June 14, 2022

Crypto market instability and what investors should be thinking about

Faculty of Law assistant professor Ryan Clements discusses the complexities of the crypto-asset ecosystem
Ryan Clements
Dr. Ryan Clements, SJD

Recent volatility in the cryptocurrency market has undermined confidence among some crypto investors.

In mid-May 2022, crypto markets reeled as investors sought safe haven from risky assets and the world's largest "algorithmic stablecoin," TerraUSD (UST), failed in catastrophic fashion, erasing many billions of dollars in a matter of days and creating a contagion sell-off across other crypto assets.

Terra promoters had previously claimed that this wouldn't happen, that their coin was a "stable" store of value, and that it was safely pegged to the U.S. dollar. The collapse had devastating consequences for many unsuspecting investors who didn't realize how risky their crypto investments actually were.

Several months prior to the crash, Dr. Ryan Clements, SJD, assistant professor and chair in Business Law and Regulation at the University of Calgary's Faculty of Law, published a law review paper identifying concerns around algorithmic stablecoins. He also warned about these concerns in several high-profile pieces in April before the crash, including the Wall Street Journal, Fortune, Barron's and CoinDesk

Algorithmic stablecoins are one of several unregulated areas right now in crypto. Clements’ work on this subject has now been cited in more than a dozen major media outlets since the crash. While this might be enough to scare off some potential investors, crypto is still a flourishing industry, with no sign of slowing down soon.

Clements spoke with UToday about where to start when it comes to investing in cryptocurrency, the recent instability in the market and emerging regulatory frameworks for crypto assets:

If someone wants to invest in crypto, what is the first thing they should do?

If you are thinking of getting started in investing, the Alberta Securities Commission (ASC) has published a helpful checklist to assist potential investors. However, the first thing anyone should have before investing in crypto is a basic understanding that a crypto asset is, in fact, a risky asset. It is not the same as money. Even stablecoins have unique risks. Historically, crypto assets, including the largest ones like Bitcoin and Ether, have been extremely volatile. Therefore, if you are holding a crypto asset because you believe it is a money substitute, then you should be prepared for significant volatility in the price movement of your crypto. 

What considerations should someone keep in mind before investing?

There are many other factors to consider. Importantly, how will you hold your crypto asset? Will you “self-custody” using a digital wallet and private keys that you control, or will you rely on an intermediary? If an intermediary, is this intermediary in compliance with all applicable regulatory frameworks? 

With respect to the crypto asset itself, what due diligence have you done? What is its intended purpose? How many coins are in circulation? There are many, many other questions to consider, and using the ASC’s published checklist as a starting point is a good idea.

Recently, in the news, we’ve been hearing about instability in crypto markets. What factors play into that?

Even though Bitcoin, and many other crypto assets, have purported use value as a form of online “money,” that’s not how they have been used or traded to date. Rather, crypto assets have been held as an investment, and have traded largely in correlation with other high-risk assets like technology stocks, making them a very volatile asset class. 

Earlier in May, when central banks started to raise rates, there was a large crypto-asset market sell-off, alongside a broader technology and risk asset sell-off as investors retreated to safe assets. There was also a significant market event in mid-May which impacted the larger crypto-asset ecosystem. That is, the largest “algorithmic stablecoin” in existence, Terra (UST), failed in a catastrophic fashion, alongside its investment token, LUNA, wiping out a combined market value of over $60 billion at their peak. The failure of Terra exacerbated the general market sell-off in crypto.

How do sound regulations help to make crypto investing more stable?

I strongly believe that a sound regulatory framework  which provides investor and consumer protections, ensures fair and efficient markets and establishes safeguards against financial system instability  is critical to create trust in emerging technology ecosystems like crypto. Regulation and innovation are not mutually exclusive concepts. In fact, for innovations like crypto to thrive long-term, and be widely used by society, there must be an ecosystem of trust. 

Canadian regulators are doing a good job at balancing innovation supportive frameworks in crypto, while ensuring adequate consumer protections, fair and efficient markets, and financial-system safeguards. Sound regulations provide several benefits to investors including risk and fee disclosures, conflict-of-interest policies, safekeeping of assets, confidentiality of personal information, reliable record-keeping and reporting, fair pricing, and measures that prevent against market manipulation, fraud and other harmful practices.

How do gaps in the regulatory framework around crypto expose investors to harm?

