‘Experience is simply the name we give our mistakes.’
Oscar Wilde
Crypto moves fast, breaks things, then shrugs and says, ‘That’s all part of the journey.’ That rapid pace of innovation certainly has developed some amazing breakthroughs, but there have also been some huge failures along the way.
The part that matters is that most big busts follow patterns. Looking back at the collapse of exchanges, the spin of stablecoins, the bankruptcy of lending platforms, or the straightforward instances of cheating, the same fault lines appear over and over.
What are the latest trends?
Crypto can have some issues because the simple things can still go wrong fairly easily. A wrong character in a wallet address, and your money is gone. And while a lack of custody can be empowering, it can be merciless too.
It’s why activities involving verified identity layers and safe transfer flows are important. The Crypto Credential initiative by Mastercard in partnership with Mercuryo and Polygon Labs involves making self-custody transactions feel more seamless by allowing users to make transactions using verified usernames rather than wallet addresses. Mercuryo is the first company that will give you the latest crypto insights and bring self-custody users into that space, and it’s the first blockchain network that will be supporting the credential. Essentially, the point is straightforward: reduce errors and make crypto transactions simpler.
However, the honest truth is that nothing can completely eliminate the danger. Nevertheless, it’s a good start in that a lot of historical failures were due to complexity, overconfidence, and a perception that seemed safe when it was not.
Lesson 1: If you cannot verify reserves and controls, assume the risk is higher than advertised
The FTX blow-up is the clearest example today of where ‘trust me’ is no actual risk model.
FTX appeared like a large, legitimate exchange for a long period until it collapsed in November 2022. According to a Reuters news piece, a minimum of $1 billion of client funds had gone missing, with billions of dollars being transferred from FTX to Alameda Research, which is a sister trading firm.
And irrespective of the platform you choose, the message for regular users remains the same: If you cannot independently confirm the Custody, Solvency, and Governance yourself, you assume Platform Risk, not Market Risk.
What can you do differently in this case?
- Make audits, third-party verification, and sound storage arrangements minimum requirements rather than added value.
- Be cautious about operators who are very secretive regarding the holding, rehypothecation, or use of assets.
- Have one rule that distinguishes ‘hot money’ from ‘sleep money.’ Trading funds may be left on the exchange. Long-term funds need one rule on custody.
Lesson 2: ‘Safe yield’ is usually a warning label, not a feature
In the traditional world of finance, yield comes with parameters of risk which are usually well-defined. In the world of cryptos, it comes with rather vague marketing. Usually, there is also leverage involved.
A good example here is Celsius. The company froze all withdrawals in June 2022 and filed for bankruptcy in July 2022. According to Reuters, Celsius attributed this to ‘extreme’ market conditions and then presented a huge hole in its balance sheet during its bankruptcy filing. Any offering that promises high returns has to earn those somewhere. It’s usually leverage and maturity mismatches.
Things to do differently:
- Just one direct question: ‘Where does the yield come from, in plain language?’
- If the answer involves sophisticated strategies which you cannot easily describe to your friend, cut down on your exposure to it.
- Beware of lockups, withdrawal limitations, and ambiguous language. In a crisis, these are the pitfalls.
Lesson 3: Algorithmic “stability” is not stability unless it survives stress
The UST crash is a testament that a stablecoin is no stronger than the ecosystem it’s pegged to when it heads south.
TerraUSD and its entire ecosystem crashed in a short period of May 2022, resulting in the loss of value of over tens of billions of dollars. According to the Associated Press, it shaved $40 billion off its value. A memo by the Hong Kong Monetary Authority mentioned the crash of May 2022, citing panic withdrawal of TerraUSD, with overall greater spillovers in crypto markets.
Algorithmic systems may be stylish in quiet periods. But it is what happens during times of lower confidence and subsequent massive redemptions that is really telling. Terra demonstrated the power of reflexive feedback mechanisms to transform stability into a stampede.
Was there something that could be done?
- Distinguish ‘price peg’ from ‘peg defense.’ How does it perform when it comes to a bank run?
- Increase transparency: clear collateral, clear redemption mechanics, and clear risk disclosures.
