While the fallout is ongoing, it’s safe to say that the collapse of FTX has created a seismic shift in the digital asset landscape. One of the industry’s most prominent – and ostensibly successful – firms has filed for bankruptcy, unable to meet its obligations to creditors, investment funds and individual investors. It's a veritable nightmare for those exposed, but it also raises questions about the adoption of digital assets as a whole. The reality is that in today’s financial landscape, crypto often plays a role that is markedly different from what was originally intended, and in this case, the results were disastrous.
The outcry has been swift. Bloomberg recently published a story on how the incident has scared off institutional investors, featuring quotes from leading asset managers like Fidelity, Pinebridge and BlueBay. Meanwhile, many voices have understandably zeroed in on the strangeness of FTX as an organization, focusing more on cryptic tweets than cryptocurrency.
The main lesson is one that spans all industries – a reminder that bad actors can take advantage of hype and public adulation to cause harm at a massive scale. But when it comes to digital assets specifically, the doom-and-gloom take completely misses the point. If the crypto industry had developed as it was intended to, the FTX implosion might not have been so disastrous. Users would have had more options in terms of how to store and safeguard their assets, including ones that might have saved them from the staggering losses we saw last month. That should make all of us think long and hard about the future of this asset class.
To understand why, we need to go back to the early days of crypto. In his seminal whitepaper, Satoshi Nakamoto explained his vision for Bitcoin as an ownerless, peer-to-peer version of electronic cash. Payments would be sent directly from one party to another, without the need for financial intermediaries. Validation would be delivered via blockchain technology, providing an ongoing ledger of non-reversible transactions including timestamps and transaction data.
While there has been significant progress, many crypto firms today employ business models that do not reflect this decentralized vision. Despite the accepted nomenclature, entities like FTX should not be thought of as crypto-focused versions of traditional exchanges – that is, they are not matching engines, but custodians. The digital asset space is dominated by centralized “exchanges” that house client-owned assets and trade on their behalf, as opposed to connecting buyers and sellers at an agreed-upon price.
To put a finer point on it, consider the case of FTX from a client’s point of view. When you don’t house your own assets, your control of them is limited by the custodian (FTX) – their people, their decisions, their liabilities and their failures. This reliance on middlemen is the exact problem that crypto was conceived to solve. Centralized exchanges have enabled access and fueled adoption, but they have also distracted the industry from building an ecosystem of truly bilateral transactions, with each side having full visibility and control. The result is that many crypto users today are as tangled up with institutions as their traditional counterparts.
To right the ship, stakeholders must continue to embrace decentralized finance (DeFi). Instead of relying on intermediaries, users can leverage a wide range of DeFi applications (dApps) for trading, lending and more. These dApps are built on various blockchains and facilitate automatic and anonymous transactions – the two sides of each transaction are the only entities involved. Many individual investors have embraced these capabilities, with decentralized exchanges like Uniswap increasing their market share even before the FTX debacle.
But institutional adoption has lagged, largely because these entities demand a higher level of risk management. For all their shortcomings, centralized exchanges can and often do serve as a buffer between asset owners and fraudsters. With DeFi, your assets are only as secure as you allow them to be, and that creates challenges.
For example, smart contracts are largely unreadable to human users – how do you ensure that they will function as expected? If a dApp is compromised and users inadvertently send funds to the wrong address, they can’t be reclaimed. Another obstacle is building connectivity and designing comprehensive risk policies for a wide range of disparate dApps. Finally, there’s the question of access – how can wallet keys be kept out of the wrong hands without inviting key-person dependencies and inefficiencies?
For individuals, these challenges are only as severe as one’s own risk tolerance. For institutions, they create significant and unfamiliar burdens, especially at scale. Therefore, the key to institutional adoption of DeFi – and, by extension, digital assets as a whole – is to invest in robust security infrastructure to enable and support a decentralized ecosystem.
The destination is clear, and the path to get there is being blazed before our eyes. Driving institutional adoption of DeFi will take a collective effort from investors, technology vendors and cryptography experts alike. From specialized custody platforms to contract auditing tools and beyond, this work is already underway.
In this difficult moment, we have a unique opportunity to highlight why the momentum surrounding DeFi points to the true future of the crypto industry, enabling institutions to realize the full benefits of a revolutionary asset class. Let’s not waste it.