Why FTX's collapse highlights the need for decentralised finance

The failure of the crypto exchange is 'eerily similar' to the events of the global financial crisis

Shortly before its collapse, cryptocurrency exchange FTX exchange halted all withdrawals and locked away billions in customer assets. AFP

Over the past couple of weeks, the cryptocurrency ecosystem has been shaken to its core by the Lehman-like collapse of FTX, the world's second-largest crypto exchange.

Valued at $32 billion before the events unfolded, FTX turned out to be insolvent and was forced to file for bankruptcy in the space of a single week amid shocking revelations surrounding the alleged illicit actions of its founder, Sam Bankman-Fried.

As often happens in the modern world, it all started with a news story and a couple of tweets that called into question the liquidity of the exchange.

These concerns were centred on a revelation that FTX had close ties to Alameda Research, a crypto-trading company also owned by Mr Bankman-Fried, whose balance sheet held significant reserves of illiquid assets.

This included FTX’s own token, FTT, which had been created for the sole purpose of providing users with 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 about $6 billion in withdrawals in only 72 hours — money that FTX did not have on its balance sheet.

At this point, the exchange took the only remaining option and halted all withdrawals, locking away billions in customer assets.

A failure of centralised finance

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

In addition, information has emerged to shed light on the full extent of risk-taking by Alameda, which resulted in significant losses.

In short, the situation is eerily similar to the events of the global financial crisis, while Mr Bankman-Fried has been compared to the late Bernie Madoff, who ran the largest Ponzi scheme in history.

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

As is the case with Mr Bankman-Fried, Madoff was a well-respected figure who worked closely with financial regulators to develop the very frameworks that governed his own activities.

This allowed him to pass under the radar for many years. At the time of his empire’s eventual collapse, prosecutors estimated his fraud amounted to $64.8 billion across some 4,800 client 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 such magnitude.

Similarly, in the aftermath of the swift and brutal collapse of FTX, global regulators have already been quick to criticise the cryptocurrency ecosystem as a whole.

Financial watchdogs from Australia to the US have vowed to focus their attention on the digital assets landscape in the coming months in the interests of consumer protection.

However, we must not forget that the downfall of FTX was not caused by a failure of blockchain technology, nor was it connected in any way to the burgeoning decentralised finance ecosystem.

FTX fell for the same reasons that traditional financial institutions fail again and again — centralised control was held in the hands of a small number of people, who succumbed to corruption and poor decision-making.

Why the world needs decentralised finance

Decentralised finance, on the other hand, promises a financial system that is vastly different. It is built on the principle that anyone with an internet connection should be able to access financial products and services in a trustless and permission-less manner.

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

Stefan Rust,
founder of Laguna Labs

In practice, this means there is no need to trust a single individual with one’s savings since assets always remain in self-custody.

Furthermore, there is no central authority managing a financial service provider and bearing responsibility for decisions — all decentralised organisations are managed through a transparent member voting system. In such a model, an FTX-style failure becomes impossible.

This brings us to the question of regulation. For centralised cryptocurrency businesses such as FTX, improving regulatory oversight may well help to keep potentially fraudulent people with multibillion-dollar empires at their fingertips in check.

Yet, applying this same regulatory framework to the decentralised finance space would be detrimental to the development of this novel financial system.

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

It is the role of those of us working to build a decentralised future to educate the public, and the legislators, on its value proposition.

After all, it is precisely the failure of centralised finance in 2008 that led to the creation of Bitcoin — the biggest decentralised digital currency in the world.

About 13 years after its creation, the need for truly decentralised finance has become clearer than ever.

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