The Case for DeFi in a Post-FTX World
A call-to-action for adopting fast, transparent & fraud-proof platforms
Written by: Cody Garrison // In Collaboration with: Algofi | 1/3/2023
Introduction
The last few weeks have continued to expose the stark contrasts between CeFi crypto companies and their DeFi counterparts–only further highlighting a need for transparent, fraud-proof and decentralized financial platforms.
The deterioration of trust caused by poorly managed and possibly fraudulent centralized exchanges and lending platforms is a tailwind for the adoption of decentralized alternatives— this is a call-to-action for institutional and retail adoption of transparent and open finance in a post-FTX world.
SBF spent months lobbying to kill DeFi, because he knew that transparent autonomous protocols were a threat to trust me assets are fine finance
Robert Leshner, founder of Compound Finance
Continued Deterioration of Trust in CeFi
This year will be remembered as the year that trust was shattered in crypto— particularly within the space of black box, centralized exchanges and lenders that have proliferated in the last few years. These platforms grew in part by co-opting the DeFi brand of “Open Finance.”
CeFi broke. DeFi didn’t. Perhaps this was ultimately needed for the trustless economy to reach mainstream exit velocity. Whereas DeFi has been a speculative bet on the future of finance, today it feels more like a solution to the mismanagement problem that plagues CeFi crypto.
Centralized Exchanges
The lack of transparency and single sourced decision making are among the most obvious factors that led to FTX’s epic collapse. The fall of crypto’s golden boy and one of the most well known brands in the space has caused a perfect storm to bleed into the mainstream zeitgeist. At this point, the story has been hashed out numerous ways from Sam himself, and both crypto-native and mainstream media reports have given their take. We’re not here to outline it again in detail, but rather to explore alternatives in the wake of this incineration of trust.
You might be saying, “sure, but SBF was a calculated scammer who used his uniquely privileged background and resume to dupe some of the best investors in the world. There are still good actors in CeFi with the best for crypto in mind, and surely I can trust them to keep my funds *safu.*” Not so fast — take Crypto.com , who in the chaos of November’s drama it came to light that they accidentally sent nearly 285,000 ETH (~$500M!) to Gate.io before it was sent back according to the CEO and on-chain transactions.
It’s not just the possible fraud seen with SBF and the team at FTX; CeFi still suffers considerably from human error. With DeFi, well written smart contract code can extinguish the opportunity to commit fraud and neutralize human error. Assets and the code used to operate on them are displayed real-time on an immutable ledger, right in front of you. DeFi doesn’t need Proof of Reserves nor does it need GAAP audits–DeFi is auditable 24/7 and the reserves are always available for review.
Centralized Lenders
The story for centralized lenders and their ‘institutional’ borrowers paint a similar story of corruption, incompetence & greed. This time last year, Celcius, Voyager Digital, BlockFi, Nexo and Genesis were paving the way for centralized crypto lenders, amassing hundreds of millions in funding on the back of rapid AUM growth. They were creating so-called crypto-backed banks for their customers. Just 12 months later, 3 of those 5 have declared bankruptcy while the other two have found themselves in hot water. Three Arrows Capital and Alameda, two trading firms previously operating with billion dollar AUMs have eviscerated virtually every dime of that capital in 2022. Risky leverage afforded to these funds by their lenders and a lack of transparency surrounding the re-hypothecation of these loans ultimately led to a cascade of liquidations for borrowers who didn’t have the funds to repay their creditors. Ambition from executive teams to grow AUM through attractive yields and horrendous risk management enabled trading firms to delete retail funds.
The combination of fraud, mismanagement and greed (through excess leverage) remains a consistent pattern among the top centralized exchanges and lenders — trustless & transparent code fixes this. If market participants had been aware of the risks being assumed by lenders, the outcome would have likely been far different.
The Pros and Cons of DeFi
Like many building and participating in this ecosystem, we believe that decentralized financial rails are a net positive to society and promote broader financial inclusion. In the wake of a rocky year, we also recognize one of DeFi’s less touted, though potent, strengths–that it is fraud-proof. If users can trust the code, vetted by an ecosystem of tech savvy participants and auditing firms, then we can eliminate obvious sources of fraud. We also realize there are inherent trade-offs in being an early adopter of radically new technology, not the least of which is performance.
