Why the collapse of FTX underscores the need for decentralized finance

In recent weeks, the cryptocurrency ecosystem has been shaken to the core by the Lehman-like collapse of FTX, the world’s second largest crypto exchange.

FTX, which was valued at $32 billion before the events, found itself insolvent and was forced to file for bankruptcy within a week after shocking revelations emerged about its founder Sam Bankman-Fried’s alleged illegal actions.

As is often the case in the modern world, it all started with a message and a few tweets questioning the stock’s liquidity.

Those concerns centered on a revelation that FTX had close ties to Alameda Research, a crypto trading firm also owned by Mr. Bankman-Fried, whose balance sheet contained significant reserves of illiquid assets.

This included FTX’s own token, FTT, which was created for the sole purpose of giving users access to the products and services of the exchange itself.

This news was not welcomed by the market. Tensions escalated, eventually leading to an effective “bank run” on FTX, with users requesting approximately $6 billion in withdrawals in just 72 hours — money that FTX did not have on its balance sheet.

At that point, the exchange seized the only remaining option and halted all withdrawals, freezing billions of dollars in customer assets.

A failure of centralized finance

Since then, investigations have uncovered widespread wrongdoing by Mr. Bankman-Fried, including a $10 billion loan made to Alameda using customer funds.

Additionally, information has surfaced that sheds light on the full extent of Alameda’s risk-taking, which resulted in significant losses.

In short, the situation is eerily similar to the events of the global financial crisis, while comparing Mr. Bankman-Fried to the late Bernie Madoff, who ran the greatest pyramid scheme in history.

For those who might not remember the details, Madoff’s wealth management business turned out to be an elaborate multi-billion dollar Ponzi scheme.

Like Mr. Bankman-Fried, Madoff was a respected figure who worked closely with financial regulators to develop the very framework that governed his own activities.

This allowed him to stay under the radar for many years. At the time of the final collapse of his empire, prosecutors estimated his fraud at $64.8 billion across around 4,800 customer accounts.

Watch: What is Bitcoin and how did it start?

The 2008-2009 financial crisis led to sweeping regulatory changes aimed at preventing another financial collapse of this magnitude.

Similarly, following FTX’s rapid and brutal collapse, global regulators have been quick to criticize the cryptocurrency ecosystem as a whole.

Financial watchdogs from Australia to the US have promised to turn their attention to the digital asset landscape in the coming months in the interests of consumer protection.

However, we must not forget that FTX’s demise was not caused by a failure of blockchain technology, nor is it in any way related to the burgeoning decentralized finance ecosystem.

FTX fell for the same reasons that traditional financial institutions continue to fail – central control was in the hands of a small number of people who succumbed to corruption and poor decision-making.

Why the world needs decentralized finance

Decentralized finance, on the other hand, promises a completely different financial system. It is based on the principle that anyone with an internet connection should be able to access financial products and services without trust or permissions.

We must not forget that FTX’s demise was not caused by a failure of blockchain technology, nor was it connected in any way to the burgeoning decentralized finance ecosystem.

Stefan Rust, founder of Laguna Labs

In practice, this means that one does not have to entrust one’s savings to a single person, as the assets always remain in self-custody.

Furthermore, there is no central authority managing a financial service provider and taking responsibility for decisions – all decentralized organizations are managed through a transparent membership voting system. With such a model, FTX-style failure becomes impossible.

This brings us to the question of regulation. For centralized cryptocurrency companies like FTX, improving regulatory oversight can certainly help keep potentially scammers with multi-billion dollar empires at bay.

However, applying the same regulatory framework to the decentralized financial space would be detrimental to the development of this new type of financial system.

There is a real danger in painting all cryptocurrency units with the same brush.

It is the role of those of us working to build a decentralized future to educate the public and legislators about their value proposition.

After all, it was precisely the failure of centralized finance in 2008 that led to the creation of Bitcoin – the world’s largest decentralized digital currency.

Some 13 years after its inception, the need for truly decentralized funding has become clearer than ever.

Stefan Rust is the founder of Laguna Labs, a blockchain development house, and former CEO of bitcoin.com

Updated November 23, 2022 at 4:00 am


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