The spectacular $32 billion collapse of the FTX exchange and its sister trading firm Alameda Research recently once again has crypto’s detractors gloating in the headlines. In fact, FTX bears no resemblance to most of what the longtime believers in blockchains and Web3 are trying to build.
The failure of FTX was not one of insufficient regulation nor of a corrupted codebase, but a human failure. Rather than condemning crypto, FTX demonstrates that truly decentralized, transparent and open Web3 technologies can better protect users and support a more fair and more resilient digital financial system. Here’s why.
Illia Polosukhin is a co-founder of Near Protocol and Unchain Fund.
There was nothing decentralized or transparent about Sam Bankman-Fried’s FTX empire. In reality, FTX bears a lot more resemblance to the overleveraged institutions that failed in 2008 than it does to what most of the blockchain industry is building. The reason is simple: It is centralized and therefore restrictive in participation, owned by few, governed by even fewer. The platform controls the order books and users’ funds, holding reserves within its own vaults.
Bitcoin, the first blockchain, allows peer-to-peer value transfer between two parties anywhere in the world, without the need for an intermediary like a corporation or a bank. Ethereum introduced programmable smart contracts to this paradigm, allowing entire applications to run on this global, distributed network.
Now there are many such programmable blockchains that form the backbone of Web3, the movement to decentralize internet infrastructure using blockchain-based technologies. These open blockchain networks run on transparent, open ledgers where transaction records are verifiable by anyone in the network and therefore very difficult to censor. The benefit of decentralized systems is that they are transparent, so stakeholders know what is happening; censorship resistant, so it’s difficult for bad actors to exploit or take over; and antifragile, so they can adapt in response to challenges.
Centralized exchanges are most useful as an on- and off-ramp between fiat currencies and cryptocurrencies, with retail users going through extensive know-your-customer processes. These centralized entities, whose reserves and balance sheets are not required to be shared with users or the public, require prudent regulation just as legacy banks and lenders do. And FTX was regulated across the jurisdictions it operated in, just as Bear Stearns and Lehman Brothers were. Bad loans, illiquid collateral and overleveraging have clearly happened in institutions dealing with regulated securities also (FTX held traditional as well as digital assets).
But if investors and users of FTX had access to the same information that users of decentralized exchanges and protocols such as Uniswap and Aave do, this collapse would have been nearly impossible. Account holders on decentralized exchanges have full control of their own funds and can participate in the governance of the platform.
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We’ve seen some other centralized exchanges responding to pressure recently to disclose their reserves, notably Binance and Crypto.com. While reserves don’t reveal corresponding liabilities, this is a positive development in the space toward self-regulation and applying decentralized financial practices to centralized institutions.
FTX’s collapse highlights the need for more decentralized approaches. It’s notable, for example, that both FTX and Celsius Network, another centralized institution that collapsed in July of this year, repaid their decentralized finance (DeFi) loans first because they were publicly visible before eventually declaring bankruptcy. This is clear evidence of the need for data-rich, transparent accounting and compliance systems that protect participants while also preserving an individual’s privacy.
Best practices that apply to DeFi and centralized crypto projects alike, in addition to self-disclosures of reserves and liabilities, might include on-chain asset registries or mandatory transaction posting. For exchanges, a hybrid approach might avoid an exchange custodying users’ funds while still offering recovery via centralized institutions (or support for social recovery).
Regulation can only go so far in closed systems and walled gardens. Transparent code and public accountability can go much further in helping Web3 transition to a better future. By embracing the transparency of DeFi while continuing to invest in privacy-preserving technologies like zero-knowledge protocols, we can avoid situations that may lead to overreaching regulatory crackdowns while also creating safer environments for retail users and Web3 projects supporting real-world use cases.
I’ve been thinking about these issues of trust and fairer financial systems since I was building my first projects as a coder growing up in Ukraine. I believe in Web3 because I want to build systems that are not easily corrupted or subject to takeover by a bad actor. I want citizens of the entire globe to be able to control their own assets and data rather than having to trust an untrustworthy bank or getting shut out of the system entirely because of their native nation’s economic status.
After the events of the last week, I believe more than ever that the world needs Web3 to build a better digital infrastructure for the planet. FTX is not crypto. Let’s not judge the entire industry by its failure.