Lesson from the Crypto Winter: OECD Urges Countries to Collaborate on Regulation

The Organisation for Economic Co-operation and Development (OECD) has released a report titled "Lessons from the Crypto Winter," which suggests the need for additional regulations for the cryptocurrency industry. While the collapse of crypto companies currently has minimal impact on traditional finance, the OECD is concerned that as the digital asset industry grows, the situation may change in the future. The OECD calls for international cooperation among countries in cryptocurrency policy to avoid regulatory arbitrage opportunities and prevent global regulatory fragmentation.

CeFi and DeFi Interaction Causes Crypto Winter

The OECD report analyzed the interaction between CeFi and DeFi. CeFi serves as the primary source of funds and collateral flowing into DeFi, such as through stablecoins, acting as a lifeline, while DeFi protocols provide an ideal venue for cryptocurrency trading as they allow CeFi companies to hold leveraged positions. In its simplest form, cryptocurrency lenders borrow cryptocurrency at a certain interest rate and invest the borrowed assets in DeFi protocols, which provide higher returns as long as the market is bullish, similar to arbitrage in traditional financial markets. This behavior has led the crypto market to continuously rise during bull markets but collapse like a domino effect during bear markets, resulting in the current crypto winter.

Within this cycle, retail investors are often the ones being slaughtered in the absence of investor protection and financial regulatory measures, with some experiencing total investment losses without any recourse. Considering that some crypto whales or dominant market participants manage to exit failed platforms with limited losses or unscathed, the losses of retail investors may be even more concerning.

Asset Over-Concentration Could Intensify in the Future

The report suggests that the recent turmoil in the crypto market has exposed the high level of interconnectedness within its ecosystem, which may intensify post this crypto winter. As illustrated in the figure below, before FTX and Alameda went bankrupt, the stablecoin USDT was heavily concentrated in Alameda's hands, amounting to $36.6 billion, nearly half of the total USDT issuance. After the winter, the market may become more concentrated in the hands of a few dominant players controlling crypto assets. If any of these major participants encounter difficulties in the future, it could increase the risk of large-scale disruptions and contagion within the crypto asset market.

Potential Impact on Traditional Financial Markets

The report indicates that, at present, traditional finance has not been significantly affected by the turmoil in the crypto market, as they are relatively small in comparison and currently lack deep connections. However, with the growth of the digital asset industry, the situation could be different in the future.

The OECD report also mentions concerns about the excessive concentration of stablecoin issuers, especially with strong interactions between certain stablecoin issuers and crypto companies. The overflow of stablecoin reserves into traditional financial markets, where Tether previously held commercial paper as reserves, is also a concern for the OECD. Fortunately, Tether recently announced the clearance of its commercial paper and reduced its secured loans to zero, converting all reserves to cash and US Treasury bonds. The depth of the US Treasury market makes it less prone to liquidity squeezes.

Urgent Need for International Coordination on a Cross-Border Level

Given the global nature of crypto asset market activities, cross-border international coordination is necessary to prevent some non-compliant crypto asset companies from taking advantage of regulatory arbitrage opportunities. Cooperation between different jurisdictions can help mitigate resources and burdens by expanding solutions. Investment in enhancing skills related to the crypto industry is also needed to improve the internal expertise of regulatory agencies in certain jurisdictions, especially through the use of digital solutions for financial regulation, such as employing innovative technology for policy analysis and supervisory operations like SupTech.