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FTX vs. DeFi

Chris Campbell

Posted November 14, 2022

Chris Campbell

If you’ve been off the grid for the past week…

You’ve probably got a few questions about what’s going on in cryptoland.

Here’s the recap…

→ FTX is dead.

→ The exchange had some $900m of assets and $9b+ of liabilities.

→ SBF, the founder, was using a “backdoor” to grab billions in customer deposits.

→ The executives knew they were rats on a sinking ship. .

→ Several funds had hundreds of millions on FTX.

Tally it up.

Three of the worst events in crypto history have happened this year. The losses surrounding FTX, Celsius, Blockfi, Voyager, 3AC, etc. have been enormous.

Though many are framing this as the beginning of mass crypto contagion…

I think it’s more likely that FTX’s collapse is the tail-end of the Luna contagion.

FTX’s problems appear to have begun when Luna collapsed. They’ve been papering up the holes ever since.

And, while regulators might point fingers at DeFi for the failure of these protocols…

What they won’t tell you is that FTX is just a microcosm of Big Finance.

Today, all of CeFi is perpetually one bank run away from a new stone age. DeFi was conceived to solve this inherent fragility.

To understand how, it’s important to understand the glue that holds the economy together: trust.

Why Regulations?

Trust is the most important layer of every economy.

No trust = no economy.

The intention of regulation is to improve trust in the systems.

Unfortunately, it’s difficult to improve trust through regulations alone without it also turning into a scheme to harden incumbents over time. (And then those incumbents, resting on their laurels, overextend themselves, destroying the trust. The greatest paradox of history so far might be that, on a long enough timeline, everything becomes what it hates.)

Recall, Bitcoin was launched as a response to the systemic failures of 2008. It was a rage against the machine for and by people who’d lost trust in the system. (Same for the Gamestop saga.)

Though there’s a philosophical battle between “Bitcoin maximalists” and “crypto,” both sides operate under the same basic principles. They agree more than they disagree. But human nature being what it is… both parties succumb to the narcissism of small differences.

To me, Bitcoin falls under the “DeFi” rubric. DeFi protocols, just like Bitcoin, removes the need to “improve trust” on a superficial level.

Trust beyond family and friends is flimsy. It’s just an image. And, in the age of the “deepfake,” looks are increasingly deceiving.

That’s why Bitcoin’s battle cry has always been: “Don’t trust, verify.”

As compared to centralized finance…

1.] DeFi is auditable in real-time from anywhere in the world.

2.] DeFi protocols are credibly neutral. By design, they don’t favor specific people or outcomes over others.

3.] DeFi protocols don’t hold customer funds, nor do they have ANY access to them under any circumstances (even under the threat of force).

That last one is important because it’s how centralized financial flophouses find themselves in trouble. It’s important to recognize that a non-custodial (self-custody) exchange system in the traditional fiat world simply can’t exist.

This is something unique to crypto that can’t be replicated in CeFi. Meaning, you’re always going to have to trust some guy in a suit telling you “Everything is fine.”

Taken together, these three things above represent a massive improvement over centralized intermediaries.

The FTX saga is just one of the latest — and, sure, one of the greatest — examples.

FTX vs. DeFi

That Sam Bankman-Fried began coming out against DeFi in recent months, in hindsight, was indicative of just how spoiled the milk really was.

SBF couldn’t explain why

But he was afraid of the transparency, openness, and the self-custodial principles of decentralized exchanges.

Well, now we know why: Because he wouldn’t have gotten away with 1% of what he was doing behind everyone’s backs.

Amanda Cassatt of Coindesk put it best:

“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.”

Silver Linings

Though it might take crypto some time to recover from this fiasco…

There are some silver linings.

To build customer confidence, centralized exchanges will likely implement proof-of-reserves (POR). It’s not going to be perfect, but it’s a step in the right direction.

Right now, centralized exchanges are black boxes. We have no idea what’s going on. And that’s part of the problem.

Proof-of-reserves will use blockchain data to prove a centralized exchange’s assets and liabilities.

This is easy to do without giving up anyone’s personal information and precisely zero exchanges have any reasonable excuses not to be transparent in this way.

The more transparent an exchange is, the more it will earn trust. Exchanges that refuse to embrace transparency will lose trust.

Another silver lining: more people will embrace self-custody. Centralized exchanges carry unnecessary risk when you can hold your assets in your custody. Having the choice is a game-changer.

Still Here to Stay

In short…

If you’ve been in crypto long enough, you’ve survived flash crashes, exploits, explosions, implosions, hackers, phishers, worms, bugs, bank runs, and the like.

Crypto is one of the most incredible industries for accelerated evolution and experimentation. But it also means that failures and explosions will happen. And more quickly, too.

By pushing risk to the edges, DeFi aims to solve many of the systemic risks of traditional finance, which is perpetually one bank run away from collapse.

And though there’s no shortage of talking heads dancing on its grave today…

Crypto’s still here to stay.

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