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Why DeFi is the Answer to the FTX Saga

Validated Individual Expert

TX’s collapse is a wake up call for the crypto industry. While in the bull market people rushed into the simplest way to buy crypto and speculate, the bear market has made evident the trade-off between convenience and security. At the same time, the FTX debacle also underscores the importance of a decentralized financial system — which perhaps now unsurprisingly SBF was seeking to regulate.

“Don’t be evil” was for years Google’s motto. Although this is a noble mission, it implies trust in their employees to act in users’ best interests. Millions of users trusted FTX to hold their funds, after all they were backed by top investors and SBF was the media’s crypto darling. Needless to say the trust was misplaced.

So why is DeFi the answer to such fraud? Because it can’t be evil.

Admittedly this statement is idealistic, but there are reasons to believe in DeFi as the solution to this problem. For one, users of DeFi protocols remain in custody of their funds. This places the power in the user, who is in charge of how to deposit, invest and store their assets. DeFi protocols do not have the capacity to withdraw your funds like FTX did.

Secondly, DeFi is transparent and accountable by design. If depositors want to see where their assets are, they can check on-chain where they are at any time. No need to trust a company’s statements when you can simply verify on a block explorer. The code behind DeFi protocols is also open source, allowing anyone to evaluate it if they wish. This enables a deeper financial and technical transparency to a much greater extent than what existing companies offer.

DeFi does not discriminate. Large depositors receive the same yields as the smallest. There is also no preferential treatment at the time of liquidations. Multi-billion-dollar asset managers, both in traditional finance and within crypto, typically have an advantage with more favorable terms with their loans. This is not the case in DeFi as we saw with Alameda’s DeFi positions. Their eight figures loan on Abracadabra accrued the same interest and was subject to the same liquidation ratio as small borrowers. This also made Alameda’s DeFi debt senior to their traditional creditors: since their liquidation would have happened programmatically, Alameda opted to repay this debt before it did centralized lenders, where they leveraged their reputation as long as they could.

All loans are collateralized, even if many don’t realize it at first. It’s just a matter of whether that collateral is someone’s assets or their reputation. While DeFi’s overcollateralization of assets may seem capital inefficient and inconvenient, it has proven to be more secure. To a certain extent, this has prevented DeFi contagion like we saw with centralized lenders in the crypto space following the collapse of FTX and Three Arrows Capital.

While DeFi offers a fundamental shift from trusting institutions to oneself, we are still early in this journey and there are many obstacles to overcome.

Roadblocks & Progress

Using new technology is always inconvenient at first. Just like there are 5+ steps to start using DeFi at the moment, using the internet in the 90s was a cumbersome process.

It takes time to build a seamless onboarding architecture. Crypto is still not there yet, but it’s moving in the right direction. Coinbase users can now interact with DeFi directly from their main app, while self custodying their assets. Circle announced Apple Pay integration, making it simpler for businesses to accept USDC payments. Progress like this moves us a step closer to a general audience using DeFi directly from their phone to pay for groceries. And due to DeFi’s permissionless nature, advances like these get us closer to every smartphone user having access to financial services.

Then there is also an educational obstacle. Being in charge of one’s funds means that if they are incorrectly stored, you may lose them all. This was a massive problem in crypto’s early days, when people did not anticipate their assets to go in value as much as they did and at times led to people losing millions due to trusting themselves to hold their crypto. The learning curve to hold your own crypto keys may take time but it is becoming easier as educational resources become more widespread. Newer mechanisms like social recovery also make it less likely for someone to lose access to all of their funds.

Finally, there are also technical and economic risks to consider when using DeFi. Multi-million dollar hacks in DeFi have happened in the past and will likely continue over the foreseeable future. However, due to the adversarial nature of DeFi, over time we can expect established protocols to be battle-tested and technical risks to become lesser. Auditing this code is also likely to become more of a built-in functionality than an after-thought, with a few startups currently aiming to automatically identify potential security vulnerabilities prior to deploying code. Economic risks can also be monitored real-time and automated for users to exit a DeFi protocol based on certain parameters.

Final Thoughts

Currently “crypto” is thrown around as an umbrella term encompassing both centralized services like FTX and decentralized ones like Uniswap. While FTX did offer access for users to buy crypto-assets, it did so through their own private books, with only small traces of transactions happening in the exchange being visible on-chain. As we saw, they were also in control of user funds and misappropriated them without their consent. DeFi protocols do not allow such thing to happen, and it is important that we make that distinction.

DeFi can bring broader access to finance and potentially prevent large-scale fraud to happen due to its transparent nature. That being said, DeFi is not a panacea that will magically solve all of humanity’s problems. We are still shaping this embryonic technology and there are many roadblocks to overcome for it to reach its potential. While its success is still uncertain, the need for such financial infrastructure is increasingly evident.

At IntoTheBlock we look forward to supporting the growth of DeFi as much as we can. Be it through our analytics, automated yield-generating strategies or risk management services, we are excited to contribute to this movement.

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