Crypto’s Transparency May Be Part of the Problem Right Now

That is quite different from traditional finance, where bank ledgers and payment networks are usually accessible only by their owners. This can give investors helpful information about flows and price action. But when it comes to market panics and customer “runs,” this kind of transparency can also be destabilizing.

Following the collapse of tokens such as TerraUSD earlier this year, and the bankruptcies of firms holding customer money such as Celsius Network and Voyager Digital, crypto holders were likely already on high alert for problems when concerns about FTX began bubbling up.

Perhaps in another context, the interplay between Binance and FTX that played out publicly on Twitter wouldn’t itself have sparked a loss of confidence in FTX. As that unfolded, though, observers of blockchain data were also tweeting out information on activity around FTX, such as movements out of wallets known to be associated with the exchange.

Lucas Nuzzi, the head of research and development at Coin Metrics, tweeted on Nov. 8, before it was announced that Binance’s potential deal with FTX was off, about data on FTX’s token FTT that to him were evidence of problems at FTX. The on-chain data “definitely precipitated the notion there was something wrong,” says Mr. Nuzzi.

One thing that fuels bank runs is a fear of fear, or the worry that other people will run to withdraw, according to Douglas Diamond, professor at Chicago Booth. His work on bank runs, along with Philip Dybvig and former Federal Reserve chief

Ben Bernanke,

won them the 2022 Nobel Prize in Economic Sciences. Mr. Diamond likens it to the adage that you don’t have to outrun a bear, just anyone else being chased by the bear.

Another dynamic is that when actors perceived to have the most information make a move, others will follow. For example, crypto research firm Nansen was tracking movements by “smart money,” or addresses associated with top-performing traders, out of wallets associated with FTX.

Recent examples in traditional finance have made clear the role of information about other people’s activities in runs, says Mr. Diamond. That includes a study of a bank run in India that showed that people’s decision whether to “run” was highly correlated with their neighbors also running. It also includes evidence from money-market fund runs, in which plugged-in institutional investors pulled money while individual investors didn’t, even though they were invested in similar vehicles.

Based on the evidence, watching activity on a chain when you’re able to see exactly what is happening is something that could make panics or contagion fears worse, according to Mr. Diamond. “This is especially true when the chain provides information about otherwise opaque entities,” he says.

Sometimes non-transparency has been used strategically in finance. The Federal Reserve, for example, hasn’t immediately disclosed which specific banks are using its discount window. 

But there can be a problematic mix of transparency and non-transparency in crypto. Centralized exchanges, or firms that handle customer trades and money, may have wallets visible on a chain that shed light on their assets or customer reserves—yet they also have non-visible balance sheets showing how much of those assets are pledged to, or spoken for by, other parties. That could be a toxic combination of information: Enough to know when others are fleeing, but not enough to know if they are right or wrong to do so.

“Liabilities are the key information you don’t know,” says Clara Medalie, director of research at Kaiko. “Proof of reserves is a good start to improving overall transparency, but it’s not a panacea to the core problem we still have with loosely regulated centralized exchanges.”

In that regard, more transparency might be part of the solution, which could be a feature of “decentralized finance,” or DeFi, exchanges that exist entirely on blockchains. Mr. Diamond said that “if everything were on the blockchain directly, the added transparency could lead to more trust and fewer unpleasant surprises about questionable activities.”

More transparency also puts the burden on investors to understand what they are looking at, and possibly to rely on analysts or other parties to connect and interpret data. “There are trade-offs with transparency in crypto data,” says Mr. Nuzzi. “The data can be fully transparent, but not always legible.”

For now, though, getting out first has often proven to be the right move. That is hardly a foundation for a stable crypto ecosystem. A key part of a durable solution may also be universal prescriptions for how customer assets are held, and clear lines between times when they are segregated, like at a brokerage, or commingled and invested, like at a bank. At least then, customers can know when they are deliberately taking a risk and when they are not.

In theory this clarity could be self-imposed by crypto firms. But regulation might be the best way to earn the market’s trust at this point. It is a solution to a problem of crypto’s own making.