The Krypton perspective on the news.
The downfall of FTX provides an interesting window into some of the pitfalls of centralized finance (or CeFi). In the 72 hours leading up to Tuesday, November 8, 2022, FTX saw about $6 billion in withdrawals, and as of this writing FTX has suspended withdrawals and a proposed takeover by Binance has fallen through.
It would be easy to treat this as just another story about why crypto is dangerous. But this is much deeper: This is the story of why centralized finance is dangerous.
There are two key issues at work in this situation, and these issues have arisen repeatedly in finance history:
In the simplest terms, big blowups in finance (and the fallout that sometimes follows), happen because the risks taken exceed the risks managed. Regulatory rules attempt to mitigate those risks, especially if they involve consumer assets.
Unfortunately, regulations are generally put in place in response to blowups, not in anticipation of them.
Just one example, it was only after the Financial Crisis that new rules about capital reserves intended to avoid another one (known as Basel III) came down. Regulation is often backward-looking like that–it’s not the fault of regulators, it can just be really hard to see how bad risk exposures can be until after they come to light.
But that lack of visibility is not random: It’s a result of centralization and Points 1 and 2 above.
Let’s talk about that.
First and foremost: Incentives without rules. Traders and centralized financial institutions have a profit motive, and that profit motive creates incentives to aggressively value assets and aggressively de-value liabilities, or to simply push the limits of whatever risk management model is in play. After all, you do not get paid on the risks you didn’t take.
When there are rules, there are at least limits to what an institution can do in pursuit of that advantage. But when the rules are vague, as they are in crypto, there might be very few limits–or even none.
The news is changing every day, but it’s clear there was an excessive amount of risk commingling between FTX and Alameda, and it’s unclear what level of preferential treatment Alameda had with FTX. Whatever is going on, one look at the financials by Binance was apparently enough to get them to scrap their offer.
The thing is, this isn’t new, historically speaking. These types of situations have played out in various forms across the financial industry over a very long period of time.
That brings us to reason number two: A lack of transparency. Centralized institutions are, in many ways, black boxes–they can reveal what they want when they want to, and they can basically use whatever methodology they’d like in order to justify what they’re saying. Again, in the absence of rules, the ability to remain opaque is heightened.
Combine this ability to be secretive with very strong incentives to be self-interested, and these institutions have every reason to behave as aggressively as they want. (Again, at least until a regulator with power comes along and says no).
When institutions have the opportunity to fudge the truth for the benefit of their own short-term self-interest, they will do so. Maybe not every time, and maybe not after regulation comes down, but that’s a bit of a trite consolation to anyone who hasn’t been able to access their own assets.
Maybe the next regulatory wave will close some loopholes, but what good will that do when centralized institutions find yet another way to accidentally engineer another collapse?
The cat and mouse issue of regulatory oversight has been playing out for decades. But as long as the incentives and the opacity are there, the opportunity for this kind of mess remains.
One of the core tenets of decentralized finance is trust minimization. You don’t have to trust that I’m doing what I say I’m doing, or that I’m not taking advantage of the incentives that any sane profit-motivated trader would want to take advantage of.
You can check. Anyone can check.
Coming from the traditional financial industry myself, I personally found this a sort of strange concept at first. Trust surely lies at the heart of all exchange, doesn’t it?
But just because it used to be that way (with hundreds of years of failures to show the downsides), it doesn’t mean it has to continue to be that way.
In DeFi, we have a level of transparency that is simply unheard of in any centralized setting.
Because it’s transparent, there is no place to hide. The kinds of shenanigans that were going on at FTX, and that have gone on throughout financial history are out in the open for everyone to see. Indeed, we at Krypton have spent a lot of time talking about the problems that still need to be solved in DeFi (namely, in our case, to eliminate predatory trading and give people better trade execution).
But one of the reasons we have those data points to talk about in the first place is because the data is they’re there for us to see.
So do “bad” incentives exist in DeFi? Yes, of course. They exist everywhere. But traditional finance tries to solve the problems that arise from these incentives with regulation; DeFi solves them by shedding light on what was heretofore in the dark.
There’s more to “trust” than risk management — there’s also control.
Bank runs and withheld assets are nothing new in centralized finance–we just tend to forget about this when things are going well and everyone is happy. And then we are filled with dread when things are going poorly and people can’t access their funds.
This is another place where DeFi gives something that centralized finance simply cannot provide: Full control over your own assets.
In DeFi, you do not place permanent custody of your tokens with a third party who can withhold access to the wallet that bears your name. You control your own wallet.
You might release tokens into a smart contract that carries out a transaction or other agreement, but the nice thing about a decentralized smart contract is that you don’t have to trust that someone will enforce it. You don’t have to rely on the promise of one person that everything is going to be okay. A smart contract executes on its own, without any intervention. If you want your tokens back, you’ll get them back.
And again, all of this is public. Everything can be validated and verified.
This is ultimately why we’re building Krypton as a DeFi protocol, and it’s why we’re using Chainlink’s decentralized oracle nodes to provide our computing power. We believe that decentralization is ultimately safer for consumers and simply provides for better-functioning financial markets.
This situation just illustrates again why DeFi has such enormous potential to change finance for the better.
Is there still work to be done? Yes, of course. Our first step as a company is to eliminate the profitability of predatory trading and thus make DeFi the home of the best, most cost-effective trade execution in finance. From there, we hope to be part of the vanguard in helping DeFi become the global standard in trading.
Look, this week has been brutal for crypto (and it’s only Wednesday as of this writing). But it also highlights the topography of the crypto landscape, and the significant advantages that DeFi has over centralized systems, both in crypto and in traditional finance.
If you haven’t thought about DeFi before, take a look, compare it to what you know, and ask yourself why these same stories keep playing out in centralized financial institutions.
Then join us in building the future of finance.
Krypton is dedicated to the idea that functional markets are fair markets, where you can get the trade you want at a cost that makes sense. Our academic roots are the foundation of our novel approach to solving the challenges of building a decentralized financial system, and we’re proud to offer a truly novel approach to exchange architecture with the Krypton DEX.