The past year has not been a good one for the crypto industry. Rug pulls, fraud and theft have caused the loss of billions of dollars. Like many other very early crypto people, I’ve been through several of these cycles in the past, and each time we came out stronger.
The big difference now is that we as an industry are no longer just a bunch of paranoid crypto fanatics who have gone back to building and innovating while ignoring the world’s naysayers. Contrary to popular belief, banks and governments are also enthusiastically continuing to build new products and competitive regulatory regimes around the world to support the next cycle.
The underlying technology has proven itself capable of scaling and has been trusted to hold and transact many billions of dollars worth of assets, thanks to the security and immutability of the underlying blockchain technology. However, counterparty risk management for crypto is still in its primitive stage, mainly provided by a few loud voices on crypto Twitter providing analysis of crypto products and institutions.
Although it may not feel like the time to celebrate, we’ve created a lot of incredible new concepts and products since the last crypto winter. In order to survive 2023, companies have to move from creating self-serving innovations and move to products that are inherently safe for the wider community. In 2023, we have the chance to overcome our trust deficiencies and cross the chasm into safe widespread adoption.
Revisiting innovations in the crypto ecosystem
Our breakthroughs as an industry were the result of hundreds of teams working hard during the last crypto winter on building very innovative technology and also on solving many of the problems we ourselves had as individuals in the crypto ecosystem,
Decentralized finance (DeFi) developers created yield-generating staking mechanisms for coin HODLers and collateralized lending protocols, allowing us to take money off the table and buy real-world assets while side-stepping capital gains tax. Other developers created new, better blockchains and practical layer 2s that allowed us to ship innovative products at scale. Better and more efficient crypto exchanges sprouted up, offering more creative leveraged ways of trading.
What is true with all of this innovation is that while it proved a lot about the value of our technology, it was also, by necessity, very inwardly focused. We solved genuine problems that people like ourselves, who hold cryptocurrencies, had at that time. A common thesis was that we needed to build trustless financial protocols where counterparty risk was a thing of the past, to distance ourselves from early exchange hacks and the exuberances of the ICO bubble.
These developments brought an onslaught of external smart money into the industry to fund large bets on tokens and the industry itself and a new class of financial products that attracted the next generation of retail crypto investors seeking yield and growth. But this caused increased interconnectedness and the mixing of tokens with considerable counterparty risk (such as FTX) eventually led to the failures of 2022.
Building the next generation of crypto use cases
This year will be the first full year of building the next generation of crypto use cases. Many experts in the field, including me, believe that the best way to drive growth in the industry is to take what we have learned from previous cycles and start applying it to practical, real-world situations to fully mature as an industry and finally cross the chasm.
In particular, we are now ready to apply tokenization and DeFi to use cases with off-chain assets and liabilities. Examples include centrally issued stablecoins as well as NFTs (non-fungible tokens) that fix an ownable and tradeable blockchain-based right to real-world intellectual property. While primarily used for crypto use cases, centralized stablecoins also exemplify tying tokenized rights to off-chain value.
A vital skill needed for this is counterparty risk management for transactions, token issuers and DeFi participants. This is still somewhat primitive and often handled by a cadre of pundits on crypto Twitter pontificating about worst-case scenarios around exchanges and protocols.
This year, the industry has the crucial task of filling critical gaps, including:
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Making stablecoins practical for traditional payment use cases.
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Making tokenized securities a reality by embracing securities law and not looking for loopholes.
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Using NFTs for financial purposes such as uncollateralized debt by actual counterparties.
By addressing these and other use cases, the industry can finally see the benefits of the technology developed in the last cycle. It is a pivotal year for the crypto industry and a chance to show its worth to the broader public.
Rebuilding trust in the crypto industry
First, we must rebuild trust as an industry; it has to be our top priority. Although our layer-1 blockchains are mostly trustless, the sector as a whole is not.
We must work toward restoring trust between each other, our end users, and financial regulators. If we, as the crypto industry, do not take the necessary steps to rebuild trust, others will. The steps we take must come from ourselves rather than imposed by regulators or traditional finance.
In the end, trust is essential for making crypto safer for everyone. Not only must we minimize risk, but we must work together to manage risk and continually improve safety. This includes minimizing theft of funds, minimizing loss of funds, minimizing rug pulls, improving data privacy, minimizing the impact of sanctions risk on critical infrastructure, and improving record keeping to meet the tax, audit and other requirements of end users and businesses.
Why has it taken so long to improve critical areas?
While a lot of innovation has happened in DeFi and NFTs since the last crypto winter, we have been very resistant to changing the core aspects of most crypto transactions. Sending, withdrawing and depositing funds haven’t changed much since the first crypto exchanges appeared more than 10 years ago. For more complex use cases such as DeFi and NFTs, most people still use Metamask or something similar, and the technology’s core hasn’t changed much since the early days of the ICO boom.
Most people still in crypto in the previous crypto winter were rightfully very paranoid about changes due to a lot of fraud and theft during the ICO boom. Yet the newest wave of crypto users joining the last few years are at a much greater risk than ever. Many early crypto stakeholders see the loss or theft of funds due to the inherent difficulty of using legacy wallets as the cost of doing business. This is not acceptable — we can and must improve this to drive the next generation of adoption.
Critical steps to overcoming the industry’s trust deficit
Our initial focus should be on counterparty risk management. Like in traditional banking, everyone from institutions to individual users needs to know and trust who they transact with to minimize the risk of loss of funds, money laundering, and exchange hacks. To achieve this, we need to rethink our approach to depositing and withdrawing crypto from exchanges and self-hosted wallets. Non-technical users should be able to expect privacy and security in their transactions, and the details should only be shared among the parties involved.
Second, we must implement higher-level authorization flows giving every transaction participant the right to reject unwanted funds or liability. Finally, contrary to popular belief, exchange-hosted crypto plays a crucial role in ensuring the privacy and security of keys for most users. On the other hand, self-hosted crypto will continue to be essential for maintaining the integrity and safety of the industry as a whole. It is the ultimate checks and balances that keep the ecosystem safe and centralized parties accountable.
None of the above should require changes to underlying protocols, yet new protocols could easily differentiate by supporting the above directly.
Infrastructure providers have already taken the initiative to address some issues centralized exchanges face. On-chain analytics, for instance, offers businesses practical tools to monitor risk and investigate incidents. Meanwhile, multi-party computation (MPC) wallet providers are simplifying key management and speeding up funds settlement. Regtech solutions are also working towards making it easier for centralized exchanges to manage the real-world risk associated with transaction counterparties.
With these building blocks in place, the time has come for us to break away from past failures and forge ahead toward attracting the first billion crypto users.
