FTX Showed the Problems of Centralized Finance

FTX Showed the Problems of Centralized Finance, and Proved the Need for DeFi

Our community keeps learning the lesson of decentralization the hard way. Celsius Network. BlockFi. Voyager Digital. Now FTX.

These are all centralized exchanges (CEXs) and centralized financed platforms (CeFi). Their business models are centuries old; the only new thing about them is they offer users exposure to crypto assets – but crucially, not root ownership, since they hold the keys to those assets.

Amanda Cassatt is the founder and CEO of Serotonin, a Web3 marketing agency and product studio.

Like the financial institutions that collapsed in 2008, their economic incentive is to under-collateralize and take risks with user funds. They play political games, cozying up to regulators who claim to care about consumer protection.

The pseudonymous developer Satoshi Nakamoto was inspired by the events of 2008 when creating Bitcoin that year. When the network launched, they inscribed these words in its genesis block, “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”

This headline from The Times of London sent a powerful message about Satoshi’s intentions: Large financial institutions had spent years privatizing the gains from taking risks that led to collapse, and once it came they forced the public to bear their losses thanks to their influence on politicians with discretionary decision-making power.

With Bitcoin, Satoshi changed the locus of decision making from politicians to an automated code base, giving regular people the option to permissionless-ly participate in an alternative financial system, one where the rules are public, apply to everyone and execute automatically. Then, with smart contracts, Ethereum-based decentralized finance (DeFi) delivered these benefits in various forms to hundreds of thousands of people.

In an echo of the 2008 financial collapse, the collapse of FTX and Alameda Research has triggered a “run on the banks” across crypto markets. Some CEXs and CeFi platforms are overwhelmed with users withdrawing funds forcing them to freeze transfers off the platform. Some must be insolvent.

Those with funds on FTX will likely lose their money. A number of large venture firms as well as Web3 companies told their investors Wednesday that a significant portion of their AUM [assets under management] or treasuries were lost to CEXs. It’s a hard way to learn the basic hygiene of keeping minimal funds on CEXs only for immediate trading.

Despite sell-offs, Uniswap, Balancer, Curv, and other decentralized exchanges (DEXs) and decentralized finance (DeFi) platforms have been functioning smoothly, enabling users to exit their crypto positions or, if they prefer, to capitalize on low prices and buy in. Users may have seen their portfolios decrease in dollar value, but they never lost access to their assets. If that isn’t consumer protection, I don’t know what is.

When I was at ConsenSys and we were first introducing Ethereum to the world, we had a sign at our events that said, “Welcome to the decentralized future.” Our community was then, and is still, asked to explain the use of this new technology. The best answer was, and still is, decentralization.

DeFi platforms are designed to preserve the benefits introduced by Bitcoin and magnified by Ethereum: permissionless, transparency, censorship resistance and self-sovereign custody of assets.

Users should insist on a base settlement layer for economic activity that is as decentralized as possible, to avoid exactly the scenario that has played out in recent days. History may not repeat itself, but it sure does rhyme – and we would do well to heed the lessons it teaches.

Like the large financial institutions involved in the 2008 meltdown, which donated generously to political campaigns, the FTX crypto exchange spent its final weeks spending lavishly to court regulators. Its founder and CEO Sam Bankman-Fried even had the audacity to say DeFi needed consumer protections while, as has become clear, playing fast and loose with user funds.

Consider for a moment that SBF was running the second-largest CEX, and centralized platforms see DeFi as a competitor. What he wanted from regulation wasn’t consumer protection, but rather to protect his incumbent position and entrench his competitive moat.

Regulators are paying attention to this collapse, as is their job. Those with good intentions should see through the Times Square billboards about ESG [environment and social governance] and the fancy soirees and understand that centralized players calling for DeFi regulation do so because it serves their interests. Regulators should also recognize that as far as consumer protections goes DeFi has beat CeFi time and time again.

Regulation that doesn’t overprotect incumbents or harm actually decentralized projects could be a boon for the industry, offering the clarity institutional investors waiting on the sidelines need to start deploying capital. It could clear our space of many of its scams by making it riskier to perpetrate them.

If there is a silver lining for the FTX fiasco, it is a reminder of the importance of decentralization. While it has taken a sledge hammer to all crypto prices, layer 1 blockchains that de-prioritized decentralization as a design goal have been the hardest hit.

The FTX collapse was a failure of CeFi, not DeFi – and smart investors, builders and users are already taking notice. I believe that many have learned their lesson this time. To them: Welcome, once again, to the decentralized future.