Interdependencies in Crypto Ecosystems: Drivers, Implications and Policy Responses

24 Pages Posted: 1 Mar 2023 Last revised: 12 Apr 2023

See all articles by Douglas W. Arner

Douglas W. Arner

The University of Hong Kong; The University of Hong Kong - Faculty of Law

Tanvi Ratna

Policy 4.0.

Sijuade Animashaun

The University of Hong Kong

Jatin Bedi

Policy 4.0.

Date Written: February 16, 2023

Abstract

A paradigm shift is manifesting in the global crypto ecosystem. Akin to traditional financial systems, crypto markets are fast-developing into networks of complex interrelationships between systems and significant market participants. The events of the crypto winter, which began in early 2022 with the crash of sister tokens USDTerra and Luna and resulted in a series of cascading crashes, underscore the significant potential that interconnection, interdependencies, systemic risks and contagion can have in the evolving ecosystem. Compared to traditional finance, which is underpinned by a wide range of regulatory and supervisory interventions of central banks and other international and domestic regulatory bodies, the crypto space remains largely unregulated.

In this paper, we explore the role of interdependencies in the effectiveness of internal risk management practices and crisis control mechanisms in the crypto ecosystem. In particular, we highlight the role that known factors contributing to interdependencies in traditional financial systems have had in crypto ecosystems. Following this, we use case studies of several significant events of 2022-2023 in evaluating the role of these emerging interdependencies in recurring crisis cycles by overwhelming internal risks management mechanisms and propelling known and unknown systemic risks.

These interdependencies create a clear web of “systemically important crypto institutions” in the crypto ecosystem. These institutions take a variety of forms, spanning the range of crypto infrastructure, crypto intermediaries and crypto conglomerates. These interdependencies have been worsened by a lack of transparency, poor risk management and market misconduct. There is a need to build regulations for crypto based on where the risks actually are in the crypto ecosystem, focusing on identifying actual vulnerabilities and applying focused approaches to address market failures and negative externalities in order to support market functioning and development. If we are to design regulations, we must first properly understand the dynamics that underlie market failures and negative externalities in the crypto ecosystem which have been put into stark relief by both the crypto contagion of 2022-2023 as well as a range of other crises which have emerged over the evolution of crypto.

From this basis, we suggest three fundamental adjustments as potential approaches to risk management and crisis mitigation going forward: (1) substantial remodelling of internal risk frameworks to consider broader risks perspectives arising from direct and indirect interdependencies; (2) restructuring of risk control and crisis mitigation practices through regulation and supervision to address interconnections and interdependencies arising in the crypto ecosystem, similar to those which have evolved in traditional finance; and (3) supporting the evolution of decentralised frameworks through appropriate guidance to take into account lessons and experiences in system design and operation.

Keywords: FTX, cryptocurrency, crypto regulation, stablecoin, financial crisis, crypto crisis, interdependency, SIFIs, risks management, systemic risks, DeFi, crypto conglomerates, macroprudential regulation

JEL Classification: K10, K20, O30, O10, G01, G21, G28, K23

Suggested Citation

Arner, Douglas W. and Ratna, Tanvi and Animashaun, Sijuade and Bedi, Jatin, Interdependencies in Crypto Ecosystems: Drivers, Implications and Policy Responses (February 16, 2023). University of Hong Kong Faculty of Law Research Paper No. 2023/17, Available at SSRN: https://ssrn.com/abstract=4361739 or http://dx.doi.org/10.2139/ssrn.4361739

Douglas W. Arner (Contact Author)

The University of Hong Kong ( email )

Pokfulam Road
Hong Kong, Pokfulam HK
China

The University of Hong Kong - Faculty of Law ( email )

Pokfulam Road
Hong Kong, Hong Kong
China

HOME PAGE: http://hub.hku.hk/rp/rp01237

Tanvi Ratna

Policy 4.0. ( email )

NGEF Lane
Indiranagar
Bangalore, Karnataka 560038
India

HOME PAGE: http://www.policyfourpointo.com

Jatin Bedi

Policy 4.0. ( email )

NGEF Lane
Indiranagar
Bangalore, Karnataka 560038
India

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