Crypto future: growing pains or bursting bubble?

Once touted as the future of finance, cryptocurrency has taken a few steps back in recent months. With the collapse of FTX demonstrating its volatility and the emergence of crypto shadow banking showcasing its potential for high risk and high reward, many are questioning if the current iteration of crypto will reach the heights that many first predicted for it. So, is crypto just experiencing growing pains or has the bubble well and truly burst? In this article, we take a closer look.

Shadow banking

The Corporate Finance Institute defines the shadow banking system as “the broad collection of financial institutions and financial markets that offer the same type of services as commercial banks but that are not within the regulatory environment that traditional banks are subject to.”

Anton Golub, a Strategic Advisor at decentralized OTC marketplace Pazar, claimed in a LinkedIn post that Genesis Trading is the largest player in crypto’s shadow ecosystem. Golub uses their loan book as a proxy for their shadow banking activities and says their active loan value collapsed from a peak of almost $15bn in Q1 2022 to $2.8bn in Q3 2022, a drop of over 80% in less than six months.

According to Brendan Beeken, the Chairman of Moni Talks, Genesis Trading is not the only company engaging in shadow banking practices either.

He says: “If it looks like a duck, quacks like a duck, and acts like a duck, then it is a duck – so the saying goes. But just because it acts like a bank, that doesn’t make it a bank, and this is the case with shadow banks. Some exchanges and entities within the sector do act like this. FTX was a true example. It has been going on under the noses of governing bodies for too long. My concern is how quickly policies can be implemented globally to ensure shadow banking – which symbolises one of the many failings of the financial system leading up to the global financial crisis – stops!”

However, banking industry expert Emmanuel Daniel says the practice in crypto is tiny compared to other shadow banking industries.

He continues: “I would argue that the crypto shadow banking industry has not even started yet. The phrase is a reference to the lending and leveraging of cryptoassets in decentralised finance to generate income. Shadow banking refers to activities of non-banks to lend to traditional bank customers to leverage their traditional assets. The crypto version is mostly contained within the decentralised finance space where the lending and leveraging is designed to fund staking and generating new cryptoassets. This kind of lending is an important component of growing the digital asset space, which is an area that banks are not present in the first place.

“Naturally, when leveraging grows unbridled, the fall in the value of the primary asset that is leveraged causes a chain reaction that destroys all the players that are exposed to the credit. It is true that in the absence of regulations on how much capital the lenders in the crypto space should carry, or how they should value their assets, many of the players over-leverage and cannot survive a liquidity crunch. They deserve the consequences, especially if they have been greedy.

“But these fallouts are an important part of maturing an industry. It removes bad actors, it strengthens decentralised finance so that no one player is able to dominate the asset, and it causes the industry to start self-regulating and set in place governance structures. All very reasonable phases in the growth of any industry.

“The fallout in crypto shadow banking was not a symptom of a problem in the crypto industry, but a forerunner of the fallout that was to come in all other regulated lending industries. We now see the fallout in the banking industry itself, with banks like Silicon Valley Bank, which has nothing to do with crypto going into a tailspin because the traditional lending assets it was invested in started to lose their value, including treasury bonds. I am waiting for widespread corporate defaults next.”

So, although the lack of regulation poses some risk, especially where crypto lenders who over-extend themselves are present, crypto shadow banking may not be as widespread as many think, and any potential fallouts could just be a precursor to a better regulated, more-refined crypto industry.

 FTX’s failure

Speaking of fallouts, the collapse of cryptocurrency exchange and hedge fund FTX in early November 2022 is the biggest seen in the industry to date. Its collapse knocked billions off the crypto market, taking it below a $1trn valuation. Incredibly, just hours after filing for bankruptcy, FTX experienced a possible hack and close to $500m worth of tokens were stolen.

According to Beeken, the crypto market has not yet recovered from its collapse either.

He continues: “With other collapses in the sector, from banks to lenders, we are seeing uncertainty still and a cautious approach from the average investor. I do think, unfortunately, that we will see another top 20 exchange disappear from the industry, but we need to focus on the long term now and look for stability, along with regulation.”

Daniel Takieddine, CEO MENA at BDSwiss, says the risk of collapse also remains present as cryptocurrency prices remain at very low levels after a year-long decline.

“Several entities have assured their partners and clients of possessing sufficient reserves to operate but the nature of those reserves has not always been clearly and independently identified,” continues Takieddine. “Moreover, the absence of regulation leaves some uncertainty in this regard. We have periodically witnessed episodes of major crypto industry players failing, adding to the pressures on the sector.”

As the lack of regulation is creating some uncertainty in the sector, does this mean crypto will become better regulated in the future?

Beeken believes regulation of the sector is “inevitable” and “essential”.

He says: “We are seeing the shift in the UK happening this year with the impending Financial Promotions Regime. However, just having regulations in place in relation to anti-money laundering (AML) and promotion isn’t enough when it comes to cryptocurrency exchanges. This industry needs to be regulated to a level like that of a stockbroker, that’s where the industry needs to be long-term. Regulation of assets should ensure we don’t have as many scams in the market or projects with a short-minded mindset. Those investing need to do their own research and investigate the project behind the asset rather than just its short-term performance.”

However, looking at the US, Emmanuel Daniel says the different regulatory agencies are pursuing sometimes widely different agendas.

He comments: “The SEC wants to regulate cryptos as a security, the OCC wants to regulate stablecoins as deposit taking companies and so on. They are fast in punishing a Binance for crimes it has not committed yet, and very slow in pursuing an FTX for its clearly reckless and criminal conduct. They are very accommodating of a Circle and its USDC stablecoin but quick to pursue other stable coins and Silvergate’s exchange network, Sen. I certainly believe that the SEC’s definition of all cryptos except Bitcoin, as a security, has a potentially positive impact on “cryptonomics” or the economics that drives crypto today to be valuable only because of its price hikes. The real value in crypto is in its utility and applications.”

The future for crypto

It seems crypto’s future is one that will be better regulated. But that’s not all. Traditional banking institutions, such as Morgan Stanley, Goldman Sachs and the biggest bank in the US, JP Morgan Chase, have already jumped on the cryptocurrency bandwagon and more could follow suit.

According to Beeken, institutions large and small cannot ignore the shift in this sector and risk being left behind but the current recessionary environment, crypto’s volatility and the collapse of Silvergate Bank at the end of last year mean there will be caution from many institutions. However, he believes that big names embracing the space can only have a positive impact in the long term.

Takieddine also believes the tough economic climate could also have an impact on the willingness of big institutions to get involved in the crypto space.

He says: “The cryptocurrency market has been in a consolidation phase after declining for more than a year while investors’ sentiment improved to a certain extent. However, the market could come under renewed stress as inflationary pressures could push major central banks to continue tightening their monetary policies more than was previously anticipated. As a result, and like other risky assets, cryptocurrencies could see a decline in prices this year before lower inflation and softer monetary policy allow for more suitable conditions.”

So, just how significant will crypto’s role be in the future of banking?

According to Daniel, the highly paid bankers will only confirm what the cryptokids have always known: the future is in decentralised finance that will require these traditional banks to reimagine their own roles in the future of finance.

Cryptocurrencies have certainly experienced a few hiccups in recent months and, combined with the tough economic climate we’re currently experiencing, those operating in the industry are likely to proceed with caution in the near future. However, with regulation looking like an inevitability and more traditional banking institutions plunging themselves into the world of cryptocurrencies, the long-term outlook for the future still looks very bright indeed.