werblog

When disasters strike, everyone’s natural instinct is to run away. Sometimes, though, it’s not so easy to separate yourself from the source of devastation.

In response to the FTX collapse, commenters in the crypto community are rushing to distance themselves from the disgraced exchange. FTX was a centralized intermediary, they point out, not a decentralized blockchain. In fact, manipulation and fraud by intermediaries epitomize the untrustworthy behavior that blockchains were created to prevent. A variant of this argument is that the answer to the problems FTX highlights is to abandon opaque custodial digital asset platforms in favor of radically transparent DeFi. Another is that FTX demonstrates the failure of virtual tokens created on top of blockchains like Ethereum, which will inevitably produce risky speculation and scams, and reinforces the case for Bitcoin as the one true blockchain.

There is merit to all these claims. FTX was able to, apparently, misappropriate investor funds for speculative activity of its affiliated trading firm because it had custody over those digital assets. In this way, its role was no different from a broker or exchange managing investments in traditional securities. Users may have thought they were in a new decentralized blockchain world trading Bitcoin or Solana tokens on FTX rather than Apple or GM stocks on the NASDAQ, but they weren’t. In fact, offshore exchanges like FTX, Binance, and Bitfinex are the worst of both worlds: all the risk of centralized opaque control, without the protections of traditional financial regulation and corporate auditing.

However, we shouldn’t be so fast to declare “real” crypto as the solution to the problems FTX represents.

One enduring question about digital assets is whether they do, or will, create any real value. If not, they are simply tools for boundless speculation, where the only winners are those lucky or crooked enough to sell at the right time. Traditional finance involves risk and speculation, but it also generates positive-sum wealth creation and capital formation to fund valuable things in the real world. This remains an open question. There is much debate over whether any large-scale use cases exist for digital assets and the Web3 model. I won’t try to resolve that debate here. As I see it, trading markets are a legitimate segment of activity as long as digital assets have some value, which they do thanks to cryptographically enforced digital scarcity and tokenization of other assets. But they are the least important of the four major blockchain use cases I identify, which I call the Four Ts: Trading, Transacting, Tracking, and Trust-Minimizing.

When people describe cryptocurrrencies, Bitcoin, blockchain, or DeFi as breakthrough innovations with revolutionary potential benefits, they’re talking about something more than another asset class listed on your trading screen. Blockchains also have costs. To justify investment in building and scaling them, the benefits must exceed those costs. We can’t yet be confident of that. Until we have an answer, it’s impossible to distinguish clearly the “unproductive” speculation on tokens from the “productive” uses.

The second reason that FTX can’t be separated from the rest of crypto is the entire ecosystem rode a wave of growth based on capital flows since 2017 driven by exchanges. The reason the price of bitcoin went from hundreds of dollars to tens of thousands during that period, even after pulling back substantially from the highs of 2021, is the flood of new investors excited about the upside. The speculative boom of the crypto trading ecosystem is what brought in the capital that funded development of blockchains, decentralized applications, and ancillary services. It’s what paid the salaries of the new developers and others moving into the space. If the exchanges and yield-generation platforms went away, all that capital wouldn’t stick around. The relatively small cadre of true believers who were around before 2017, and before the earlier bubble in 2013, will remain excited about Bitcoin as a payment or store of value mechanism, but most of those who rushed in later when prices spiked won’t.

Finally, there is DeFi. DeFi protocols are non-custodial operate programmatically according to their smart contracts, without human discretion. So in theory, they don’t allow for the abuses we saw with FTX. That statement, however, must be qualified. Not everything labeled as DeFi is truly transparent or truly decentralized. Terra Luna, the stablecoin ecosystem that blew up spectacularly in May 2022, promoted itself as a decentralized platform, but actually wasn’t. Some DeFi protocols have deliberate backdoors; others have flaws that allow hackers to exploit them from the outside. And even those DeFi protocols that deserve the label create other policy concerns and risks beyond the ones at issue for centralized exchanges. For example, DeFi makes it harder to police illicit financial activity and sanctions compliance, because there appears to be no identifiable controlling actor to regulate. DeFi services also pose new forms of systemic risk, because they are so easily composable and programmable. Like the issues with centralized exchanges, there may be effective responses, both technical and legal. Moving to DeFi shifts the regulatory debate to a new arena; it doesn’t eliminate it.

The real problem at FTX was not the technical architecture of the platform; it was the unethical and destructive actions of its leaders and enablers. The challenge for everyone in the crypto space is to identify how bad actors can be thwarted and potential benefits realized.