryptoasset values across the entire market. Next came $10bn hedge fund Three Arrows Capital in June, followed by lenders Voyager and Celsius in July, all of which suffered from a combination of the factors leading to failure identified above. Finally, FTX collapsed in November, shortly followed by closely linked lender BlockFi and, after putting up a brave fight, cryptoasset lender Genesis in early 2023.

A lot of column inches have been taken up documenting both the origins of FTX’s collapse and the dramatic liquidity crisis of its final days, which continues to unravel in US bankruptcy courts. What has become clear, however, is that a lack of strong corporate governance, systems, records and checks and balances contributed significantly to the downfall, as best summarised by the now infamous quote from John J. Ray III, who replaced Sam Bankman-Fried as chief executive of FTX as it fell into bankruptcy: “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”

While the cryptoasset space has shown some remarkable resilience in the face of substantial challenges, if it is to remain a disruptive influence on modern finance, its biggest businesses will need to start taking governance seriously. The incoming flood of regulation may force them to do so whether they want to or not.

Fallout and regulation

Regulation of financial services tends to emerge either where failure risks having a systemic impact on financial stability or where failure might impact vast numbers of consumers. Legislators are also mindful of gaps emerging due to the march of technology.

While the true scale of the FTX collapse remains to be seen, particularly in terms of those impacted and its likely knock-on effects, it is clear that many retail customers using the exchange, and significant venture capital investors who had invested in it, have lost out. However, even in what is recognised as being the most significant cryptoasset business collapse to date, there has not been a significant or material impact on the stability of the financial system as a whole, suggesting that the industry may not yet have reached a systemic level.

As such, while systemic risk is likely to be on regulators’ minds, consumer protection and a need to grasp the mantle appear to be the driving forces behind much of the regulation that is currently emerging. It seems that regulators are intent on bringing cryptoassets within their control, but the impact on the ecosystem as a whole remains to be seen.

In the European Union (EU), the Markets in Crypto Assets Regulation (MiCA) is expected to be published in 2023, likely coming into force by the end of 2024, providing a harmonised set of rules for significant cryptoassets, exchanges, stablecoins and wallet providers, with a view to enhancing financial stability and consumer protection. In the UK, HM Treasury is currently consulting on proposals to regulate activities relating to a wider range of cryptoassets (certainly wider than its previous proposals to cover only fiat-backed stablecoins) in line with its approach to mainstream finance, including in respect of financial promotions.

In the US, long the epicentre of cryptocurrency litigation and restructuring activity, lawmakers are holding hearings on FTX’s collapse and regulators continue to pursue cases against crypto industry participants for breaches of securities law and sanctions. The US Bankruptcy Court has set significant precedent, determining that assets of certain previous customers of Celsius are assets of the insolvent estate rather than held on trust for the customers, and will no doubt continue to do so as the Three Arrows liquidation and Voyager, Celsius, FTX and BlockFi Chapter 11’s rumble on.

Any wide-reaching regulation affecting cryptoasset businesses will bring with it significant compliance challenges. Failure to comply will likely result in civil penalties, suspension of licences, or potentially even criminal liability. While the traditional financial world has lived with this for a long time, crypto businesses will need to navigate the regulatory landscape in one or more jurisdictions in a manner that has not been required of them previously. Of course, crypto businesses are frequently located in jurisdictions with lesser regulation, but the US, EU and UK are three very substantial markets that businesses will not want to miss out on. While regulatory standards will no doubt differ across the globe, those three markets may have the power to set the benchmark for compliance. Only time will tell what regulation will come into play before any other large crypto failures occur, and how the cryptoasset industry will evolve and adapt to a new regulated environment.

Nick Cooper is an associate, Emma Gateaud is a counsel and Claire Harrop is a senior associate at Freshfields Bruckhaus Deringer. Mr Cooper can be contacted on +44 (0)20 7936 4000 or by email: nicholas.cooper@freshfields.com. Ms Gateaud can be contacted on +44 (0)20 7936 4000 or by email: emma.gateaud@freshfields.com. Ms Harrop can be contacted on +44 (0)20 7427 3259 or by email: claire.harrop@freshfields.com.

Nick Cooper, Emma Gateaud and Claire Harrop

Freshfields Bruckhaus Deringer