Instability has plagued cryptocurrency markets since the collapse of the Terra Luna and FTX exchanges in 2022. Concern only increased this year amid wild price swings, the conviction of FTX founder Sam Bankman-Fried, and the impending sentencing of Binance co-founder Changpeng Zhao.

Gary Gensler, chair of the U.S. Securities and Exchange Commission, believes that events unfolding in the sector necessitate stricter regulations. MIT Sloan finance professorAntoinette Schoar,who researches the sector, agrees in principle.

“Regulatory uncertainty is always the worst thing, especially for well-intentioned and reputable players,” Schoar said. “They don’t want to come into an area where the regulatory situation is not clear because they have the most to lose, but this in turn means higher barriers to entry.”

Insights from two new MIT Sloan research papers co-authored by Schoar plumb lessons learned from the 2022 collapse of Terra Luna, show how retail traders deal in crypto, and demonstrate why the industry needs clarity on regulation.

How crypto investors behave

In “Are Cryptos Different? Evidence From Retail Trading,” Schoar and co-authors Shimon Kogan, Igor Makarov, and Marina Niessner wanted to better understand how retail investors — “who dominate crypto trading” — approach the market.

“For a long time, people inside and outside crypto have basically said, ‘Oh, all these traders are just driven by hype and don’t understand anything,’” Schoar said. “There was a lot of judgment about crypto traders without having much data on how they actually trade.”

To address that gap, the researchers examined patterns in retail investors’ trading data across cryptocurrencies, stocks, commodities, and other assets on the discount brokerage platform eToro. They found the following:

• Retail investors trading in crypto hold on to their investments even in the face of large price swings, even though they are more contrarian on stocks or commodities (meaning they sell when the price has gone up in the past and buy when the price has gone down). This pattern holds across all types of crypto traders, whether they are young males (the stereotypical crypto traders), middle-aged women, or anyone else, Schoar said.

• The research also suggests that while there is a lot of hype in crypto, there is also some method to the madness. If investors think that a higher price bodes well for crypto’s future, making it more likely that other investors, or even regulators, will look more favorably at cryptocurrencies going forward, it helps continue to drive the price upward. As a result, investors do not think it irrational to bet on momentum or hold on to their crypto portfolio when the price goes up.

These insights provide valuable information for not just market participants but also regulators thinking about consumer financial protection.

Lessons from a crypto crash

In “Anatomy of a Run: The Terra Luna Crash,” Schoar and co-authors Jiageng Liu and Igor Makarov delve into the May 2022 collapse of Terra — which at the time was the third-largest cryptocurrency ecosystem (after Bitcoin and Ethereum).

At the center of the collapse was a run on a blockchain-based borrowing and lending protocol (Anchor) that promised high yields to investors in its TerraUSD stablecoin (ticker UST). Although the crypto market has evolved in the ensuing 18 months, the lessons are even more applicable today, Schoar said.

Using data from the Terra blockchain and trading data from exchanges, the authors determined the following:

• The run on Terra UST was a complex phenomenon that happened across multiple chains and assets.

• The transparency of blockchain technology allowed investors to monitor each other’s actions and amplified the speed of the run.

• Wealthier, more sophisticated investors were the first to exit and experienced much smaller losses, whereas poorer, less sophisticated investors ran later and recorded larger losses.

A crypto crash has implications for the rest of the sector — and other parts of the economy as well. Looking specifically at the Terra crash, Schoar said that it affected the crypto space dramatically, depressing the price of Bitcoin and Ethereum, and also led to the demise of large institutions such as Celsius, Voyager, and, ultimately, FTX.

The crash had ripple effects and “showed how quickly it can have repercussion for the rest of the economy,” she said. For example, banks like Silver Lake that were dealing in crypto were immediately affected. “It shows you that actually, a crypto crash can very easily affect the rest of the economy,” Schoar said.

Crypto’s 24-7 nature amplifies existing risks

Terra Luna collapsed over three days in May 2022, wiping out $50 billion in valuation. Schoar’s research showed that smaller, less informed retail investors held on to their crypto investments, even in the midst of wide price swings.

“A lot of people — the small guys — had this willingness to hold on, and I think unfortunately it shows that among the small investors, there were many that just didn’t understand how that system worked,” Schoar said. “They somehow thought, ‘Oh, this is like a stock that’s going down. Let me keep holding because it’ll come back up once everybody’s not afraid anymore.’ But, of course, not when there is a run.”

The 24-7 nature of the blockchain only made it worse. In a more traditional environment, trading stops and banks shut their doors at the end of the business day, even if they’re digital, whereas the blockchain never closes. And with a traditional bank, the FDIC will protect small traders that have deposit insurance, so they often don’t experience a run as quickly. But in crypto, none of those safeguards exists.

“Everything is online and open 24-7,” Schoar said. “We see no physical barrier in the crypto space, but still, the fact that many small traders just lack the human capital or the wherewithal of trading, even when they could have traded, shows you that consumer financial protection really is very important in a world where you have lots of uninformed retail investors.”

The transparency of the crypto platform has its limits

Schoar said that just because transaction data is available on the blockchain, that doesn’t make it 100% transparent and it does not level the playing field for all investors.

For example, the authors’ primary data source in their Terra Luna paper was Terra’s own blockchain, which was substantially more complex than Bitcoin’s, which only records bitcoin transfers from one account to another.

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The structure of Terra’s blockchain, however, doesn’t involve the simple transfer of tokens but incorporates the inputs and outputs of smart contracts, which is even more complicated because each smart contract has its own data structure, the authors said.

“It takes a lot of effort to process this data and is not easy to do,” said Schoar, who worked for six months to process data for her Terra research. “A regular retail trader might not have the time nor the knowledge to do that, so that is clearly a barrier.”

Even the employees working at Terraform Labs, the company that started Terra Luna, made many missteps. Even though they “probably processed and tracked information in real time, probably even better than us, you can see the mistakes they made,” Schoar said. For example, “because they allowed so much UST to be issued, they actually made the system much more fragile and run-prone.”

“Maybe they did not set out to do this on purpose, because it’s not in their interest to destroy their own reputation with these bad decisions,” Schoar said. “But once there was so much hype and the value went up dramatically, they were unable to manage the risks and fully understand the dynamic of the system. Even for relatively sophisticated players, there is still a lot of complexity to take in.”

The industry needs a regulatory framework, not regulation by lawsuit

Schoar said it makes sense for legislators to “proactively regulate” rather than sue firms that have done something wrong after the fact. For one thing, lawsuits can take an incredibly long time to resolve. Schoar said that organizations like Coinbase and Binance that have a lot of money have an incentive to drag out a lawsuit. And often, fines are tiny relative to profits made while evading regulations.

“The Securities and Exchange Commission and the Treasury Department are pursuing enforcement action by suing Voyager, Coinbase, Binance, and other organizations, and that I think is actually a bit suboptimal,” Schoar said. “It would be much better for Congress to lay out the laws and provide a regulatory framework, because regulation by lawsuit is quite ad hoc.”

Take the case of Binance. The company’s CEO and founder recently pleaded guilty to violating U.S. anti-money-laundering requirements in a Seattle court. While the fine of over $4 billion might seem high on face value, it pales in comparison to the profits Binance has been able to amass. “It shows you that we really need a regulatory framework, not just regulation by lawsuit,” Schoar said.

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