Casting a glance back over the year, the conclusion is unavoidable: centralized crypto players are hard to trust. Same as it ever was, some may wryly opine, but millions of users bought into the too-big-to-fail narrative and learned a cruel lesson the hard way. From the collapse of the FTX exchange to the bankruptcy of crypto lender BlockFi, 2022 has seen many demolition balls swung at the digital asset industry. Despite the significant reputational damage, the edifice is still standing.
Now seems like as good a time as ever to stress the differences between centralized entities and their decentralized counterparts.
Day of the DEX
Although trading volume on centralized exchanges actually rose during November, decentralized platforms were the main beneficiary: DEX volumes hit $65 billion last month, an increase of 93% since October. According to The Block Research’s Lars Hoffman, the demise of FTX compelled many users to de-risk from CEXs to on-chain, taking custody of their private keys and turning their backs once and for all on centralized platforms.
Is it any wonder? The unscrupulous behavior of not just Sam Bankman-Fried (FTX) and Caroline Ellison (Alameda Research), but the management at BlockFi, Celsius, Three Arrows Capital and Terra, proved just how fatal human error, greed, and hubris can be in a market where sentiment – and prices – swing violently.
Perhaps the most egregious example is Alameda Research, the fund founded by Bankman-Fried, which inflated its balance sheet through tokens printed ex-nihilo by what was essentially its sister company, FTX. Did the exchange’s customers know that their deposits were being used to fund risky bets in a volatile market? Of course not.
On the contrary, users’ concerns were assuaged by the fact that FTX had been audited by a top accounting firm, Prager Metis. Crypto forensics firm Chainalysis had access to FTX’s internal ledger data and failed to spot the fraud. Actually, they now join burned retail investors in the long line of creditors.
“Like any financial institution, the CEX business model is ultimately predicated on trust,” says Harrison Comfort, Co-Founder of DAM Finance. “It promises to safeguard deposited assets while taking a fee on transactions between buyers and sellers. For a CEX to fail, it has usually either misappropriated deposited funds or failed to generate a sustainable business. In the case of the most recent meltdowns, it has largely been cases of the former.”
Peer Inc. President Tony Tran points to the often layered complexity of unethical processes pursued by centralized platforms. “Any decision tree that deals with a multitude of parties, against a multiple of value set, will ultimately lead to entanglement so thick, it’s bound to foster thieves. That’s why oversight is so onerous in traditional setups.”
The surging volumes we have seen on decentralized exchanges reflect an acknowledgement that unlike many CEXs, these trading venues do not run on fractional reserves like banks: they trust code rather than human-decision making at a management level. Customer funds are inaccessible, since users retain keys to their own funds rather than utilizing hot wallets on the exchange, meaning they can't be co-mingled and gambled on the market.
The evolution of the DEX landscape has been impressive, and there are now options for spot trading, perpetuals, even liquidity management. So, what’s the catch? Well, they are considerably less liquid than their big-name CEX peers. And they are often less user-friendly and ill-equipped for high-frequency trading. But improvements are being made all the time.
CEXs Pursue Hybrid Model
The growing popularity of DEXs is even motivating centralized platforms to launch their own decentralized trading platforms. On December 8, Bybit announced the integration of ApeX Pro, a permissionless, non-custodial, DEX offering high-performance perpetual contracts using StarkWare's scalability engine, StarkEx. ApeX Pro has been designed to look and operate like Bybit, with zero-knowledge proofs deployed to give users maximum privacy.
Binance also launched its own open-source DEX back in 2019, and its CSO Patrick Hillman recently claimed the company’s centralized exchange may not exist in 10 years – because the crypto market is moving toward decentralized finance.
“DEXs, as the most commonly-used ones are designed, are not susceptible to the same risk factors as CEXs because you are trusting auditable software that runs on decentralized computers and your ability to self-custody, not a centralized organization,” says Harrison Comfort. “On a DEX, assets are stored in auditable smart contracts running on blockchains by anyone interested in creating a market for token pairs, in exchange for fees. The developers behind the DEX can’t take your funds, only you can. And you will maintain that right provided you don’t misplace your private keys or the security of the blockchain where you deposited your funds isn’t compromised.”
Although major platforms publish proof of reserves to assure customers of their trustworthiness, the scales have already fallen from many users’ eyes. After all, these same users were told Mt. Gox was a black swan event from the formative years of the industry. They were convinced to trust Terra and FTX and Celsius. In the latter case, one investor lost over $40 million.
But is the rehypothecation of customers’ collateral really impossible with DEXs? “Anything can be leveraged if it’s tokenized, coded, and bounded properly,” says Tony Tran. “The exception with DEXs is that everyone can see this happening on-chain. That’s the difference.”
Not all centralized parties are shady, of course, and many will continue to thrive – particularly while DEXs struggle with the depth of their order book or speed of execution. But it seems clear that decentralized trading will continue embracing those users whose trust in the centralized model has been broken. Expect more advanced DEX features, hybrid trading models, cross-chain functionality, and a growing focus on privacy, security and transparency. Perhaps SBF was the industry's savior, after all.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Nikolai Kuznetsov
Nikolai Kuznetsov is a financial analyst and professional trader. Based in Israel, he has been trading in multiple markets and educating traders as a teacher and mentor. Nikolai has extensive experience in , and in various assets such as cryptocurrencies, FX, commodities, equities and bonds. In the last decade, Nikolai has devoted his energy and skillset to the crypto market, contributing analysis pieces, trade commentaries and op-eds to publications such as Cointelegraph, Forbes, TheNextWeb, and Investing.com, among others. He also holds a black belt in Brazilian Jiu-Jitsu.
Read Nikolai's Bio