Investor Protection and Security: A regulatory approach to crypto servicing
As crypto markets continue to show high volatility, it comes to no surprise that many new investors may be feeling uneasy about how their investments will unfold throughout the remainder of the year.
In the last two years alone, crypto’s total market capitalisation has risen over tenfold, from USD 240 billion to USD 2.9 trillion, but now currently sits at USD 930 billion as of June 2022. Questions such as “how safe are my assets?” and “how secure is my service provider” are justified, particularly as many popular crypto services have been seriously tested whilst investors attempt to pull out their funds due to market extremities. Many newcomers are realising the risks that come with locking up their investments with lending platforms. Major crashes, suspended trade activity, and potential insolvencies are all posing a real threat, so it is important to highlight some key events below.
Terra-Luna’s USD 40 billion crash resulted in investors unable to redeem their losses.
Celsius Network suspended all withdrawals, swaps, and transfers – locking USD 12 billion in assets from 1.7 million users with no date to lift the suspension.
BlockFi agreed to pay USD 100 million in penalties and pursue registration of its crypto lending product.
SEC issues a new accounting guideline asking crypto trading platforms to treat customer crypto holdings as liabilities.
Three Arrows Capital facing possible insolvency after suffering at least USD 400 million in liquidations from lending firms.
The rise in regulatory scrutiny for crypto lending firms
Crypto lending platforms have been facing increased regulatory scrutiny as securities regulators demand more oversight into their high yield bearing products. High rates look attractive, but many of these platforms are not regulated and are therefore subject to several risks. Below are a few underlying concerns when using non-regulated crypto lending platforms:
Security interests may be problematic as they do not comply with statutory frameworks. Are they valid and enforceable?
Crypto lenders may not be fully protected against market volatility. This is especially the case if crypto assets represent a large proportion of the secured collateral.
Lack of due diligence before granting crypto credit. Without this, it makes it difficult for the lender to track the intended use of the collateral.
Non-regulated platforms are not subject to capital adequacy and liquidity rules and may not be entirely transparent with their accounts. This means that during adverse shocks or major sell offs, these platforms may not be able to meet the redemption requests without risking insolvency.
How exposed are creditors to loan counterparty risk? Crypto lenders should mitigate this via over-collateralising the assets they lend out. However, this is not always transparent with unregulated crypto lenders.
Are there deposit insurances available? Interest account funds are not insured like a bank account. Basically, if the platform fails, investors can lose everything.
However, it is not just crypto lending platforms that address similar concerns. Many unregulated trading platforms have similar issues regarding investor protection, both via their exchanges and their loan products. Back in March, the SEC issued a new accounting guideline asking crypto trading platforms to treat customer holdings as liabilities. The guideline also warns investors who own cryptos on these platforms that they are effectively making unsecured loans to these companies.
Protecting investors as a regulated entity
When taking a regulated approach to crypto it is also for the benefit of protecting investors. The significant loss of funds in today’s markets prove that there are repercussions for investors using non-regulated services. However, it is the responsibility of the regulated service provider to protect its customers as they are governed by law to do so (e.g., FinSA in Switzerland). Crypto lenders should follow regulatory compliance to ensure their security interests are enforceable, their liquidity coverage is healthy, and what mechanisms are in place to help against market volatility.
Let’s take the example of a regulated crypto bank. As a regulated Swiss bank, Sygnum provides all the securities of a traditional bank. So here are a few things that regulated entities do differently whilst still servicing crypto.
Subject to capital adequacy and liquidity rules. Just like a traditional bank, they must hold a minimum amount of capital relative to its on-balance assets as set by the financial regulator (i.e., FINMA). These rules are catered to ensure that there is enough capital to absorb losses.
Due diligence process needs to be rigorous before evaluating a loan application.
Client assets are off-balance, fully segregated and therefore not subject to counterparty risk. This means that in the unlikely event of a Sygnum bankruptcy, clients still have their assets. In addition, these wallets are segregated from each other (unlike Omnibus or collective wallets on some exchanges).
Deposit insurance is guaranteed. This enables investors to confidentially place their money with regulated financial institutions.
Custody solution is independently audited and fully complaint with security standards.
Looking at the bigger picture
Not all unregulated crypto services are bad per se, but when looking through the lens of institutional investors and their protection rights, regulated crypto services triumph on these grounds. During bull markets, it is easy to get caught in up risky investments, as markets all move together in one direction. The main concern here is that when markets are down, how protected are your investments? and how trustworthy are these service providers to help you during times of uncertainty?
When looking back at previous market cycles, it is normal that many crypto service providers will rise and fall. Whether this was because of market volatility, issues with their models, security breaches or simply bad operational management, we are witnessing the outcomes of rapid innovation combined with a massive influx from mainstream with limited regulatory scrutiny. Once hype dies down, companies either fail or are forced to develop more robust systems in order to withstand market extremities.
Adverse shocks are part of the innovation process and blockchain is still in its early stages, but investors should be using these times to become smarter with their investments. This means looking at more credible service providers, investor protection measures, insurance benefits, and selecting services that are transparent with their operations.
Total Value locked in DeFi: Timestamped 23.06.2022. Source: Defillama
We’ve witnessed the DeFi boom with a peak of USD 256 billion in total value locked in DeFi. As this number has dropped to USD 74.01 billion, we should expect to see tighter regulation around crypto service providers, as the pressure to push for more security, stability and investor protection – three of the biggest concerns for institutional investors – is becoming ever more paramount.
A responsibility to build trust
It is not always the investor at fault. Rather, during times of market uncertainty, it is also our responsibility as a regulated crypto service provider to guide and protect our clients throughout challenging macro environments. More precisely, in order to avoid mistrust that derives from non-credible crypto service providers that were bound to implode.
This document is purely for educational purposes and has been issued by Sygnum Group. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication. It does not constitute an offer or a recommendation to subscribe, purchase, sell or hold any security or financial instrument. It contains the opinions of Sygnum Group, as at the date of issue. These opinions and the information contained herein do not take into account an individual‘s specific circumstances, objectives, or needs. No representation is made that any investment or strategy is suitable or appropriate to individual circumstances or that any investment or strategy constitutes personalized investment advice to any investor. Therefore, you must verify the above and all other information provided in the document or otherwise review it with your external advisors. Some investment products and services, including custody, may be subject to legal restrictions or may not be available worldwide on an unrestricted basis. The information and analysis contained herein are based on sources considered as reliable. Sygnum Group uses its best efforts to ensure the timeliness, accuracy, and comprehensiveness of the information contained in this document. Nevertheless, all information indicated herein may change without notice.