What to expect from crypto the year after FTX

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The cryptocurrency had its Lehman moment with FTX or, perhaps, another Lehman moment. The macroeconomic downturn has not spared crypto, and as November wore on, no one knew we were headed for the collapse of a trillion-dollar empire.

As rumors of bankruptcy began to spread, a bank run was inevitable. Sam SBF Bankman-Fried, the once effective altruist now under house arrest, continued to argue that the assets were good. Of course, they weren’t. From Genesis to Gemini, most major crypto organizations were hit by the contagion effect afterwards.

The problem with exchanges like Binance, Coinbase and FTX

Time and again, the thin layer of stability has been shattered by the hammer of macroeconomic tensions in an atmosphere of centralization. Arguably, centralized systems are growing rapidly for the same reason: they value efficiency over stress tolerance. While traditional finance runs economic cycles over several decades, the fast-paced nature of Web3 has helped us appreciate or rather despise the dangers posed by centralized exchanges.

The problems they pose are simple but far-reaching: they trap skeptical and intelligent investors in a false sense of security. As long as we’re in a bull market, whether organic or manipulated, there are far fewer reports to publish about failing balance sheets and shady track records. The downside of complacency is precisely when this is not the case.

Related: Economic Fragility Could Soon Give Bitcoin a New Role in Global Commerce

The way forward, for most people who have been hurt by the FTX collapse, would be to start using self-custody wallets. As retail investors scramble to get their crypto out of centralized exchanges, most of them need to understand the magnitude of the centralization problem. It doesn’t stop at retail investors who store their assets in hot or cold wallets; instead, it just turns into another question: Under what asset do you park your wealth?

Often hailed as the backbone of the crypto ecosystem, Tether (USDT) has been repeatedly criticized for allegedly not having the necessary assets to back up its users’ deposits. This means that in the event of a bank run, Tether would not be able to repay these deposits and the system would collapse. While it has stood the test of time and bear markets, some risk-averse people might not push their luck against a potential depeg event. Your next option is, of course, USD Coin (USDC), which is powered by Circle. It was a reliable option for crypto veterans until the USDC associated with the Tornado Cash protocol was frozen by Circle itself, once again reminding us of the dangers of centralization. While Binance USD (BUSD) is literally backed by Binance, a centralized exchange, Dai (DAI) is created after oversized Ether (ETH) is deposited into the Maker Protocol, making the stable system dependent on price risky assets.

There is also counterparty risk here, as you have to take the auditors at their word when they say a particular protocol has the credentials to return your deposits. Even in the bull run, there have been instances where these valuations have been deemed unreliable, so it makes little sense to believe them outright under such trying circumstances. For an ecosystem that relies so much on independence and verification, crypto seems to be putting up quite a performance of iterative pleadings trust me.

Where does this lead us now? Regulators are eyeing the crypto industry with the wrath of justice, while enthusiasts are pointing the finger at several players for driving at this time. Some say SBF is the main culprit, while others consider the hypothesis that Binance CEO Changpeng Zhao is responsible for the loss of trust in the ecosystem. In this winter, regulators seem convinced that human beings and the protocols they develop require legislation and regulation.

Users Leaving FTX, Binance, Coinbase and Other Exchanges Bring Hope

It is no longer a question of whether the industry should abandon centralized exchanges. Rather, it is about how we can improve decentralized finance (DeFi) in a way that does not invade privacy while reducing current notions that it is the Wild West. Regulators alongside investors are waking up to the renovated idea of ​​centralized organizations collapsing under stress. The wrong conclusion to draw would be that centralized exchanges need to be more tightly regulated. The optimistic and honest is that they must be abandoned in favor of DeFi at a much higher rate.

DeFi was developed to completely avoid these risks. One such method is to develop agent-based simulators that model the risk of any lending protocol. Using on-chain data, proven risk assessment techniques, and the composability of DeFi, we test the lending ecosystem. DeFi provides the necessary transparency for such activities, unlike its centralized counterparts, which allow funds to be hidden and remortgaged privately to the point of collapse.

Such monitoring can be done in real time in DeFi, allowing users to have a constant view of the health of a loan protocol. Without such oversight, insolvency events that have taken place in the centralized financial sector are made possible and can then trigger a cascade of liquidations as the chain of exposure breaks down.

Imagine if all FTX assets were monitored in real time and displayed in a publicly accessible resource. Such a system would have prevented FTX from acting in bad faith towards its clients from the start, but even if there was too much unsecured leverage that would lead to a collapse, it would have been seen, and the contagion would have been attenuated.

Related: The Federal Reserve’s Pursuit of an Inverted Wealth Effect Is Undermining Crypto

The stability of a loan system depends on the value of the collateral provided by the borrowers. At all times, the system must have sufficient capital to become solvent. Lending protocols enforce this by obliging users to over-collateralize their loans. While this is the case with DeFi lending protocols, it is not the case when someone uses a centralized exchange and uses immense amounts of leverage with little to no collateral.

This means that DeFi lending protocols, in particular, are protected against three main vectors of failure: centralization (i.e. human error and humans falling into the greed of conflicts of interest), lack of transparency and under-guarantee.

Finally, for regulators, moving away from centralized systems does not absolve them of their responsibility or eliminate the need to regulate even decentralized spaces. Since such systems can only be regulated to a certain extent, they are much more reliable for decision-making and predictability. A code will replicate its content unless a systemic risk is found within it, and that is why it is easier to confine oneself to particular codes and come up with regulations around them than to believe that each human part will act in the interest of the group as a whole. For starters, regulators can start testing DeFi applications for transaction size and transparency.

Amit Chaudhary is Polygon’s Head of DeFi Research. He previously worked for financial companies such as JPMorgan Chase and ICICI Bank after earning a Ph.D. in Economics from the University of Warwick.

This article is for general informational purposes and is not intended to be and should not be considered legal or investment advice. The views, thoughts and opinions expressed herein are the sole authors and do not necessarily reflect or represent the views and opinions of Cointelegraph.

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