What to expect from crypto the year after FTX

Published at: Dec. 29, 2022

Cryptocurrency had its Lehman moment with FTX — or, perhaps, another Lehman moment. The macroeconomic downturn has not spared crypto, and as November rolled around, nobody knew that we were in for the collapse of an empire worth billions of dollars.

As the rumors of bankruptcy began to take hold, a bank run was inevitable. Sam “SBF” Bankman-Fried, the once effective altruist now under house arrest, continued to claim that assets were “fine.” Of course, they were not. From Genesis to Gemini, most major crypto organizations have been affected by the contagion effect in the aftermath.

The problem with exchanges like Binance, Coinbase and FTX

Time and time again, the feeble layer of stability has been broken down by the hammer of macroeconomic stress in an atmosphere of centralization. It can be argued that centralized systems grow quickly for the same reason: They value efficiency over stress tolerance. While traditional finance realizes economic cycles in a span of decades, the fast-paced nature of Web3 has helped us appreciate — or rather scorn — the dangers posed by centralized exchanges.

The problems they pose are simple yet far-reaching: They trap skeptical and intelligent investors in a false sense of security. As long as we’re in a “bull” market, be it organic or manipulated, there are far fewer reports to be published about failing balance sheets and shady backgrounds. The drawback of complacency resides in precisely the moment where this fails to be the case.

The way forward, for most people who got hurt by the FTX collapse, would be to start using self-custody wallets. As retail investors scramble to get their crypto off centralized exchanges, most of them need to understand the scope of the centralization problem. It doesn’t stop with retail investors parking their assets in hot or cold wallets; rather, it simply transforms into another question: Which asset are you parking your wealth under?

Often hailed as the backbone of the crypto ecosystem, Tether (USDT) has come under fire numerous times for allegedly not having the assets to back its users’ deposits. That means that in the case of a bank run, Tether wouldn’t be able to pay back these deposits and the system would collapse. Though it has stood the test of time — and bear markets — some risk-averse people might not push their luck against a potential depeg event. Your next option is, of course, USD Coin (USDC), which is powered by Circle. It was a reliable option for crypto veterans until the USDC associated with the Tornado Cash protocol was frozen by Circle itself, reminding us once again about the dangers of centralization. While Binance USD (BUSD) is literally backed by Binance, a centralized exchange, Dai (DAI) is minted after overcollateralized Ether (ETH) is deposited into the Maker protocol, making the stable system rely on the price of risky assets.

There is also a counterparty risk involved here, as you have to take the word of auditors when they say that a particular protocol has the assets to return your deposits. Even in the bull run, there were cases when these assessments were found unreliable, so it makes little sense to outright believe them in such trying circumstances. For an ecosystem that relies so much on independence and verification, crypto seems to be putting up quite a performance of iterative “trust me” pleadings.

Where does that leave us now? Regulators eye the crypto industry with the wrath of justice, while enthusiasts point fingers at multiple actors for leading up to this moment. Some say that SBF is the main culprit, while others entertain the hypothesis that Binance CEO Changpeng Zhao is responsible for the undoing of trust in the ecosystem. In this “winter,” regulators seem convinced that human beings and the protocols they come up with require legislation and regulation.

Users leaving FTX, Binance, Coinbase and other exchanges is cause for hope

It is no longer a question of whether the industry should abandon centralized exchanges. Rather, it is a question of how we can make decentralized finance (DeFi) better in a way that doesn’t infringe upon privacy while also reducing the current notions of it being the “Wild West.” Regulators — alongside investors — are awakening to the refurbished idea of centralized organizations collapsing under stress. The wrong conclusion to derive would be that centralized exchanges need to be more tightly regulated. The optimistic and honest one is that they need to be abandoned in favor of DeFi at a much higher pace.

DeFi has been developed to avoid these risks entirely. One such method is to develop agent-based simulators that model the risk of any lending protocol. Using on-chain data, battle-tested risk assessment techniques and the composability of DeFi, we are stress-testing the lending ecosystem. DeFi offers the transparency needed for such activities, unlike its centralized counterparts, which allow funds to be obfuscated and privately rehypothecated to the point of collapse.

Such monitoring can be done in real-time in DeFi, allowing users to have a constant view of the health of a lending protocol. Without such monitoring, insolvency events that have taken place in the centralized finance industry are made possible and can then go on to trigger a cascade of liquidation as the daisy chain of exposure crumbles.

Imagine if all of FTX’s assets were being monitored in real time and shown in a publicly available resource. Such a system would have prevented FTX from acting in bad faith to its customers from the start, but even if there were too much uncollateralized leverage that would lead to a collapse, it would have been seen, and the contagion would have been mitigated.

A lending system’s stability depends on the collateral value that the borrowers provide. At any point in time, the system must have adequate capital to become solvent. Lending protocols enforce it by requiring the users to overcollateralize their borrows. While this is the case with DeFi lending protocols, it isn’t the case when someone uses a centralized exchange and uses immense amounts of leverage with little to no collateral.

This means that DeFi lending protocols, specifically, are protected from three main vectors of failure: centralization (i.e., human error and humans falling to greed from conflicts of interest), lack of transparency and undercollateralization.

As a final note to regulators, moving away from centralized systems doesn’t absolve them of the responsibility — or eradicate the necessity — of regulating even decentralized spaces. Given that such systems can be regulated only up to a certain extent, they’re much more reliable for decision-making and predictability. A code will reenact its contents unless a systemic risk is found within it, and that’s why it’s easier to narrow down on particular codes and come up with regulations around them rather than believing that each human party will act in the interest of the group at large. For starters, regulators can start stress-testing DeFi applications regarding their transaction sizes and transparency.

Amit Chaudhary is the head of DeFi research for Polygon. He previously worked for finance firms including JPMorgan Chase and ICICI Bank after obtaining a Ph.D. in economics from the University of Warwick.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.