Centralization Caused the FTX Fiasco

"Sam Bankman-Fried was among the most prominent public advocates of responsible cryptocurrency regulation. The collapse of FTX, his $40 billion exchange, has amplified calls for more regulation. These demands are misplaced if they fail to distinguish between centralized and decentralized exchanges -- a critical distinction that Mr. Bankman-Fried conveniently elided in his lobbying efforts.

In a centralized exchange, customers deposit funds into an account and initiate trades by submitting a buy or sell order. That order is matched to an offsetting order from another customer in a central limit-order book, typically run on private servers, after which the trade is cleared and settled. Investors buy stocks, bonds, commodities, futures and other financial instruments the same way.

Over the past decade, entrepreneurs have created similar exchanges to trade cryptocurrencies. FTX specialized in digital assets but was conceptually similar to a simple traditional exchange. So are Coinbase and Binance, among others.

The critical element in such a system is that somebody -- either the operator of the central limit-order book or an independent intermediary like a brokerage -- takes custody of user funds. That provides certainty that when the exchange matches an order, each party will settle. If buyers or sellers could renege, they would do so whenever it was to their advantage, rendering the exchange unreliable and useless.

If FTX were a U.S. stock exchange rather than a cryptocurrency exchange, regulations would have required user funds to be held by an outside custodian and orders routed through a brokerage, but it would have been equally possible -- and illegal -- for a bad actor, working for the custodian, to misappropriate funds. Preventing that is the paramount goal of U.S. regulations governing exchanges.

Decentralized exchanges, by contrast, require no custody thanks to the blockchain-based innovation of the automated market maker. An exchange attracts liquidity providers, which deposit tokenized assets into a smart contract. A smart contract is a piece of code stored simultaneously on thousands of computers that use the blockchain to agree on the same result each time the code runs. Collectively, the assets in this smart contract provide an inventory for traders who swap them at prices determined by a formula also contained in the smart contract. For this service, traders pay a small fee on each trade, providing revenue to the exchange and a return to the liquidity providers.

Because smart contracts are publicly visible, the funds within them are easy to audit. Because they can't be altered by any one person (assuming the underlying code is strong), the money is impossible for any one person to steal. Because no actor assumes custody, there's no risk of theft by a rogue manager. This system requires us to trust bits of public code rather than potentially culpable humans.

Popular vernacular associates cryptocurrency with "decentralized finance," or DeFi. This leads to a conflation of FTX's public image with that of decentralized exchanges. But if FTX were a decentralized exchange, Mr. Bankman-Fried would have been unable to drain its accounts of customer funds.

To be sure, DeFi isn't risk-free -- code is subject to attack. Hackers have snatched more than $3 billion from decentralized financial applications in 2022, including $611 million from Poly Network, $190 million in the Nomad bridge exploit (in which a faulty code update allowed anyone to withdraw the deposits of others), and $130 million from Cream Finance. Wintermute, a sophisticated trading firm, lost $160 million after generating keys (passwords) for its own wallets that proved easy for hackers to guess.

But DeFi code grows stronger every day, owing partly to these battle scars. Leading protocols such as MakerDAO, Compound and Clipper hold more than $15 billion, and their user funds have never been hacked. Law-enforcement and industry-monitoring outfits have sharply improved their ability to trace and recover crypto assets. Authorities recovered more than half of the $4 million Colonial Pipeline ransom, and one of the largest holders of Bitcoin is the U.S. government, with more than 1% of the total supply as a result of successful seizures and recoveries.

This year, centralized crypto intermediaries have lost more customer money than decentralized protocols have. Users are starting to vote with their feet: Decentralized exchanges have processed almost $1 trillion this year, roughly 20% of all cryptocurrency trading volume.

Some claim fraud isn't possible in a U.S.-regulated exchange like Coinbase, Kraken or Gemini. But Mr. Bankman-Fried halted withdrawals and declared bankruptcy for FTX's U.S.-regulated subsidiary. Gemini froze withdrawals from its yield-generating Earn service after its U.S.-based partner, Genesis Lending, halted redemptions amid losses related to FTX.

Others argue that forcing a separation of custody, brokerage and exchange operations would have reduced conflicts of interest and kept FTX honest. This is what regulations require in most other mature markets, and it might have helped. Yet noncrypto brokerage MF Global, which was liquidated in a 2011 bankruptcy, misappropriated customer funds despite such separation of functions.

For years, observers have questioned why people would use DeFi when centralized exchanges are often faster and cheaper. The FTX story flips the question: Why should people trust their money to a third party if they don't have to?

DeFi shouldn't be ensnared in a catch-all regulatory response to the FTX debacle. Mr. Bankman-Fried's blurring of the distinction between centralized and decentralized finance is revealing: The 2022 Digital Commodities Consumer Protection Act, which he reportedly backed, might have hampered decentralized exchanges by burdening them with rules more suited to centralized ones. A one-size-fits-all regulatory approach has the effect of making decentralized exchanges less competitive with centralized ones such as FTX and thereby heightening the risk of fraud against customers.

Whenever captains of industry call for greater regulation of their own business, consumers should scrutinize their motives. Politicians who found Mr. Bankman-Fried's pitch seductive especially need to draw critical distinctions and avoid regulatory approaches that do more harm than good.

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Mr. Ramaswamy is executive chairman of Strive Asset Management. Mr. Lurie is CEO of Shipyard Software, a developer of specialized decentralized exchanges, in which Mr. Ramaswamy is an investor." [1]

1. Centralization Caused the FTX Fiasco

Ramaswamy, Vivek; Lurie, Mark. 

Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 28 Nov 2022: A.17.