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Swarm Markets: Crypto Has a Collateral Problem – What’s the Solution?

“Winter is coming.” A phrase many became familiar with through HBO’s Game of Thrones, alluding to a long-lasting, dangerous and turbulent time ahead. In the crypto world, Winter has come, and after a year of struggles, there finally appears to be light at the end of the tunnel. But what’s to stop this sort of downward spiral from happening again?

In the crypto world, the domino effect is apparent. When one digital currency collapses, there is a ripple effect that impacts others. Even if they have nothing to do with the impacted one, all cryptos feel the effects of it. Swarm Markets is a licensed DeFi platform — a unified exchange for securities and crypto.

The platform’s co-founder, Timo Lehes has over 20 years of experience working in the fintech field, and experienced the impact of the 2008 financial crisis first-hand. Drawing similarities to that event, Lehes has noticed the collateral impact cryptocurrencies are having on one another is hindering their mainstream adoption. Fearing a repeat of what happened in 2008, investors are cautious about investing in the digital world.

Timo Lehes, co-founder at Swarm Markets
Timo Lehes, co-founder at Swarm Markets

So what’s the solution? Lehes told The Fintech Times the introduction of real-world assets to the blockchain was a must to tackle crypto’s collateral problems:

Crypto has a collateral problem – here’s a solution

The events of the past few months – which began with Celsius and goes on now with FTX – have laid bare one of the biggest failures of the crypto sector since its inception. That is the failure of collateral and transparency.

Crypto began with small, often ideologically driven projects over a decade ago. In the intervening period, it has grown exponentially to represent a diverse array of ideas, technologies and innovations.

But one unifying issue has been laid bare these past few months. Crypto, broadly speaking, has created a market from scratch of digital currencies and tokens, starting with Bitcoin, then Ethereum and later protocols such as Maker, Uniswap and many more.

Domino effect

Although Bitcoin and protocol tokens do different things and have different value cases while underpinning key functions of many projects, the market itself has become too heavily correlated with itself. When one crypto asset sneezes, the rest of the market tends to catch a cold. There is also a tokenomics issue, where in some cases, tokens can be produced or ‘printed’ at whim.

This year, we have seen projects or platforms failing to provide the right collateral for its token or underlying, mostly yield-bearing, services. A lack of transparency, or even sometimes sheer lack of coherence, has exacerbated this problem to disastrous proportions.

Celsius and FTX, via their affiliates, seemed to have overleveraged their positions and failed to post collateral either in insufficiency or in quality. Inherent within this were systems, risk management and transparency failings that caused sizable collapses.

Crises such as Celsius and FTX have done great damage, which will only be repaired if the sector looks to adopt solutions to this collateral problem. Not only do we need to diversify the type of collateral available within the crypto ecosystem, but the market needs transparency and better protocols to verify assets are where we think they are.

Preventing disaster 

Some firms are offering new ideas such as proof of reserves. However, these solutions only provide singular snapshots rather than giving consistent proof of collateral.

As consumers have limited abilities to truly assess the validity of financial audits, regulators will continue to step in in order to protect the consumer. Regulators will reach this conclusion in the same way as they did for banks during the financial crisis and act accordingly. It’s incumbent upon the sector to be wise to this and provide better solutions that return confidence to the market.

For us this means creating collateral confidence. The sector needs more confidence about on-chain collateral issuance, attestation, certification and redemption to facilitate trading, lending and staking. Invariably it means more collaboration with regulators and trusted third parties to oversee ongoing collateral obligations.

History doesn’t repeat itself, but it often rhymes

The platforms at the centre of this year’s chaos offered tokens, products and services that were untethered from any kind of tangible collateral. The highly correlated assets sent leveraged positions spiralling, as soon as these tokens came under real pressure from global investment market pressures.

This led to carnage as user confidence evaporated – essentially creating digital runs on the exchanges. It has also led to a resurgence of self-custody by crypto holders.

These are novel platforms, but this problem is one which banks faced in the bad old days of casino banking. For years, major financial institutions played with customer deposits, while collateral and risk management obligations imposed by regulators were trifling.

This ended after the Great Financial Crisis (GFC). Legislators and regulators got tough on banking with measures such as Dodd-Frank in the US and EMIR or Basel II in the EU and UK.

In a sense, crypto has now had its own GFC. The net result will be the same for the sector as it was for banks in 2008-09 – more regulatory oversight, capital and collateral obligations.

Enter digital assets

Amid the noise of high-profile collapses and market issues in the crypto space this year, the quiet work of building a new and profoundly important market for digital assets is well underway.

There is likely to be a marked shift away from the speculative asset bubbles of the early days of crypto toward the institutional adoption of DeFi technologies. In order to digitise assets that plug into the deep liquidity of traditional markets, participants must be able to verify their existence on demand.

Trusted and transparent infrastructure must combine with trusted actors, like a regulated institution or auditor, who do not own the collateral but can attest to its existence. Timestamps and records can be facilitated by immutable blockchain technology.

There’s already a growing list of major institutions looking to create ecosystems for digital assets to work within, which could be the defining trend for the future of DeFi.

The use of stablecoins and wider digitisation of RWAs is the future of the crypto sector. The endgame of this will be the unification of traditional asset classes and institutions with modern digital blockchain technologies led by the DeFi sector.

It is through these kinds of innovations, drawn together with sensible regulation and the wider onboarding of RWAs, that crypto can move on from the Winter of 2022, and toward its crucial role in the technological future of global financial infrastructure.

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