A crypto exchange founder argues for decentralized finance
The demise of FTX, the crypto exchange run by Sam Bankman-Fried, is gruesome, but it’s a story as old as time. Opaque processes and mediation hid extreme influence, poor risk management and alleged fraud. The Economist recently asked whether, in the wake of FTX’s collapse, crypto could be useful for anything other than fraud and speculation. The decentralized finance movement, or “DeFi,” built on the technology that underpins cryptocurrencies has begun, but it offers transparent protocols that also enshrine unbreakable user protections.
The demise of FTX, the crypto exchange run by Sam Bankman-Fried, is gruesome, but it’s a story as old as time. Opaque processes and mediation hid extreme influence, poor risk management and alleged fraud. The Economist recently asked whether, in the wake of FTX’s collapse, crypto could be useful for anything other than fraud and speculation. The decentralized finance movement, or “DeFi,” built on the technology that underpins cryptocurrencies is nascent, but it offers transparent protocols that also enshrine unbreakable user protections.
Centralized crypto companies that hold user assets, such as FTX, are known as “CeFi”. CeFi and traditional financial institutions, such as banks, are exposed to risk build-up. That’s because their balance sheets are insufficiently transparent to investors and regulators, and their interests are often not aligned with the interests of users. For example, when employee compensation models encourage risk-taking, other stakeholders can be left in the lurch if things go wrong. FTX is not the only casualty among cryptocurrency firms in recent months. Major consumer lenders, including BlockFi, Celsius and Voyager, have also met similar fates. Public blockchains allowed users to watch $6 billion worth of assets transact in real-time from a wallet owned by FTX. But because FTX is a CeFi company, there was no insight into how much was owed to the customers and where the withdrawn funds went. As for more traditional financial bodies, consider that it took months to dissolve. e-flows between Archegos Capital, an investment firm that collapsed in 2021, and its counterparties, and more than a decade to unwind Lehman Brothers, a bank that filed for bankruptcy in 2008.
Centralized crypto companies that hold user assets, such as FTX, are known as “CeFi”. CeFi and traditional financial institutions, such as banks, are exposed to risk build-up. That’s because their balance sheets are insufficiently transparent to investors and regulators, and their interests are often not aligned with the interests of users. For example, when employee compensation models encourage risk-taking, other stakeholders can be left in the lurch if things go wrong. FTX is not the only casualty among cryptocurrency firms in recent months. Major consumer lenders, including BlockFi, Celsius and Voyager, have also met similar fates. Public blockchains allowed users to watch $6 billion worth of assets transact in real-time from a wallet owned by FTX. But because FTX is a CeFi company, there was no insight into how much was owed to the customers and where the withdrawn funds went. As for more traditional financial bodies, consider that it took months to dissolve. e-flows between Archegos Capital, an investment firm that collapsed in 2021, and its counterparties, and more than a decade to unwind Lehman Brothers, a bank that filed for bankruptcy in 2008.
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In DeFi, where data and analytics are free and publicly available, the balance sheets that support lending or trading are transparent. Anyone with an internet connection can track a protocol’s assets and liabilities on a second-by-second basis. Institutions such as JPMorgan, Goldman Sachs and the European Investment Bank are experimenting with on-chain bond issues, which they believe can reduce “settlement, operational and liquidity risk compared to existing issues”.
DeFi’s “self-storage” model provides new levels of control and risk management for users. When an individual or institution “stores” their digital assets through a cryptographic wallet, they can choose their own security model, trusting themselves with their private keys or sharing keys with a security provider such as Coinbase or Fireblocks. These self-custodial wallets gain direct access to trading and lending protocols rather than requiring customer funds to be on the balance sheet of a financial intermediary.
While I think DeFi and self-storage are better models, they are still in their early days. At my company, Uniswap, the protocol that facilitates exchange between different tokens is only four years old. Like the Internet in its infancy, it is slow and often difficult to navigate for new users. Further work is required, particularly in terms of transaction speed, administration, user experience and other support services. These efforts are well under way, but – like the Internet – they will take some time to mature. It is also important to note that not all projects calling themselves “DeFi” are legitimate – as is often the case in new industries, there are scammers and opportunists.
The past 12 months have tested DeFi protocols – and they have proven resilient. The leading DeFi-based money markets, Aave and Compound, have processed more than $47 billion in loans and $890 million in liquidations with relatively little bad debt. All this has happened in an extremely volatile environment. When users pledge collateral and borrow assets on Aave and Compound, there are no clearing brokers. The pair’s smart contracts are designed to limit liabilities so that they are no larger than the assets backing them – a restriction that FTX may have allegedly breached. In fact, the FTX-affiliated hedge fund at the center of this mess – Alameda Research – paid back its loans to the DeFi money markets before its centralized counterparties because you can’t negotiate margin calls with smart contract code.
DeFi shares financial processes in isolated smart contract-based protocols. It contains any risk from interdependence. Over time, both centralized finance and traditional finance will benefit from a similar degree of segregation. In CeFi, we should separate custody from exchange functions, as well as collateral/loans from exchanges. To its credit, the leading CeFi exchange, Coinbase, has made progress in that direction, giving users access to interest-paying accounts through the Compound protocol. In banks and other traditional financial organisations, existing regulation ensures that brokers are separated from exchange and custody functions. Ideally, broker-dealers should also separate client management services: the integration of these functions famously led to the demise of MF Global, a derivatives broker, in 2011.
The Internet has created a more interconnected world, and has accelerated the age-old problem of greed and exploitation by those in positions of power. Geography makes regulation patchy, and regulators’ arsenals are ill-equipped to protect consumers. FTX operated out of the Bahamas, but people around the world have been affected by the fallout from the implosion. Structural reforms of CeFi and traditional institutions will help, but risks are inherent to dissemination. DeFi still has a lot of room for improvement, but through its transparency and self-storage, it has begun to prove the utility of new forms of consumer protection for a digital world.
