It is frightening to see Sam Bankman’s cryptocurrency exchange, FTX, fail, but this is a well-known story. Extreme leverage, inadequate risk management, and purported fraud were masked by opaque systems and intermediaries. The question of whether crypto could serve any purpose other than fraud and speculation after FTX’s demise was recently raised by The Economist. Built on the technology underlying cryptocurrencies, the decentralized finance movement, or “DeFi,” is in its infancy. Nevertheless, it provides clear protocols that likewise firmly establish unwavering user safety.
“CeFi” refers to centralized cryptocurrency firms that take custody of customer assets, like FTX. CeFi and conventional financial institutions like banks are vulnerable to risk accumulation. This is due to the fact that investors and regulators do not have enough access to their balance sheets, and their interests are frequently at odds with those of their customers. When compensation plans for employees, for instance, reward risk, other stakeholders may be left out in the cold if anything goes wrong. Not all cryptocurrency businesses have experienced recent failures, including FTX. Significant consumer lenders, including BlockFi, Celsius, and Voyager, had similar outcomes. Users were able to see $6 billion in asset withdrawals from an FTX wallet in real time thanks to public blockchains.
Yet, since FTX is a CeFi company, it was impossible to know how much was owed to clients or where the money that had been withdrawn was going. When it comes to more traditional financial institutions, take into account that it took years to dissolve Lehman Brothers, a bank that declared bankruptcy in 2008, and months to unravel flows between counterparties and the investment firm Archegos Capital, which collapsed in 2021.
The balance sheets used to facilitate lending or trading are openly available, free data, and analytics in DeFi. A protocol’s assets and liabilities can be monitored per second by anyone with an internet connection. Institutions such as JPMorgan, Goldman Sachs, and the European Investment Bank are experimenting with on-chain bond issuances, which they believe can decrease “the settlement, operational, and liquidity risks vis-à-vis existing issuances”.
“Self-custody” by DeFi: “User-friendly levels of control and risk management are provided by the model. When someone or something “custodies,” they can choose their own security model, trusting themselves with their private keys or sharing keys with a security provider like Coinbase or Fireblocks when storing their digital assets through a cryptographic wallet. Instead of needing customer assets to be listed on the balance sheet of a financial intermediary, these self-custodial wallets access trading and lending protocols directly.
DeFi and self-custody are superior models, in my opinion, although they are still in their early stages. The protocol that allows for the exchange of various tokens at my company, Uniswap, is only four years old. Similar to dial-up internet, it is slow and frequently challenging for novice users to navigate. It still has to be improved, particularly in terms of transaction speed, management, user experience, and other auxiliary services. These initiatives are well underway, but they will take time to develop—much like the internet. It is also crucial to keep in mind that not all projects that identify as “DeFi” are genuine; scammers and opportunists exist in emerging businesses, as is frequently the case.
The DeFi protocols were put to the test throughout the last 12 months, and they passed with flying colors. Aave and Compound, two of the top DeFi-based money markets, have processed more than $47 billion in loans and $890 million in liquidations with comparatively little bad debt. All of that happened in a setting that was very unstable. There are no clearing brokers when users provide collateral and borrow assets on Ave and Compound. The purpose of the two parties’ smart contracts is to limit obligations so that they do not exceed the value of the underlying assets, a restriction that FTX may have allegedly broken. Because smart contract code cannot be used to negotiate margin calls, the FTX-affiliated hedge fund at the center of this problem, Alameda Research, paid back its loans to DeFi money markets before its centrally cleared counterparties.
DeFi separates financial procedures into discrete smart-contract-based protocols. That covers any interdependence-related concerns. A similar level of segregation might eventually be advantageous for both traditional and centralized banking. We should isolate exchange functions for leverage and borrowing from exchange functions in CEFI. To its credit, the top CeFi exchange, Coinbase, has advanced in that direction by giving customers access to interest-paying accounts using the Compound Protocol. Existing regulations ensure that brokers are segregated from exchange and custody responsibilities in banks and other traditional financial institutions. Broker-dealers should ideally also break off customer asset management services because MF Global, a derivatives broker, was notoriously destroyed in 2011 as a result of the merging of both roles.
The Internet has made the globe more connected, which has accelerated the age-old issue of power brokers’ avarice and abuse. Geographical factors make regulation patchwork, and regulators lack the tools necessary to adequately protect consumers. FTX had its headquarters in the Bahamas, but its collapse had an impact on people all across the world. Yet, risk is inherent to intermediation, notwithstanding structural improvements to CEFI and conventional institutions. Although DeFi still has a lot of room for growth, it has started to demonstrate the value of new types of consumer protection in a digital world through its transparency and self-custody.