By CJ Reim
On the surface, decentralized finance (DeFi) and centralized finance (CeFi) appear to be opposites. Over the past few years, however, DeFi and CeFi have become complementary, respectively providing the decentralized infrastructure and compliant onramps for crypto to grow in its early days. Nonetheless, placing them under one “crypto” umbrella has blurred the line distinguishing their individual responsibilities. The FTX debacle has retraced that line with a bright red marker, illustrating what can happen when trust lies with people, rather than with systems and code.
Inspired by the 2008 financial crisis, networks like Bitcoin and Ethereum have emerged over the last decade-plus as budding alternatives to the traditional financial system. By baking trust into code, these early protocols circumvented the need to trust and utilize centralized custodians and mediators. Total financial self-sovereignty became a possibility.
Despite crypto’s promise of individual empowerment, its nascent infrastructure limited both functionality and accessibility. With few protocols, uncoordinated exchanges, and hardly any bridges to the physical world, mass adoption was impossible. Total decentralization may have made blockchains unbreakable, but it also made them unusable for broader society.
Introducing order to the chaos of crypto, the earliest centralized exchanges like Mt. Gox removed many technical barriers to entry. By centralizing trading activity and custody services, the earliest traces of CeFi made crypto accessible to non-technical people. At one point, Mt. Gox was responsible for over 70% of all bitcoin transactions, illustrating how centralized entities can bring significant value to decentralized systems. Nevertheless, this constructive centralization ended in devastation. Mt. Gox was hacked for over 800,000 bitcoins, demonstrating how centralized custodians are subject to the same security risks as individuals, but at an even more massive and devastating scale. Today, Mt. Gox is little more than a ghost of crypto’s past, but its reverberations set in motion a pendulum swinging back and forth between decentralization and centralization to this day.
As the pendulum swung towards decentralization following Mt. Gox’s collapse, early builders sought to bring crypto’s trademark decentralization to the interconnected infrastructure that made Mt. Gox so valuable. The resulting ecosystem, Decentralized Finance, connected various interoperable protocols to make self-custody, transactions, and other financial functions workable in a decentralized landscape.
Despite some DeFi applications finding early product-market fit, the fully decentralized ecosystem has thus far been insufficient for crypto mass adoption. The complicated crypto ecosystem, combined with regulatory uncertainty, fiat on-ramp limitations, and continued security concerns, has limited DeFi’s accessibility for most people. The seeds of a fully decentralized financial system have been planted, but sizable gaps remain.
With DeFi’s inaccessibility swinging the pendulum back towards centralization, a new generation of centralized exchanges emerged. These exchanges offered streamlined, user-friendly crypto experiences with the comfort and familiarity of traditional finance. Safe and compliant crypto onramps, standardized financial statements, easy ways to earn tokens, and curated experiences inspired a wave of crypto mass adoption. Working hand in hand with DeFi, entities like Coinbase grew rapidly and proved centralization could still play a vital role in crypto, particularly when the focus was on compliance and simplicity. That is CeFi at its best. At its worst, however, CeFi merely duplicates the system it was meant to replace.
In the case of FTX, decentralization met defenestration. Armed with buzzwords and bull market momentum, Sam Bankman-Fried became the human at the helm of the world's fastest growing centralized exchange. He captured the attention of speculators, regulators, and crypto idealists alike, making the FTX brand nearly synonymous with crypto itself. Despite its branding, FTX was not a true embodiment of the ethos it espoused. It was the one-stop-shop for this bull market’s brand of crypto, a platform designed purely for speculation rather than innovation. Without the open, decentralized, and trustless characteristics of DeFi, FTX users were left with the illusion of self-sovereignty. Trust in humans rather than code is what failed FTX customers, investors, and other stakeholders.
Although the rapid rise and fall of SBF and FTX is unbelievable and shocking, should it be? This Icarus story is so archetypally human that much of the FTX coverage has consisted of comparisons to similar events in the not-so-distant past: Madoff, Lehman, Enron, Theranos. Additionally, although less discussed, apt examples on a grander scale include hyperinflation in Venezuela and Zimbabwe, bank freezes in Greece, asset seizures in Lebanon, the 2008 housing crisis in the U.S., and even the turbulence in our present day economy. Individually, each event is always shocking. Collectively, however, they couldn’t be more human.
Of course, societies have already created systems of checks and balances in response to past crises. Nevertheless, today’s regulatory, corporate, and legal systems are slow, expensive, and inconsistent. They still rely on humans to manage humans, manifesting in a circular game of catch-up and, as evidenced in lived experiences, remain fallible. Decentralized, blockchain-based systems carry the promise of replacing these laborious structures with transparent, immutable, and automated code.
Imagine structuring new loans not as expensive and time-consuming legal contracts, but rather as smart contracts embedded with specific, determinable criteria. Imagine dodging extractive corporate intermediaries by exchanging on peer-to-peer on-chain liquidity pools. Imagine interacting with a financial system that seamlessly integrates with other applications and efficiently provides services 24/7/365 with negligible costs to its users. Imagine if Lehman Brothers’ assets, liabilities, and other health metrics were openly and perpetually on-chain for real-time monitoring. Or even better, imagine if FTX operated in a truly open, trustless, and decentralized blockchain-based financial system where a massive misuse of customer funds could be totally prevented.
FTX is not the end of the road for crypto. Its collapse is far more emblematic of issues that crypto addresses than those it introduces. And if these stories are endemic to the human experience, then the demand for alternatives - systems where trust lies in code rather than humans - is clear. Decentralized technologies have handed us the keys to those systems. We simply have to remember where we can trust to store them.
CJ Reim is a co-founder and managing partner at Amity Ventures, a San Francisco-based venture capital firm. He is also a contributor to Core DAO, an independent blockchain combining the decentralization and security of Bitcoin with the composability and scalability of Ethereum.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.