While the recent fall of FTX has largely been seen as a referendum on crypto it may be more of a necessary evolutionary step than a breaking point. All financial technologies go through cycles of ease of use and security. The most user-friendly methods grow like wildfire until their flaws are exposed.
Puka shells were readily available, but supply was unregulated. Gold supply is well regulated, but difficult to transport. Fiat currency is easy to transport, but has inflationary incentives.
In the case of exchanges the earliest companies in the space (Kraken, Coinbase, Binance, Gemini) made it easy to purchase BTC with a credit card. This enabled wide-spread adoption. However, this was accomplished by building black-box trading system that closely resembled those of the traditional banking system with one flaw: poorly understood regulation.
Traditional financial institutions are heavily regulated under regimes that have been battle tested since the 1800s. This has evolved to the state today where the FDIC will even underwrite the risk of stored deposits. Crypto institutions have had less than a decade to evolve the same checks and balances. This weights the Web3 market heavily in the ease of use end of the scale — leaving security severely lacking.
The first warning against this have been the attacks on exchanges by hackers (Mt Gox being the post prominent). This has resulted in around $2Bn lost to hacks this year. This has been seen as an acceptable risk in line with the industry norm that had been mitigated with exchange provided insurance. However, the recent FTX case may single handedly double that number of consumer losses with no backstop.
The incentives behind the losses at FTX are common enough. An institution made a bad loan (FTX to Alemda) using customer funds that over-leveraged the institution. At that point the only way out was to continue to pour money into the position in the hopes that the institution can outgrow the mistake. This happened in the 1980 Savings and Loan Crisis, 2007 Mortgage Crisis, and Archegos Capital Management Collapse in 2021. While certainly all the result of bad behavior — it’s endemic to the human condition. Financial systems need to anticipate and be resilient to these risks.
The unique promise of the blockchain here is decentralization — which makes it possible to remove that risk. However, the cost of decentralization has been to push the complexity directly to the user. This results in the state of DeFi today which is largely still struggling to overcome the ease of use provided by the centralized exchanges:
What is clear from FTX is investors should flee from entities that are not transparent or regulated. The uncapped risk in those entities is rarely compensated for by their asset holdings unless used for highly targeted speculatory bets.
At the present time the two alternatives are well regulated, but non transparent entities (ie Gemini and Coinbase) or unregulated transparent entities (current DeFi such as Uniswap). The former is easy to interact with, but impossible to truly understand. The latter is difficult to interact with, but possible to fully understand with public contracts and on-chain transactions.
The great potential for this space is a fully regulated DeFi regime. A collection of contracts and participants that have been well understood by both regulators and sophisticated investors. This would provide the community with a fully trusted solution that has the potential to scale independent of the risks of individual leaders.
Regulated Defi is no mean feat and has the following challenges blocking its creation:
- Regulatory interface. Without centralized leadership the communities are often not as effective at interacting with regulators and advocating for their approval.
- Restriction of activities. Regulation (especially from the US) will constrain activity. Much of DeFi is oriented towards full freedoms — which will likely be unacceptable to regulators.
- Ease of Use. Without longer term market-capture incentives DeFi communities often don’t invest in making easy to use interfaces that enable them to acquire less sophisticated cryto users. This is compounded by the choice/freedom inherent to DeFi. This will need to be constrainted to provide new DeFi users a clear well lit path to onboarding.
While large, none of these challenges is insurmountable. The prior promise of DeFi summer was loftier and loftier interest rates. This was merely a mirage on it’s true path. Easy to implement, easy to adopt, but lacking in any long term potential.
Creating complainant DeFi will be an arduous decades long incremental mission to build trust and community. It required the current winter to sweep away the false promises and distractions preventing its progress. Out of this winter we now have a true north star of regulatory compliant DeFi that can guide us to the world’s future financial system.