Advocates in crypto-asset spaces often tout the benefits of “disintermediation” and the ability of individuals to obtain analogous financial products, services and applications peer-to-peer on a blockchain, without having to use legacy institutions like banks, investment dealers or stock exchanges. The problem is that these advocates don’t often identify the risks to investors in doing so, or the “gaps” in the regulatory framework that leave investors exposed to potential harm. 

For example, consider investors who lost substantial amounts from the Terra (UST) collapse and failure. The Wall Street Journal reported that many investors had their entire life savings wiped out, without understanding the risks in what they were investing in. They thought that, because Terra simply called the crypto asset a “stablecoin,” that it would be stable. It wasn’t stable at all. Investors didn’t realize how many unrealistic assumptions this claim of stability relied on. There were no standardized disclosures for the algorithmic stablecoin or the related DeFi (decentralized finance) savings application that was promising unrealistic returns, and no recourse mechanisms for investors against misrepresentations by the issuers and promoters of these coins and DeFi applications. Interestingly, I was interviewed by the Wall Street Journal, and in several other media outlets, nearly a month before Terra’s crash, where I warned of the risks in these coins, and I was personally attacked by Terra promoters on social media for doing so. This is one example of the unregulated “Wild West” environment that still exists in many corners of the crypto ecosystem where investors need to be very careful.

What do you see as the greatest threat to prospective investors going forward?

Retail investors in the crypto space are largely utilizing intermediary firms and products, like crypto asset-trading platforms which provide a custodial solution on an app that resembles a stock-trading app, or crypto exchange-traded funds that can be purchased through a brokerage account. This isn’t surprising to me, as investors like dealing with processes and applications that are familiar to them. It is, however, one of the paradoxes of the crypto space. Crypto’s fundamental attribute is “decentralization” and “disintermediation,” yet the market is growing largely around the use of centralized intermediaries, similar to legacy finance. The benefit of this evolution, however, is that regulatory frameworks are able to easily apply to these intermediaries, similar to how they apply to stocks and other investments. 

Where the regulatory application is much more challenging is when investors “self-custody” crypto assets and use DeFi applications to interface with a smart contract directly. There doesn’t seem to be evidence, however, that most retail investors are engaging with crypto this way. Rather, the DeFi space is largely populated by institutional investors seeking high returns and longstanding crypto-market participants. I believe that trust in the DeFi ecosystem must increase before we will ever see widespread retail consumer take-up, or the disintermediation of legacy institutions like banks, exchanges and investment dealers. To create trust, we need sound regulatory policy and enforcement in this area. 

What advice do you have for anyone who wants to get into the crypto market?

Do your research, speak with an investment professional, determine your individual risk profile and understand the unique risks of the specific crypto assets that you are wanting to invest in. 

The Canadian Securities Administrators (CSA) provides a national public database for registered firms and advisors, and updates a list of firms who have obtained compliant status as registered crypto asset-trading platforms. If you want to “self-custody” crypto assets, through your own crypto wallet, then you need to ensure that you adequately safeguard against cybersecurity risks, and that you have a private key-management system in place. Fraud and hacking are very common on DeFi applications, and much of the DeFi space is operating without regulatory safeguards like registration requirements and standardized disclosures, so investor due diligence is paramount. As the CSA has recently warned, fraudsters are everywhere in the crypto space and lure investors using use high-pressure tactics and misrepresentations about returns.

How have students at the Faculty of Law been involved in exploring emerging regulatory frameworks for crypto assets?

For several years, I’ve taught a very unique course at the Faculty of Law called Fintech Law and Policy. It was the first course of its kind in Canada, and in this course I help students understand the regulatory frameworks that apply to financial technology, including crypto assets, blockchain and DeFi in Canada, and become familiar with comparative international regimes. Through this course, students learn to recognize the challenges in regulating crypto assets, blockchain and other decentralized applications which extend beyond national borders. They also become familiar with regulatory adaptations that are being used in the crypto space, including regulatory “sandboxes," like that recently created through the Financial Innovation Act in Alberta, to provide flexibility while ensuring adequate systemic risk and consumer-protection safeguards.

The course helps law students as they progress in their legal careers, either working as legal counsel to emerging technology and crypto-asset firms, as “in-house” lawyers at these firms, or in the regulatory space as a lawyer with a regulatory agency. Students are able to analyze emerging areas of finance and evaluate evolving gaps in the regulatory framework. At the Faculty of Law, we also help facilitate summer job opportunities in the financial technology space, including with the regulator, where students can apply these concepts in real applications.

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