The Organisation for Economic Cooperation and Development (OECD) analyzed the crypto winter in a new policy paper titled âLessons from the crypto winter: DeFi versus CeFi,â released Dec. 14. The authors examined the impact of the crypto winter on retail investors and the role of âfinancial engineeringâ in the industryâs current problems and found a lot not to like.
The paper from the OECD, an intergovernmental body with 38 member states dedicated to economic progress and world trade, concentrated on events in the first three quarters of 2022. It placed the blame for them squarely on a lack of safeguards due to ânon-compliant provision of regulated financial activityâ and the fact that âsome of these activities may fall outside of the existing regulatory frameworks in some jurisdictions.â
The report noted that institutional market participants exited their positions sooner than retail investors, who may have even continued to invest as the market collapsed. Investors in TerraUSD (UST), for example, had âlittle understanding of the circular and reflexive character of the so-called stablecoin, which had no tangible value.â Meanwhile, contagion spread through the industry due to its high interconnectivity.
The crypto winter also âexposed new forms of financial engineeringâ that had a negative effect on the market. According to the report:
âDevelopments such as liquid staking, creating derivatives backed by illiquid locked assets, create extreme liquidity transformation risk and maturity mismatches. Consecutive rounds of re-hypothecation of crypto-assets that are considered by platform clients to be lent and/or âlockedâ as collateral create risks related to high leverage and liquidity mismatches in crypto-asset markets.â
Many of those practices derive from the âcomposabilityâ of decentralized finance (DeFi), that is, the ability to combine smart contracts to create new products, and the practices continue unabated, the report said.
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 wade into the CeFi/DeFi divide within crypto, noting that DeFi worked âwithout issuesâ in the first half of the year, although DeFiâs automated liquidations could lead to greater market volatility. Both types of platforms may lack regulation or regulatory compliance, and CeFi and DeFi are highly interconnected in a concentrated ecosystem.
Related: OECD releases framework to combat international tax evasion using digital assets
More faults were found in DeFi. The report documents an oracle failure during the Terra ecosystem collapseÂ thatÂ created opportunities for abuse on some exchanges. Differences in information access led to DeFi and CeFi platforms behaving markedly differently during that crisis. The report noted:
âCeFi and DeFi markets work better in bull markets.â
The report stressed the need for educated retail investors. âWhen appropriate disclosure about risks is not provided by market participants, policymakers could provide warnings to investors, and in particular to retail investors, about the increased risks of such activities,â it said. It added that crypto market crises will have greater potential to spill over into traditional markets as the industry develops, and international coordination would be necessary âto avoid regulatory arbitrage opportunities currently exploited by some non-compliant crypto-asset firms.â