DeFi Supporters Say FTX’s Black Box Model Shows Peril of Centralization

Contagion Wipes Out $10B of DeFi’s Market Cap in 48 Hours

Don’t blame DeFi. 

That’s the vibe running through the decentralized finance community as project teams and investors cope with the damage wrought by the meltdown of FTX, the centralized derivatives exchange. 

Even though DeFi stalwarts had nothing to do with the practices that sank Sam Bankman-Fried’s high-profile company they have been impacted by the contagion from its demise. 

The market capitalization of the top 10 DeFi tokens has dropped 26% in the last 48 hours, to almost $38B, the worst plunge since four days in May when the fall of Terra poleaxed the market, according to CoinGecko data. Solana’s SOL token has been especially hard hit, losing more than half of its value in the last seven days.

Black Boxes

For proponents of Ethereum and its fellow networks, it’s suddenly become vital to highlight how business conducted on public blockchains is different from the opaque model at the heart of FTX, and its sister firm, Alameda Research, a hedge fund that looks like the infamous black box models found on Wall Street. 

 “DeFi protocols provide a financial [system] that is truly transparent, void of back-room deals, and has firm risk policies,” David Mihal, an engineer who develops the data platform CryptoStats, told The Defiant. 

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Last week investors were shocked by a serious off-chain revelation: FTX’s manufactured token, FTT, was the linchpin for Alameda Research, a crypto hedge fund that is also controlled by Bankman-Fried. After CoinDesk reported that an internal document showed 40% of Alameda’s balance sheet was dependent on FTT, the model unraveled. 

How could an intertwined exchange and a hedge fund have any credibility in the marketplace when their positions relied on an ersatz token instead of hard assets such as the U.S. dollar or even Bitcoin?

That was the question that prompted Binance to announce on Sunday it was going to dump $500M worth of FTT and triggered the run on FTX. Mihal pointed out that Celsius, the failed centralized exchange, and Three Arrows Capital, the bankrupt $10B hedge fund, pursued similar practices. 

Underwater

“They’ll often repay DeFi protocols before other creditors,” he said. “You can’t strong-arm or negotiate with DeFi protocols. If your position is underwater, you get liquidated, no questions asked.”

Now DeFi proponents fear the FTX failure will tarnish the entire crypto sector and make it harder to escape the worst bear market since 2018. 

“The problem that is happening is people are conflating decentralized finance with centralized finance,” Jim Bianco, a macro markets researcher, said on Fox Business. “And that’s my fear,” he added, saying that DeFi didn’t have a whole lot to do with FTX’s collapse.

Builders of the largest DeFi protocols such as Aave and Compound have emphasized DeFi’s self-regulating properties. “The best regulatory framework for crypto would be DeFi,” Stani Kulechov, the co-founder of Aave, tweeted. Aave is a money markets protocol with $5.4B in total value locked (TVL), according to The Defiant Terminal.

Robert Leshner, the founder of Compound Finance, another major money market protocols with $2.1B in TVL, sounded a similar note. “[Sam Bankman-Fried] spent months lobbying to kill DeFi, because he knew that transparent autonomous protocols were a threat to ‘trust me assets are fine’ finance,” he tweeted.

Leshner was referring to Bankman-Fried’s activities on Capitol Hill. The 30-year-old entrepreneur has contributed millions of dollars to Democratic Party lawmakers and last month he came under fire for supporting a bill with potentially adverse effects for DeFi protocols. At the same time, Bankman-Fried proposed an  “industry norms manual” for best practices in crypto. His self-appointed role as crypto’s ambassador grated many even before FTX collapsed.

Off-chain Deal

Of course, the meltdown with Terra happened due to a faulty on-chain mechanism. But even then, the project was backstopped with an off-chain deal, Mihal said. 

In any event, the FTX fiasco is bound to accelerate a crypto crackdown and lead to potential new statutes. It’s safe to say lawmakers will see the difference between DeFi CeFi as hairsplitting. Sen. Elizabeth Warren (D-Mass.), long a forceful advocate for tighter control of crypto and a former bankruptcy professor at Harvard Law School, urged watchdogs to intensify their scrutiny of the sector. 

Stability

“The collapse of one of the largest crypto platforms shows how much of the industry appears to be smoke and mirrors,” Warren tweeted on Wednesday. “We need more aggressive enforcement and I’m going to keep pushing [the SEC] to enforce the law to protect consumers and financial stability.”

DeFi proponents say it will be more imperative than ever to separate decentralized finance from its centralized brethren. 

“The transparency of DeFi lets us understand the risk to DeFi and on-chain markets,” Mihal said. “But the risk to other off-chain entities is still unknown”


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