The last few months have borne witness to major failures in the cryptocurrency space, among them FTX. As FTX crashed, centralized platforms like BlockFi, which had deep relationships with FTX and its sister company Alameda Research, also hit the ground face first. These recent spates of failures highlight several important issues in the cryptocurrency space – lack of regulation, commingling of funds, unvetted borrowing and lending, and the problems of custodial wallets and centralized platforms within the crypto space, to name a few.
FTX’s downfall, in particular, has shaken Bitcoin (BTC-USD) and the overall crypto ecosystem, concerning many market participants about the long-term implications and the dent “centralized platforms” have put in the nascent ecosystem.
“The latest few meltdowns are clearly a case of human failure. These were centralized entities in which human beings had discretionary control of funds and suffered from some combination of failed investment strategy, lack of proper risk management and business procedures, or maybe just outright fraud,” notes Orbs Vice President of Business Development Ran Hammer.
Echoing this take, Ben Far, Radix’s Head of Partnerships, stresses, “The latest calamity was the result of complete and utter lack of practically any risk management; a litany of human errors so long that it is hard to believe it wasn’t deliberate; fueled by inexperience, greed, and lack of moral compass.”
The “Centralized” Dilemma of the Decentralized Space
FTX’s case – as highlighted by John J. Ray in the U.S. Bankruptcy Court – is due to “failures of oversight, incomplete records, missing and unreliable financial statements and potentially compromised leadership.” Yet, other centralized crypto platforms, namely lenders, faced similar deficiencies. Celsius Network and Voyager Digital found themselves in a similar circumstance back in August after Do Kwon’s Terra (LUNA) and algorithmic stablecoin Terra USD (UST) crashed.
Centralized exchanges and crypto lending platforms act as the de-facto “banks” of the crypto world. They frequently offered consumers double-digit returns on digital asset deposits, far outstripping comparable offerings from regulated brick-and-mortar banks. On the flip side, these platforms lent customers’ funds backed by limited collateral or safety nets. Or, as was the case with FTX, the firm likely commingled user assets with operational funds and let Alameda use customer assets to fund risky bets, investments, and loans.
For failed lenders, the collateral pledged by borrowers to secure loans from lender’s users was often re-pledged by the lending platform to raise more funds to be lent and so on, known as rehypothecation. Commingling and rehypothecation practices by banks and financial institutions are subject to serious regulatory oversight, ensuring transparent accounting and the safe return of customers’ pledged collateral.
Unfortunately, there is no comparable regulation in the crypto space. Centralized platforms directly control users’ assets, commingling funds and engaging in rehypothecation to earn outsized returns to deliver on double-digit yield promises. To achieve this, these firms often place risky bets, some of which don’t turn in their favor.
These incidents drain funds from platforms, forcing platforms to engage in ever-riskier bets, sparking a spiraling cycle where no one realizes that the web of rehypothecation has grown beyond control until it is too late. Because the locked funds are already gone, these platforms have nothing left to repay users.
“It’s a combination of poor risk management with hubris and an excess of confidence in one’s estimation of market trends,” stresses Balancer Labs’ CEO and co-founder Fernando Martinelli. “You don’t just use customer deposits in your own gambles or that of affiliated entities that have preferred access to your exchange without impunity.”
Matthijs de Vries, Founder & CTO at AllianceBlock, underlines the inherent problems of centralized platforms, explaining, “Centralized players have been operating in an unregulated environment. They have the freedom to do what they please with the assets they’re entrusted to hold. Poor to zero risk management of these funds and unrealistic yield strategies offered to their users means these players were mismanaging users’ funds.”
Decentralized Exchanges (DEXs) Stand Strong
Despite the ongoing centralized crypto meltdown, there’s a silver lining and an important takeaway. For one, it proves that trusting exchange and lender wallets shouldn’t be the “new normal” in crypto and that the saying “not your keys; not your crypto” still holds true. Importantly, this dramatic showdown demonstrates that decentralized exchanges (DEXs) are promising alternatives.
DEXs remained untouched by both the Terra and the FTX contagion because these systems don’t need any human input. Everything operates via smart contracts and is fully transparent. Because there are no centralized middlemen or exchange and lender-based custodial wallets, users’ funds are indeed the property and responsibility of the users.
While DEXs may not have the same liquidity as their centralized counterparts, a DEX has never halted user withdrawals to date. This is because customers’ funds remain in their own wallets and aren’t left on deposit at the exchanges. No counterparty risk is involved because the DEX only facilitates direct exchanges between users via a peer-to-peer (p2p) model.
Talking about the possibility of an FTX-Alameda-BlockFi-like event in the DEX and DeFi space, Ben Fair notes, “DeFi doesn’t suffer from human error or hubris…while poor risk management and rehypothecation of assets is certainly possible in DeFi too, the ledgers that DeFi is built atop are public. Where you shine a light, the shadows fade, allowing anyone to identify an issue in a liquidation engine or inappropriate rehypothecation of collateral.”
For Balancer Labs’ Martinelli, DEXs aren’t susceptible to these problems by design. He opines, “DEXs are by definition non-custodial, which prevents such a train of events from happening right at the start: user funds remain controlled and owned by users. A DEX inherently brings accountability and full transparency, something that the latest crypto financial crises reminded us of has been desperately needed time and again.”
DEXs offer a promising model for how exchanges should work and highlight why enticing users with yields is destined to create risk management headaches for centralized exchanges and their users. For this reason, other centralized providers are taking note. Most recently, centralized exchange Bybit integrated the ApeX Pro DEX with its services, opening up non-custodial exchange services to its clients through the integration.
Despite its steeper learning curve, a DEX ensures that any form of centralization – which leads to human errors and fraud – is largely eliminated via smart contracts. The non-custodial approach, where users own their private keys and have complete control over their assets, is the only logical approach to mitigate these inefficiencies.
The concept of centralized crypto platforms in an ecosystem where the core ethos revolves around decentralization is a huge question mark – something that the broader community needs to realize at the earliest. By opting for centralized services, consumers willingly hand over their assets to third parties that continue to misuse them. Accordingly, it is high time that users reconsider their wallets, the assets in them, and how they want to deploy these assets.
