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By Hamzah Khan, Head of DeFi at Polygon
From their earliest days, cryptocurrencies and the blockchain sector as a whole were built on the premise of making finance more inclusive, transparent, effective, and, most importantly, independent from the vast majority of rigid financial institutions and other participants like Wall Street. As this nascent industry kept gaining more traction across the world, however, “big money” players began to take notice, and massive amounts of institutional capital started flowing in, acting as one of the biggest catalyzers for the crypto market’s constantly renewing all-time highs not so long ago.
Meanwhile, as the industry was getting more and more “institutionalized,” the most successful entities in the sector turned out to be centralized crypto exchanges (CEXs) and other platforms where, despite their ostensibly decentralized underpinnings, full control over decision-making processes was concentrated in the hands of just a few persons or firms. Even then, everything was going mostly fine across the board — until it didn’t.
Over the past few months, we have witnessed a continuous series of high-profile catastrophes that engulfed some of the biggest names in the crypto industry, including the Terra Network, major lending platform Celsius, and, most recently, behemoth exchange FTX.
While some observers might argue that all of them were instances of “foul play” — i.e. resulted from big competitors “bullying” each other — that doesn’t change the fact that those companies were inherently prone to such mishaps due to their heavily centralized nature and ensuing lack of transparency, where full control and power have been accumulated in the hands of a single entity.
Does this mean the utopian vision of a decentralized global economy ended up dead on arrival? Not even close. However, the recent examples have proved yet again that only by adhering to the core principles of decentralization and transparency — on which Bitcoin itself has initially been built — can the industry confidently move forward. And there is already a sector that came perhaps the closest to this vision thanks to its inherent features and principles — decentralized finance (DeFi).
Code is Law
The recent situation around Binance acquiring/bailing out FTX — and then walking away due to issues that “are beyond [its] control or ability to help” and “the latest news reports regarding mishandled customer funds and alleged U.S. agency investigations” — has set the crypto industry and markets ablaze. Meanwhile, this whole debacle couldn’t even be possible in DeFi.
What sets DeFi platforms apart from their centralized counterparts is that they are operating strictly according to autonomous smart contracts — most of which are open-sourced, which means that literally anyone can take a glimpse “under the hood” and verify what’s going on inside.
Because of this, there is simply no way developers of DeFi platforms can easily “mishandle customer funds” without some extra shenanigans such as using their massive holdings in community voting. While builders still can adjust their platforms’ smart contracts further down the line, this is often done via publishing new proposals and asking their communities whether they approve new changes or not. Other than that, DeFi platforms operate automatically and in line with their code for the most part.
Even though this system is not 100% “bulletproof,” it is still leagues ahead of centralized finance in terms of transparency and fairness, offering users a diverse and inclusive space where they remain in full control of their assets.
Can’t Be Evil
Unlike CEXs, which custody users’ funds on their behalf, DeFi platforms also can’t unilaterally do anything with people’s money. The saying “Not your keys, not your coins” has become so popular for a reason, and FTX’s collapse just added a lot more credence to it. Essentially, it is generally a good idea to always retain control over your assets, even when you are actively trading them.
This is exactly what DeFi allows people to do. Working autonomously, decentralized exchanges only facilitate transactions — but don’t take custody of their users’ cryptocurrencies. Among other things, this allows to avoid such unfortunate occurrences as so-called “liquidity crunches” — situations where a CEX simply doesn’t have enough assets available and is forced to freeze withdrawals because of this.
Further, a number of CEXs have previously stated in their user agreements that customers’ digital assets lack any bankruptcy protections “because custodially held crypto assets may be considered to be the property of a bankruptcy estate” and “could be subject to bankruptcy proceedings,” ultimately treating users as general unsecured creditors. Or, in other instances, a CEX can mistakenly send millions of dollars worth of crypto under their custody to a wrong address purely by accident.
Community Comes First
Communities should always be the main foundation of any decentralized platform, not some specific founders or CEOs. Ultimately, the Binance/FTX drama has shed some additional light on numerous weak points and vulnerabilities that are so common when it comes to centralized exchanges, and proved yet again why DeFi is the future of global finance.
About Hamzah Khan:
Hamzah is Head of DeFi at Polygon where he and his team are working on providing cutting-edge layer-2 Ethereum technology to the global dev community of gaming, digital art and decentralized-finance. Hamzah first heard about Bitcoin in 2017 while studying Mechanical Engineering. Previously, Hamzah worked for Citibank, where he was the youngest member of the R&D team. There, Hamzah’s focus was on building math and computer models using Machine Learning for high accuracy predictions for their investment banking.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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