A crypto-exchange founder makes the case for decentralized finance

The demise of FTX, the crypto exchange run by Sam Bankman-Fried, is gruesome, but it’s a story as old as time. Opaque processes and intermediation hid extreme leverage, poor risk management and suspected fraud. The Economist recently asked if, in the wake of FTX’s collapse, crypto could be useful for anything other than scams and speculation. The decentralized finance, or “DeFi” movement, which builds on the technology underlying cryptocurrencies, is nascent. But it offers transparent protocols that also enshrine tamper-proof protections for users.

Centralized crypto companies that take custody of users’ assets, such as FTX, are known as “CeFi”. CeFi and traditional financial institutions, such as banks, are prone to the accumulation of risk. Indeed, their balance sheets are not transparent enough for investors and regulators, and their interests are often not aligned with those of their users. For example, when employee compensation models incentivize risk, other stakeholders can be left behind if things go wrong. FTX is not the only victim among cryptocurrency firms in recent months. Major consumer lenders, including BlockFi, Celsius and Voyager, also suffered the same fate. Public blockchains allowed users to watch $6 billion in asset withdrawals occur in real time from an FTX-owned wallet. But because FTX is a CeFi company, there was no visibility into how much was owed to customers and where those withdrawn funds were going. When it comes to more traditional financial organizations, consider that it took months to unravel the flows between Archegos Capital, an investment firm that went bankrupt in 2021, and its counterparties, and more than a decade to untie Lehman Brothers, a bank that filed for bankruptcy in 2008.

In DeFi, where data and analytics are free and publicly available, balance sheets supporting loans or exchanges are transparent. Anyone with an internet connection can track the assets and liabilities of a protocol by the second. Institutions such as JPMorgan, Goldman Sachs and the European Investment Bank are experimenting with on-chain bond issuances, which they say can reduce “settlement, operational and liquidity risks compared to existing issuances.”

DeFi’s “self-custody” model offers new levels of control and risk management for users. When an individual or institution “guards” their digital assets through a crypto wallet, they can choose their own security model, trust themselves with their private keys, or share keys with a security provider such as Coinbase or Fireblocks. These self-custodial wallets directly access trading and lending protocols instead of requiring client assets to be on the balance sheet of a financial intermediary.

Although I think DeFi and self-custody are better models, they are still in their infancy. In my company, Uniswap, the protocol that facilitates exchanges between different tokens is only four years old. As the Internet at the dial-up stage, it is slow and often difficult for new users to navigate. Further work is needed, especially on transaction speed, management, user experience, and other supporting services. These efforts are well advanced but, like the Internet, they will take time to mature. It’s also important to note that not all projects calling themselves “DeFi” are legit – as is often the case in new industries, there are scammers and opportunists.

The past 12 months have tested DeFi protocols and they have proven resilient. Major DeFi-based money markets, Aave and Compound, processed over $47 billion in loans and $890 million in liquidations with relatively little bad debt. All of this happened in an extremely unstable environment. When users post collateral and borrow assets on Aave and Compound, there are no clearing brokers. The pair’s smart contracts are designed to constrain liabilities so that they are no more important than the assets that support them, a constraint that FTX might have violated. In fact, the FTX-associated hedge fund at the center of this mess — Alameda Research — repaid its DeFi money markets loans before its centralized counterparties because you can’t trade margin calls with smart contract code.

DeFi breaks down financial processes into isolated protocols based on smart contracts. This contains all the risks of interdependence. Over time, centralized finance and traditional finance would benefit from a similar degree of segregation. In CeFi, we should separate custody functions from exchange functions, as well as leverage/borrowing from exchanges. To its credit, the leading CeFi exchange, Coinbase, has made strides in this direction, offering users access to paid accounts through the Compound protocol. In banks and other traditional financial organizations, existing regulations ensure that brokers are separated from exchange and custody functions. Ideally, brokers should also separate asset management services from clients: the integration of these functions led to the demise of MF Global, a derivatives broker, in 2011.

The internet has created a more interconnected world, accelerating the age-old problem of greed and exploitation by those in positions of power. Geography makes regulation uneven, and regulators’ arsenals are ill-equipped to protect consumers. FTX operated from the Bahamas, but people around the world were affected by the fallout from its implosion. Structural reforms of the CeFi and traditional institutions will help, but the risk is intrinsic to intermediation. DeFi still has a long way to go, but through its transparency and self-preservation, it has begun to prove the utility of new forms of consumer protections for a digital world.

Hayden Adams created the Uniswap protocol, a decentralized exchange, and is the founder and CEO of Uniswap Labs

© 2023, The Economist Newspaper Limited. All rights reserved. From The Economist, published under licence. Original content can be found at

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