Written by: Donovan Choy
Compiled by: Shenchao TechFlow
“FTX’s failure declares the failure of DeFi.”
This assertion has been echoed by various Web3 skeptics over the past week amid the shocking implosion of FTX and Alameda.
The White House reiterated that FTX is the reason “there is a real need for prudential regulation of cryptocurrencies.” In a tweet, Senator Elizabeth Warren characterized the cryptocurrency industry as "smoke and mirrors" and argued that the SEC should be pushed for "more aggressive enforcement."
This isn’t just for politicians, either. Anti-DeFi Bitcoiners are seizing the opportunity of the FTX explosion to promote their "why only Bitcoin works" slogan.
FTX is not DeFi
The FTX disaster represents the failure of the centralized financial mechanism that DeFi has been working to replace.
Consider where the root of FTX’s disaster ultimately came from – FTX loaned out customers’ deposits rather than holding them as redeemable deposits 1:1. Worse, they overleveraged their balance sheet by holding a disproportionately large amount of illiquid FTT tokens as collateral instead of safer assets like stablecoins. In short, FTX is trying to play the role of a bank where it shouldn't be, and it's playing it badly.
Neither scenario is possible for a DeFi exchange or bank.
DeFi is self-regulated
Take a look at DeFi’s largest trading platform: Uniswap.
Uniswap users will never lose sleep over whether Uniswap will trade customer deposits, simply because there are no personal "deposits" in the first place. Unlike FTX, users simply execute trades in hundreds of permissionless liquidity pools.
Funding in these pools is provided by liquidity providers/stakeholders, who again have no concerns about Uniswap trading their deposits. These liquidity pools are governed by immutable smart contracts, making it impossible for Uniswap to do anything else with their funds.
The same goes for any lending/borrowing DeFi platform like Aave or Compound. If you take out a loan on Aave, you first need to deposit capital at a safe loan-to-value ratio. If the value of the collateral backing your loan falls below a preset threshold, Aave will automatically liquidate your loan. This contrasts with a series of bad loans FTX made to its own sister hedge fund Alameda, which were then used as collateral for loans elsewhere.
The most competitive, market-tested DeFi protocols follow these self-governing rules and aim to avoid situations like what is currently happening with FTX.
As for CeFi, before FTX collapsed, Alameda Research held an outstanding loan of 20 million MIM (Abracadabra’s stablecoin), while FTX’s exchange token FTT was 5 million. But whatever you think of Alameda (or Dani Sesta), the debt was fully repaid on November 9 amid market turmoil.
Why would they return it? Alameda did not repay the loan out of good faith. They pay the loan because there is no bankruptcy filing option in the EVM world. If Alameda defaults, their FTT collateral will be immediately liquidated and sold by the liquidator at the then-current price of $17.
It is in their own best interests to pay off the loan and regain their FTT. In short, it’s DeFi that forces them to pay off their loans.
What about the stablecoin part of the DeFi world? The test for a stablecoin is whether it is pegged to the U.S. dollar, which can be stressful during times of market volatility. However, Maker’s DAI performed well in last week’s test.
Even MIM, despite having a 35% FTT mortgage, turned out great. After a brief depreciation to $0.974 on November 9, MIM resumed its peg.
DeFi fails on a social level
So when crypto skeptics blame DeFi for “failure,” it’s certainly up to those in the space to push back on them.
Do DeFi trading and lending protocols work as expected? Yes, they did. Have decentralized stablecoins devalued and collapsed? No, they don't.
Ultimately, the skeptics don't seem to understand this. In a sense, though, DeFi failed.
DeFi fails because its community becomes complacent. We should have done reserve certification a long time ago. DeFi failed because we didn’t foresee SBF’s intentions and we should have been more skeptical. DeFi failed because we accepted centralized intermediaries for convenience. Self-hosting is hard, but trusting FTX leaves too many people in the industry exposed.
The failure is not with the DeFi system itself, but with the cryptocurrency community, which has compromised the value of decentralized finance too much, too much.
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