Crypto assets and crypto-related financial activities are generating considerable discourse among global regulators and financial supervisors. As key actors in the emerging alternative finance ecosystems, crypto and its market actors have drawn increasing attention to their potential policy implications, particularly on financial integrity, consumer protection and financial stability. This is primarily because crypto ecosystems remain largely unregulated compared to traditional financial (TradFi) systems. In 2021, the International Monetary Fund (IMF) highlighted the growth trend in crypto assets and trumpeted the potential financial stability risks this development could have on global financial systems. Financial stability and other core regulatory concerns have also been amplified recently with the recurring financial and market crises in crypto ecosystems, particularly since the beginning of the crypto winter in early 2022.
The regulatory ambitions of global regulators regarding crypto is higher than ever. At its inception, the majority of crypto assets and market activities were limited to the niche ecosystem. Crypto markets’—especially decentralised finance’s (DeFi)—initial core tenets of disintermediation and decentralisation implied that crypto market activities and institutions operated without interlinkages with TradFi. But recent developments have shown otherwise. According to recent reports, there has been increasing interconnections between crypto ecosystems and TradFi. Global stablecoins (GSCs) and transnational crypto conglomerates, for instance, are increasingly creating new pathways for interconnections and interdependencies between the two financial systems. As a result, the potential of crypto ecosystem transmitting risks and financial disruptions to TradFi, and vice versa, has become more pronounced, necessitating agile regulatory strategies to manage the inherent vulnerabilities.
Regulatory systems are essential to the resilience of financial systems. Through effective and efficient risk monitoring and management of markets and major financial actors, regulators are able to ensure the stability of market systems and also protect vulnerable participants, especially financial consumers. In most financial sectors of global economies, regulatory compliance is enabled by targeting the pain points in existing interconnections and interdependencies in market systems. Depending on whether the market relies heavily on critical financial activities or institutions, regulators can design their regulatory framework around activity-based or entity-based approaches respectively. However, since most crypto activities are conducted outside these major regulatory parameters, the effectiveness of traditional regulatory frameworks in the niche crypto ecosystem has been among the major concerns of global regulators. For example, the underlying technology-based framework of DeFi activities allows multiple financial activities to be stacked simultaneously, rendering any particular activity-based approach inefficient. Similarly, the borderless nature of crypto activities also imply that the effectiveness of domestic regulatory regimes on crypto institutions could easily become grossly limited by regulatory arbitrage. In addition to heterogeneities in global crypto regulatory approaches, national regulators also face considerable limitations regarding the scope of their authority, particularly on transnational institutions and financial activities. Therefore, there is a need to identify the commonalities between TradFi and crypto ecosystems as a means to effectively regulate crypto under existing traditional regulatory frameworks.
In a new report entitled Interdependencies in Crypto Ecosystems: Drivers, Implications and Policy Responses from digital finance think tank, Policy 4.0, we build on this proposition for robust and agile crypto regulations. First, it examines the dynamics of crypto ecosystems to identify whether and how similar trends of interconnections and interdependencies exist in the niche ecosystem; and if yes, what are the major drivers. Second, the research evaluates how interdependencies impacts the stability of crypto markets and the resilience of crypto institutions. In particular, the major crises in crypto ecosystems—both DeFi and centralised (CeFi) crypto institutions—are examined to identify how interdependencies have contributed to the impact these events have had on the crypto ecosystem long term. Furthermore, it considers the growing policy implications that evolving crypto contagion events could have on the stability of exposed TradFi. Lastly, to these concerns, the paper recommends a tripartite regulatory strategy to managing the emerging contagion of systemic risks and other risks management concerns: (1) substantial remodelling of internal risk frameworks to consider broader risks perspectives arising from direct and indirect interdependencies; (2) restructuring of risk control and crisis mitigation practices through regulation and supervision to address interconnections and interdependencies arising in the crypto ecosystem similar to those which have evolved in traditional finance; and (3) supporting the evolution of decentralised frameworks through appropriate guidance to take into account lessons and experiences in system design and operation.
Interdependencies in Crypto ecosystems: Drivers and Crisis Implications
Generally, interdependencies refer to interlinkages existing within financial market systems that are capable of significantly impacting the resilience of the network. According to the Committee of Payments Markets Infrastructures (CPMI), interdependencies can be categorised broadly into two types: system-based and institution-based interdependencies. In the former, the stability and performance of a system is directly and inextricably interlinked to the performance of other systems in the network. In TradFi, the interlinkages among different financial sectors, particularly arising from payments, offer an instructive example of how the function of one sector can contribute to or hinder the performance of others (e.g. investments). The latter, however, refers to mostly indirect interconnections resulting from the activities of major financial institutions (such as global systemically important financial institutions (GSIFIs)) across multiple financial systems. Therefore, disruptions or collapse of such systemic institutions can potentially disrupt the systems or market participants which rely on them for effective intermediation. Importantly, in both system- and institution-based interdependencies, the resilience of major participants in the network can affect the stability of other market actors in the system and the broader financial system. This potential contagion risks of interdependencies underlie the continuous efforts by global regulators to manage inherent risks in the critical financial market infrastructures.