Pros:
Transparency: Assets and liabilities can be seen on-chain (and recreated from transactions) in real-time and displayed front and center of most dApps. Acts of fraud should be impossible to execute.
No halting of withdrawals: Customers can always withdraw from a functioning, liquid protocol. Liquidations ensure assets are returned to depositors.
Borrowers repay DeFi protocols before other centralized creditors. You can’t negotiate with DeFi protocols.
Self Custody: You get to hold sole control over your funds without having to put trust in a third party.
DeFi can iterate and innovate faster than CeFi counterparts given its open-source nature and lean core teams. Uniswap was handling similar daily transaction volume with < 100 employees as CeFi counterpart, Coinbase, who employed 5,000+ earlier this year
Protocol fees may accrue to the users of the protocol rather than a single centralized entity
Cons:
Self Custody (a double edged sword): You are in charge of your own keys – if you lose them, you lose your money. No third party to keep the assets safe for you, it’s on you and this can be a security hurdle for some new to the space. Wallet solutions are improving to limit the effect of human error in self custody.
Exploits happen: instead of trusting 3rd party individuals, in DeFi you must trust the code (built by 3rd party individuals). While it’s often open-sourced and transparent for ongoing security checks, mistakes do happen — by developers and auditors. It’s a choice of tradeoffs: do you feel safer in centralized custody or in your own custody on audited code?
On ramps: it is still difficult and inefficient to fund non-custodial wallets without sending USD to a centralized exchange first.
Regulatory uncertainty around the role of tokens and governance in the DeFi ecosystem
Retail vs. Institutions – DeFi for Everyone
Amid this year’s incineration of trust & capital in CeFi, DeFi volume has spiked to highs not seen since May 2022. According to data from Token Terminal, the daily trading volume of perpetual exchanges reached $5 billion which is the highest daily trading volume since the Terra meltdown. Total DEX volume surpassed that of October in just the first two weeks of November with participation coming from both institutional and retail wallets.
Along with the continued development of innovative protocols and increased volumes, DeFi has matured immensely since its roots in 2020’s DeFi Summer and the quirky food-centric protocols. Today, in the depths of one of the ugliest bear markets the industry has seen, DeFi still conducts nearly 15% of all cryptocurrency trading volume according to TheBlock. The inherent transparency of blockchain tech and performance of next-gen Layer 1s allow institutional investors to diligence new protocols in real-time and participate as large-scale liquidity providers and traders in the ecosystem. The adoption of walled gardens (Aave Arc) and institutional-gated private blockchains (JPM’s Onyx) that enforce KYC/AML rules allow the more traditional and heavily regulated firms to participate in DeFi without the inherent counterparty risks of dealing with anonymous users. In addition, the application of zero knowledge technology allows retail and enterprise users to interact in trustless, open environments with privacy that is inherent in centralized platforms.
These advancements, with continued focus on scalability and security, novel token distributions, progressive decentralization in line with regulations, and streamlined governance are fostering an intellectual and perpetually innovative environment that will strongly compete with CeFi during the next expansion cycle. There is no place for complacency in a dynamically-evolving industry.
Final Thoughts
Very little good has come from this years events, but perhaps at the very least it can be a catalyst for nuanced conversations that allow users across the spectrum to better understand and educate themselves on the stark contrasts between DeFi and CeFi, as well as the importance and responsibility of self custody — which is a strong and necessary step forward into broader DeFi adoption.
DeFi is not without its concerns either — the $60B implosion of Terra/LUNA/UST in May caused the tides to wash out on much of the mentioned centralized players
Memories tend to be short in crypto and exchange frauds date back to the early days of the industry — it will take targeted and wide scale education efforts to bring the masses to trust the broad crypto industry, CeFi and DeFi alike
With the recurring carnage we’ve endured as an industry in 2022, a clear case for DeFi can be pieced together from the ashes of fraudulent, incompetent and greedy CeFi operations
