The demise of FTX, the crypto exchange run by Sam Bankman-Fried, is horrifying, but it’s a tale as old as time. Opaque processes and intermediation concealed extreme leverage, 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 scams and speculation. The decentralised finance movement, or “DeFi”, which is built on the technology underlying cryptocurrencies, is nascent. But it offers transparent protocols that also enshrine inviolable user protections.
Centralised crypto companies that take custody of user assets, such as FTX, are known as “CeFi”. CeFi and traditional financial institutions, such as banks, are prone to risk build-ups. That is because their balance-sheets are insufficiently transparent to investors and regulators, and their interests are often not aligned with those of their users. For example, when employees’ compensation models incentivise risk, 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, also met similar fates. Public blockchains allowed users to watch $6bn of asset withdrawals happen in real time from a wallet that was owned by FTX. But because FTX is a CeFi company, there was no visibility into how much was owed to customers and where those withdrawn funds were going. When it comes to more traditional financial bodies, consider that it took months to untangle flows between Archegos Capital, an investment firm which collapsed in 2021, and its counterparties, and more than a decade to unwind Lehman Brothers, a bank which filed for bankruptcy in 2008.
In DeFi, where data and analytics are free and publicly accessible, the balance-sheets supporting lending or trading are transparent. Anyone with an internet connection can track a protocol’s assets and liabilities on a per-second basis. Institutions such as JPMorgan, Goldman Sachs and the European Investment Bank are experimenting with on-chain bond issuances, which they believe can reduce “the settlement, operational and liquidity risks vis-à-vis existing issuances”.
DeFi’s “self-custody” model provides novel levels of control and risk management for users. When an individual or institution “custodies” 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 access trading and lending protocols directly instead of requiring customer assets to sit on the balance-sheet of a financial intermediary.
While I believe that DeFi and self-custody are better models, they are still in their early days. At my company, Uniswap, the protocol which facilitates exchange between different tokens is only four years old. Like the internet in the dial-up stage, it is slow and oftentimes difficult to navigate for new users. Further work is required, especially when it comes to transaction speed, management, user experience and other supporting services. Those efforts are well under way but—much like the internet—they will take some time to mature. It is also important to note that not every project that calls itself “DeFi” is 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 $47bn in loans and $890m in liquidations with relatively little bad debt. That has all occurred in an extremely volatile environment. When users supply collateral and borrow assets on Aave and Compound, there are no clearing brokers. The pair’s smart contracts are designed to restrict liabilities such that they are not bigger than the assets that back them—a constraint that FTX may allegedly have violated. In fact, the FTX-associated hedge fund at the centre of this mess—Alameda Research—paid back its loans to DeFi money markets before its centralised counterparties because you cannot negotiate margin calls with smart contract code.
DeFi unbundles financial processes into isolated smart-contract based protocols. That contains any risks from interdependency. Over time, both centralised finance and traditional finance would benefit from a similar degree of segregation. In CeFi we should separate custody from exchange functions, as well as leverage/borrowing from exchanges. To its credit, the leading CeFi exchange, Coinbase, has made progress in that direction, providing 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 out customer asset-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, accelerating the age-old problem of greed and exploitation by those in positions of power. Geography renders regulation patchy, and regulators’ arsenals are ill-equipped to protect consumers. FTX operated out of the Bahamas yet people around the world have been affected by the fallout of its implosion. Structural reforms to CeFi and to traditional institutions will help, but risk is intrinsic to intermediation. DeFi still has much room for improvement, but through its transparency and self-custody it has begun to prove the utility of new forms of consumer protection for a digital world.
Hayden Adams created the Uniswap Protocol, a decentralised exchange, and is the founder and chief executive of Uniswap Labs
© 2023, The Economist Newspaper Limited. All rights reserved. From The Economist, published under licence. The original content can be found on www.economist.com
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