In our report, we find that the mentioned categories of interdependencies and contagion risks also exists in the crypto ecosystem. Furthermore, evidence from our empirical study and relatable examples also suggest that the drivers of these interdependencies in TradFi are also applicable in crypto ecosystems, even though manifestations sometimes vary. We identify three main drivers of interdependencies in crypto ecosystems: (1) financial consolidation, (2) regulatory flexibility and public policy, and (3) technological innovation.
Financial consolidation refers to all forms of market structural integrations, especially among institutional financial actors. An instructive example of financial consolidation arrangement is mergers and acquisitions (M&A) through which two or more financial institutions jointly form a larger institution with broader leverage in the financial systems. According to the 2023 PricewaterhouseCoopers report on the growth trends in crypto ecosystems, there has been significant growth in the volume of financial consolidations among crypto firms and between crypto-native firms and traditional financial institutions (TFIs). As a result, many crypto intermediaries now have similar potentials to drive increased interdependencies in global crypto ecosystems, like GSIFIs in TradFi. Concurrently, regulatory flexibility have also contributed significantly to crypto’s growth and global acceptability. Recent reports and policy recommendations indicate that global regulatory approaches towards crypto-related assets and financial activities have mostly been permissive. Consequently, the niche ecosystem now has an increased and sustained pool of financial consumers, including retail investors and institutional shareholders. The influx of consumers have also propelled more financial consolidations among global crypto firms and TFIs to facilitate transnational financial activities “on the chain” and even in real world assets. Lastly, advancements in technology and digitalisation which underlie most crypto-related activities also stimulate increased technical and functional interconnections among crypto firms and network systems. In DeFi ecosystems, particularly, intra-ecosystem interdependencies are facilitated through embedded software protocols (e.g. oracle) and smart contracts. These technologies allow “composability” frameworks where multiple financial functions can be stacked using decentralised ledger technology (DLT) and/or blockchain. Overall, these drivers of interdependencies contribute fundamentally to the many inherent opportunities in crypto (e.g., financial inclusion). However, the drivers can also create pathways for new financial and market risks and other operational challenges that are capable of affecting whole crypto markets and, increasingly, interconnected TradFi systems.
The challenges of interdependencies in crypto markets have shown considerable potential to impact the overall efficiency of internal risks management and crisis control in the innovative financial market. To illustrate this, we explore recent case studies of the recurring crises in crypto markets, particularly since the beginning of the crypto winter that has effected both DeFi and CeFi markets simultaneously. Initially, there have been several instances of hacks and exploits in DeFi ecosystem, where loopholes in foundational protocols are leveraged in perpetuating unregulated market misconducts and other crypto-related financial crimes. The recent exploits of Mango Markets (around US$116 million) and hacks of Ronin network leading to the market losses of around USD$625million, in October and March 2022 respectively, provide instructive examples of system-based interdependencies. Similarly, the crash of Terra-Luna sister tokens and the resulting transmission of financial shocks (from high leverage and risk concentration) to major crypto institutions like Three Arrows Capital (3AC) and FTX also demonstrate that both system- and institution-based interdependencies can jointly disrupt financial systems. In particular, market actors could, as a result of interdependencies, be exposed to both known and unknown contagion risks from counterparties, similar to systemic risks which underlie the notorious Lehman Crisis. It is estimated that the crypto winter wiped out billions from the crypto market within days, while the long term contagion effects still exist. Overall, we find that through interdependencies, the vulnerabilities of emerging DeFi ecosystems identified by the Financial Stability Board (FSB) such as operational fragilities, liquidity and maturity mismatches, leverage and complexity could further complicate the existing regulatory concerns on crypto institutions and crypto markets.
Having briefly explored the drivers and crisis implications of interdependencies in crypto ecosystem, it is not hard to see how this might have potential policy concerns in global economies. In particular, the concerns around financial integrity, consumer protection and financial stability could quickly become a reality in light of the meteoric growth of crypto assets and the ever-increasing interlinkages between crypto and TradFi. The recent collapse of Silicon Valley Bank (SVB) and its effect on connected crypto firms further supports the argument that even crypto firms can now be victims of failures in TradFi. To these concerns, we propose three major internal reforms in crypto ecosystems, including the broadening of risks perspectives, the recalibration of existing risk practices and crisis control mechanisms, and the leverage of decentralised frameworks in enhancing coordinated supervision and peer learning.
