The case for DeFi in a post-FTX world
In this post we discuss the consequences of the anti-climactic collapse of FTX and Alameda Research. We’ll explore what happened, what went wrong and how we can avoid the same mistake twice. You might have guessed it, Decentralized Finance is a big part of the solution.
Last week, FTX, the second largest cryptocurrency exchange filed for bankruptcy. The timeline of exact events that transpired have been well documented in other writings and we will not dive too deep into them here. An almost complete summary of what happened can be found here: Jason Choi on Twitter
It has been amazing to see the story develop in real-time, with Twitter as the main source of new information. In total, FTX left a hole of around 10 billion dollars which means that clients that had funds at the exchange will most likely lose the majority of the value they had stored there. This is an absolute tragic event that has shocked the crypto community and has further damaged faith of the general public in the sector. One could say this is crypto’s Lehman moment but in this case, there is no government bail-out coming.
In essence, FTX was a centralized financial service company that took custody of clients’ deposits. It operated in an unregulated market and dodged many of the strict rules that financial institutions have to adhere to after the 2008 financial crisis. The crypto industry has long been asking for clearer directives on regulation of these types of companies.
Specifically, the SEC has held off on creating a general legal framework for cryptocurrency companies which has led to this type of situation. The lack of regulatory clarity pushes companies off-shore and into murky jurisdictions. There is very limited oversight and lots of room for fraudulent activities.
This is exactly what happened at FTX. Sam Bankman-Fried, CEO of FTX and majority shareholder of Alameda Research, a supposedly wildly profitable hedge fund, built out a shadow empire in just three years. Again, I won't go into detail of what exactly happened behind the scenes but what we are now learning is that many forms of fraud were committed with unsuspecting clients paying the price. Other articles on the topic will surely explore the exact nature of the crimes committed and we are learning more every day.
Centralized companies vs Decentralized protocols
FTX is what we know as a CEX, which means Centralized Exchange. It is similar to an online stockbroker in that they merely offer a market place for users to trade assets in. In order to organise such brokerage activities, they need to hold custody of client funds. Combine this with loose regulations and a lack of transparency and you have the ideal molotov-cocktail to ignite the wildfire that we’ve had in the last few days.
What happened at FTX reflects poorly on the whole cryptocurrency space. It is likely that regulators will use these events as an excuse to heavily crack down on all things cryptocurrency. The media will also have a field-day and many crypto-opponents are awakening again to bash the entire industry at a low point in its history.
FTX shows exactly why blockchain-based systems are so vital to the future of finance. The demise of FTX is completely unrelated to the underlying technology of cryptocurrencies and blockchains. It is a brutal reminder to return to the roots of the crypto-movement with core principles such as self-custody, decentralisation, transparency and disintermediation. Don’t trust, verify, as the old saying goes.
Luckily, the past few years, a large and diverse community of programmers has been building an alternative to these centralized intermediaries. Decentralized Finance is a parallel financial system built on blockchains, secured and operated by smart contracts. The role of an individual or company is of secondary importance, with the rules of the system existing in open-source code, enforced by the nature of blockchain execution and consensus.
For example, it is entirely possible to substitute all the functionalities that FTX as a CEX provided by using a Decentralized Exchange or DEX. A DEX exists primarily on-chain in the form of a system of smart contracts that enable the transparent, fair and verifiable exchange of assets. You access it with a web3-wallet through a browser front-end. The DEX is merely a tool you use when you need it, your assets are at all times safely stored in your digital wallet. This means you, and you alone, hold custody of the assets. Nobody is able to move them for you when you store digital assets by owning your own keys. Anyone using DEXs is completely unexposed to the third-party risks when dealing with CEXs like FTX.
What the future holds
This is going to be a recurring theme in the coming years. Rather than trusting third parties to hold our funds for us, we should switch to self-custody and the usage of decentralized applications for our financial needs. Self-custody is non-trivial and much better solutions are needed in the future to support use cases such as social recovery, as errors with key management can happen if you are not careful. Many think it is a pipe dream that mainstream crypto users will self-custody with the current tools available. In any case, for serious participants in the technology, it should be clear that self-custody is the only way forward and the case of DeFi has never been as clear.
Once again, we are delighted to be building for this future. This is further confirmation to us that a new way of doing financial transactions is needed. The collapse of FTX will be reflected on in the future as a turning point that has accelerated the adoption of on-chain financial applications. While it is a bitter pill to swallow right now, especially those that lost funds on FTX, we could not be more bullish on DeFi. We cannot imagine a different technology space to be building in and are continuing our efforts with increased conviction. DeFi offers the opportunity for anyone to become part of the liquidity used in financial applications. Everbloom will manage these liquidity deployments with its dedicated software framework. We are striving for a better future for all to participate in and are proud to be part of this revolutionary movement towards financial enlightenment.