- Don’t stack the liquidity plan on just one stablecoin model.
Lesson 4: Single points of failure are not a bug, they are the whole story
The lessons from Mt. Gox are old news in the crypto world, but they haven’t been forgotten: the dangers of concentration risk can ruin you.
According to Reuters in 2014, Mt. Gox placed the blame on hackers for losing 750,000 client bitcoins and another 100,000 of their own. It’s dangerous when a lot of money and trust is concentrated in one place because a breakdown in one system can lead to a disaster for the entire chain because trust travels fast in one direction as well as the other.
What to do differently:
- Don’t store more data in any single service than you could stand to lose if the service suffers an unexpected freeze.
- Diversify the operational risk: Diversify where you operate, where you store, and where you interact with DeFi.
- Create a ‘failure plan’ of your own design before it happens, and include a safe and soothing process for regaining access.
Lesson 5: Smart contracts reduce some risks, but they introduce code risk (and code always has edges)
‘It’s the code that’s the law’ is a nice saying, until there’s a gap in the code.
The hack of the 2016 DAO is the classic example. This hack resulted in the loss of around 3.6 million ETH worth $50 million to the developers, thereby contributing to the hard split of Ethereum. The hack is also referred to as one of the early jolts to the world of Ethereum.
Smart contracts can remove the need for middlemen, but they can also rely on audits, review cycles, and the truth that complex systems always break at the edges.
What to do in such a case?
- View audits as necessary but insufficient. Aim for multiple audits, bug bounties, and times in the wild.
- New procedures are necessarily more risky than they appear to be. Let others be the first wave.
- Avoid being exposed to contracts that you do not fully comprehend at a high level, even if it seems to have an attractive APY.
Lesson 6: Leverage turns market dips into wipeouts, and it spreads faster than people admit
Leverage in the crypto markets is oftentimes concealed in places where you don’t really want to look, in lending books, in chains of collateral, in networks of related counterparty exposures.
Take the case of Three Arrows Capital (3AC) as a large example of how quickly leverage and complex trading lines can come apart. A court in the British Virgin Islands ordered the liquidation of 3AC in June 2022, as reported in numerous trade publications and according to court documents. When a large levered trader goes bust, this does not simply involve ‘losing money.’ Liquidations ensue.
Maybe you could keep this in mind in the future:
- If markets are feeling euphoric, it means that leverage must be rising.
- Extra cautious with yield products during easy money vibes.
- Keep your leverage as low as possible or at zero unless you have an iron-clad risk management system in place that you can enforce.
Lesson 7: Fraud repeats because the pitch is timeless, only the packaging changes
Not all crypto failures are fancy financial bugs. This is old-school scamming with crypto gear.
BitConnect is one of the biggest ones. The SEC charged BitConnect and its leading figures in 2021 for severing retail investors of some $2 billion in a worldwide fraudulent and registered offering in connection with a ‘lending program.’
In a 2022 update regarding the charges brought against the founder of BitConnect, the U.S. The Department of Justice referred to BitConnect as a classic Ponzi scheme.
The moral of the story isn’t necessarily ‘crypto is a scam.’ It’s the conditions that you should be careful about, like incentives, hype, and a lack of regulation. They make it the perfect storm for a scam to perpetuate.
What to do differently:
- Be cautious of the promise of guaranteed returns, rapid referral growth, and so-called ‘proprietary tech’.
- Search for genuine registry, enforcement record, and leadership clarity.
- Apply the boredom filter. If a source requires perpetual entertainment value to be worth following, that may be a problem. Sometimes boring means stable.
What these failures teach us going forward
The scale of crypto failures rarely ever occurs by accident. They materialize in areas that are complex and where people are following along blindly, in areas where speeding up the process through safety precautions becomes marginalized, and in areas where incentives slowly nudge people in directions that are dangerous but are not completely understood.
Reflecting on past crypto failures and breakdowns is in no way meant to point the finger or replay past carnage. It’s more about recognizing trends while they are still fresh so that new ones named in different packaging don’t occur in the future.
A failure lays bare an illusion in each situation. This can be in terms of return on investment or in terms of invincibility.
About Author