First, we suggest that as a result of the increasing interdependencies, crypto ecosystems are exposed to broader risks management concerns. In DeFi ecosystems, specifically, loopholes in operational protocols can expose connected nodes to losses and contagion risks resulting from market misconducts such as oracle manipulations. Similarly, crypto intermediaries are also exposed to vulnerabilities of counterparties resulting from financial consolidations and concentration of liquidity reserve in similar crypto assets. Therefore, we propose the remodelling of internal risks management frameworks which would factor this new channel of risks when determining the adequate internal risk and stability mechanisms of crypto systems and major institutions. The existing macroprudential frameworks in TradFi developed after the last global financial crisis provide instructive templates on broader risks management in complex financial systems that could also be adopted in crypto ecosystems. Furthermore, we argue that with this proposed framework, crypto ecosystems could be better positioned to leverage the inherent opportunities in increased interconnections while also adequately managing the likely risks.
Second, the risk control and crisis mitigation practices in the crypto ecosystem requires an overhaul to align with recent market developments and emerging risk tendencies. The initially ring-fenced crypto markets have undoubtedly become more and more integrated with TradFi. As a result, the likelihood of risks crosspollination between the systems have become more apparent than ever. To manage the attendant risks and challenges of this new era, we suggest that it is important that the internal risks management practices must also evolve to compensate for the lack (or largely underdeveloped) regulatory framework. In particular, since there is presently no financial authority or central regulator applicable to crypto markets interdependencies like TradFi, we argue for the increased participation of investors and institutional shareholders in internal risks governance and oversight. The extensive interconnections resulting from heavy leverage in similar assets as stability mechanisms, for example, could be recalibrated to feature a more diversified pool of liquidity reserve assets. In this regard, it is possible that over time, the crypto markets could witness increased external oversight and more effective crisis mitigation mechanisms to meet the growing trends in the market.
Finally, decentralised frameworks inherent in crypto markets could offer new platforms for knowledge sharing and peer coordination in crypto markets’ regulatory compliance. Whether directly or indirectly, most crypto intermediaries are connected through related financial activities and engagements with systemically important crypto intermediaries. Leveraging this new market dynamic, we propose that major crypto market participants could leverage their existing interrelationships in further developing the efficiency of the market’s overall risk management and crisis mitigation frameworks. In particular, peer supervision and knowledge sharing could be enhanced through regulatory data sharing and peer monitoring to effectively and timeously identify emerging risks and manage them. Embedded supervision, for example, could be encouraged among counterparties through decentralised technologies such blockchain, allowing all connected nodes to actively monitor market conduct.
In sum, we appreciate that while these proposals could be very useful, their effectiveness may nevertheless require significant participation from traditional financial authorities. Afterall, most crypto systems and institutions are primarily profit-driven and may not be positioned to deal with policy failures. Regardless, there is no doubt that the consequences of failures in crypto markets affects all market participants and consumers. Therefore, all stakeholders may rightly be presumed to have one reason or the other to strive for the resilience of the innovative market and its institutions.
Professor Douglas Arner is a member of the advisory board of Policy 4.0. He is the Kerry Holdings Professor in Law and RGC Senior Fellow in Digital Finance and Sustainable Development at the University of Hong Kong. In addition, he is Associate Director of the HKU-Standard Chartered FinTech Academy and a Senior Fellow of HKU’s Asia Global Institute. He has published widely on the intersection of finance, technology and regulation, as well as works with a range of international and regional policy and regulatory organisations.
Tanvi Ratna is the Founder & CEO of Policy 4.0., and a recognized expert in cryptocurrency policy. She was a blockchain lead at EY India and a Fellow on cryptocurrency regulation at the New America Foundation in Washington DC. She holds a Bachelors in engineering from Georgia Tech and a Masters in Public Policy from Georgetown University and the Lee Kuan Yew School of Public Policy.
Sijuade Animashaun is an Adjunct Fellow at Policy 4.0. and a doctoral researcher at the Faculty of Law, The University of Hong Kong. His PhD focuses on the intersection of digital financial technologies with law and regulation. He has extensive experience working as a legal practitioner in financial regulations and has participated in several impactful projects with the Nigerian central bank and other key stakeholders in global financial systems.
Jatin Bedi is a Non-resident Scholar with Policy 4.0. He is a former fixed-income investment banking analyst with Nomura, who currently leads the traders tribe at a decentralized hedge fund. He holds an MBA in finance and has also held several roles in the alternative investments sector.
This post is adopted from their paper: “Interdependencies in Crypto Ecosystems: Drivers, Implications and Policy Responses” available on SSRN.