The FTX collapse

The crypto landscape has once again been rocked by another black swan event. The collapse of FTX and consequently Alameda Research represents another in a series of industry blunders that has eroded trust levels in the space. FTX and Alameda are organizations that have had close (on-chain) ties since the very beginning.

FTX created FTX Token (FTT), a token for their platform, involving Alameda since day one. The two of them shared the majority of the total FTT supply which did not really enter into circulation. The initial success of Alameda, FTX, and the meteoric rise of FTT most likely led to a rise in the value of Alameda’s balance sheet.

With the collapse of Terra/UST in May, a liquidity crunch ensued as many creditors started to call back loans following the 3AC and Celsius crashes. Alameda would have needed liquidity from a source that would still be willing to give out a loan against its existing collateral. Alameda deposited around ~$3b worth of FTT on FTX of which most remained there until FTX ran into problems themselves.

There is little that can be found that confirms this loan that is visible on-chain but based on known data there is evidence that up to $4bn flowed to Alameda in June and July and that this represents collateral that was used to secure loans. A Reuters interview of people with close relationships with Sean Bankman-Fried (SBF) seems to validate this theory.

While it was known that Alameda and FTX were both founded by SBF & co, a Coindesk report had exposed concerns regarding Alameda’s balance sheet. The majority of net equity in Alameda’s business consisted of FTX’s own centrally controlled token, FTT.

The back-and-forth battle between the CEOs of Binance and FTX caused a ripple effect on market participants, Binance themselves also owned a large FTT position.

With FTX being one of the largest Centralized exchanges the collapse most acutely impacts the centralized finance (CeFi) part of the crypto industry, broker Bernstein said in a research report released recently. “Part of the crypto ecosystem is exposed to this event, but it is not the entire industry” the report added.

One interesting outcome is that the decentralized finance (DeFi) ecosystem and blockchain-based applications stand to “gain from this fragility, subject to some regulatory boundaries and negotiations,” according to industry analysts Gautam Chhugani and Manas Agrawal.

Issues with CEXs

Centralized exchanges are subject to a tremendous number of problems simply because they contradict one of the cardinal laws of cryptocurrency - the owner of the private key is also the owner of the asset. The biggest exchanges like Binance, OKEx, and Huobi take control of user funds and use them for market manipulation. Instead of having the custodian working for the customer, they have their own interests at heart. Custodial exchanges can potentially be like handing over access to your bank account to unknown persons.

Some of the main risks of Centralized exchange include:

Insecurity

There is a risk of fund loss and theft due to their centralized functioning. They are legally accountable and a custodian of users’ funds. 73% of centralized exchanges take custody of user funds, while 23% let users control keys⁴. They represent honeypots for hackers as they are responsible for billions of trades per day and store most of them on their servers.

Lack of liquidity

Large orders struggle to be matched. Even at an all-time high, volumes remain low compared to what you would see in traditional finance markets.

A fragmented but not decentralized market

This divides the global liquidity into a few main marketplaces so it is difficult to make large trades. In addition, there is no clear market leader in terms of volume, which increases the liquidity problem.

Performance

There is a high level of risk for users due to potential performance issues, market manipulation, hardware failures, latency problems, and many other inherent problems when it comes to dealing with large volumes, etc.

Lack of trust and transparency

The actual costs and processes of trading are opaque and involve high trading costs, often higher than announced fees, and higher delays due to peaks of badly managed demand. Plus, they can front-run orders, which is illegal.

DeFi as a solution

The FTX collapse was a failure of CeFi, not DeFi – and smart investors, builders, and users are already taking notice. I believe that many have learned their lesson this time. Several industry commentators are using this as a case study to promote DeFi protocols as the superior offering in the market for concerned investors.

Decentralized exchanges, although not perfect, have many features that reduce their susceptibility to attacks from both internal and external sources. The issues with FTX wouldn’t have been possible for Decentralized Exchange.

Security and Hacking

Centralized exchanges are much more susceptible to hacks and data breaches than decentralized exchanges. To infiltrate the system, a hacker needs only bypass the defenses of the company running the exchange to access users’ holdings, financial information, and other potentially damaging data.

Decentralized exchanges are nearly impossible to hack, as a person would have to hack every user. The system’s peer-to-peer model leaves little to no room to infiltrate or manipulate.

Privacy

Decentralized currencies give users far more privacy protections than their centralized counterparts. Instead of having to go through the Know Your Customer (KYC) process that centralized companies require for users, peer-to-peer transactions can be done with near-total anonymity, meaning that money can be transferred by virtually any person for any reason.

Usability

Centralized exchanges are drastically easier to use than decentralized exchanges. By entrusting transactions to a company and sometimes paying a small fee, users often get the benefits of easy access to their money (think debit cards and ATMs), tools that help visualize their assets (online banking and apps are great examples), all of which are typically done with easy-to-use and visually appealing platforms.

Liquidity

Liquidity on the DeFi market is fragmented across several public chains and further siloed in many different protocols such as liquidity pools on DEXs. Despite aggregators and next-gen DeFi trading platforms attempting to solve this, trading is still inefficient and difficult for professional traders mainly because they can’t tap into deep liquidity and use the same order types as on centralized exchanges e.g. limit order without slippage and fast guaranteed execution.

Another major flaw of decentralized exchanges is that they make it very difficult to get cash quickly. Users are often limited on how much they can spend at once and must go through several steps to get from the value on their screens to fiat currency, especially given that so few businesses currently accept crypto.

Control

Though there are benefits to centralized exchanges, they come at the cost of control. On several occasions, they have been accused of manipulating the prices of their currencies, and users often don’t have complete access. Withdrawal limits and market forces mean it is possible that users cannot access their money at once, and in the worst-case scenario, the money may not be there at all.

The importance of auditing and due diligence for crypto

Smart contracts are attractive targets for malicious attacks from hackers because they exchange vast amounts of value. A small coding error could lead to huge losses. According to reports, the DAO hack on the Ethereum blockchain resulted in the loss of roughly 60 million dollars in ETH. Because of the irreversible nature of blockchain transactions, a project's code must be secure.

The secure nature of blockchain technology makes it hard to recover funds and resolve issues afterward, so it's always better to work to prevent weaknesses from happening in the first place.

This is the reason smart contract audit services are popular. An essential step for any DeFi product creator is to identify vulnerabilities and bugs in their contract. Anyone, including developers, ICO startups, DeFi developers, and owners of decentralized applications, can benefit from smart-contract audits. Thus, you prevent the possibility of losing your users' funds.

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FTX: How did we get here and where do we go?