The Organization for Economic Cooperation and Development (OECD) analyzed the bear market in a new document titled “Lessons from the Crypto Winter: DeFi vs. CeFi,” published Dec. 14. The authors examined the impact of the current bear market on retail investors and the role of “financial engineering” in the sector’s current woes, and found much to dislike.
The document from the OECD, an intergovernmental organization with 38 member states dedicated to economic progress and world trade, focused on the events that occurred in the first three quarters of 2022, and attributed them directly to the lack of safeguards due to the “non-provision of of regulated financial activity” and the fact that “some of these activities may fall outside the existing regulatory frameworks in some jurisdictions”.
The report noted that institutional market participants exited their positions earlier than retail investors, who may have even continued investing as the market slumped. Investors in TerraUSD (UST), for example, had “little understanding of the thoughtful, circular nature of the so-called stablecoin, which had no tangible value.” Meanwhile, the contagion spread through the sector due to its high interconnectivity.
The bear market too “exposed new forms of financial engineering” that had a negative effect on the market. According to the report:
“Developments such as liquid staking, which create derivatives backed by illiquid locked assets, create extreme risk of liquidity transformation and maturity mismatches. Consecutive rounds of re-mortgaging of crypto assets that platform clients consider borrowed and/or “locked” as collateral create risks related to high leverage and liquidity mismatches in crypto asset markets.”
Many of these practices derive from the DeFi “composability”, that is, the ability to combine smart contracts to create new products, and the practices continue unabated, according to the report.
1/Excellent new research by the OECD on the role of #CeFi and #DeFi in the crypto turmoil. #Crypto Advocates may try to fault centralized players, but do not overlook the role of DeFi. Smart contract flaws + leveraged trading fueled volatility. https://t.co/EVCRhp3y0a pic.twitter.com/lWA2PeUclw
— Brian Laverdure, AAP (@brian_laverdure) December 14, 2022
The authors delve into the CeFi/DeFi divide within the cryptocurrency market, noting that DeFi ran “smoothly” in the first half of the year, although DeFi’s automated liquidations could lead to further volatility in the market. Both types of platform may lack regulation or compliance, and CeFi and DeFi are highly interconnected in a concentrated ecosystem.
More flaws were found in DeFi. The report documents an oracle failure during the collapse of the Terra ecosystem, which created opportunities for abuse on some exchanges. Differences in access to information caused DeFi and CeFi platforms to behave remarkably differently during that crisis. According to the report:
“CeFi and DeFi markets perform better in bull markets.”
The report underscores the need to educate small investors. “When market participants fail to adequately report risks, policy makers could warn investors, and particularly retail investors, of the increased risks of such activities,” notes the report. He added that crises in cryptocurrency markets will have a better chance of spilling over into traditional markets as the sector develops, and international coordination would be necessary “to avoid the regulatory arbitrage opportunities currently being exploited by some crypto asset companies that are not in order”.
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