Why the crash enhances crypto’s potential

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o one wants to see losses like this, and it is not hard to imagine the human stories behind them. But every time there is a market drop there is also progress. Because these events hasten an inevitable but extended process of innovation and integration that will have the ultimate effect of bringing DeFi closer to mainstream finance and, in the process, create huge opportunities for everyone.

Behind the noise and the headlines created by fast money DeFi is a quiet and beneficial revolution that is already happening. Consider the potential when anyone with a cryptocurrency wallet has access in a few seconds to a system that allows them to utilise a lending market without going through cumbersome bank paperwork or to exchange frictionlessly without going through a marketplace. That creates the means to connect borrowers and lenders and deploy capital seamlessly and instantly at a fraction of the cost of existing structures. DeFi democratises that extraordinary capability and improves capital efficiency.

Of course, putting these tools into just about anyone’s hands is a dynamic in global finance that will benefit from careful and informed regulation. And a key effect of down turns like the one we are seeing now is that they sharpen regulatory focus on DeFi.

Whilst crypto-maximalists may resist the idea, this is a key part of the process of integrating DeFi into the mainstream. There may be concerns in the industry that overzealous regulation could make DeFi unviable (for example the current debate around the EU’s MiCA - Markets in Crypto Assets.) But there are also promising signs that some of the pioneering regulation on cryptocurrency leave the benefits of the decentralised system untouched whilst creating better protections. Switzerland’s Distributed Ledger Technology Law passed in September 2020 for example has been a leader in the space with a key feature being that digital assets under certain conditions can be held off balance sheet. That means that depositors of Digitals assets with Swiss regulated entities are protected from bankruptcies as digital assets can’t be part of any liquidation and would be fully returned to investors should the institution have an issue.

Another benefit of regulators engaging with and managing mainstream crypto assets is that their involvement and presence in the space creates a degree of reassurance for institutions. As a result, banks are just beginning to bring a crypto desk into their service offering – allowing more people to benefit from the opportunities in the crypto space but with easy access to expert advice and the reassurance that their digital assets are protected with custodian services.

In passing it should also be said that banks and regulators are the best qualified to tackle crypto’s greatest bug-bear, KYC and AML, creating approaches that utilise the inherent traceability of the blockchain. Compliance teams are already reporting that verification tools in the crypto space are becoming significantly easier to use than the cumbersome easily forged documents that are linked to Fiat currencies.

The crypto crashes are also a part of an innovation and evolution cocktail. Fast growth driven by adaptable pioneering financial technologies and an unhindered capacity to thrive or fail fast are driving an extraordinary period of development in cryptocurrency. And whilst the human impact of the kind of bear market we are seeing now is distressing, the flip side of that coin, is an environment that fosters extraordinary progress and innovation.

The space is full of examples but perhaps one of the most exciting is the upcoming “merge” of Ethereum that will create Ethereum 2. It means one of the key players in the space is moving from a Proof Of Work to a Proof Of Stake model. This matters because Proof Of Work is currently used by many cryptocurrencies and requires a blockchain mining approach generating huge amounts of capex and work that, in turn, requires energy which is frequently provided by fossil fuels. Crypto enthusiasts may argue that compared to the carbon generated by the traditional financial services sector, Proof Of Work is still better and that the ESG investing age has created a quiet revolution as miners actively seek out green, unexploited energy in order to comply.

But however you look at it, this high energy dependency and consumption is not a great look for a new technology. Proof Of Stake on the other hand involves participants validating the network by putting cryptocurrency at stake. It is more agile, and is much less energy consuming than the “ASICs” (hardware systems dedicated to performing the single cryptographic operation of hashing which secures the network in Proof of Work). Since every Ethereum 2.0 transaction will involve destruction of some of the underlying currency it will become deflationary as from October the supply of Ethereum will decrease.

The shake outs and shocks impacting the crypto sector as misallocated speculative capital are flushed can, undeniably, be shocking, but each time it happens the processes driving the evolution of this financial technology are accelerated. The underlying use case for DeFi and the opportunities it can create as a decentralised, low-cost universally accessible finance system are undeniable and that means, long term, the value it will create will grow steadily.

As with the internet, mass mainstream adoption will perhaps only really become a reality when a few super accessible, dominant and robust players emerge. Sadly, crypto crashes will happen as over valuation and speculation follow that evolutionary process (something traditional financial markets are far from immune from of course.) But for all that, we should not lose sight of the long-term potential offered by this extraordinary pioneering financial technology.