Illusions of Grandeur
Meditations on Decentralization in the wake of FTX
"It ain't what you don’t know that gets you into trouble. It's what you know for sure that just ain't so." - Mark Twain
Back In the early days of crypto, should a person wish to acquire a stack of bitcoin, there were but two ways to do so. Either mine them yourself, a slow and uneconomical solution, or take your chances with the alternative route, which involved wiring money to a manifestly dodgy exchange in Japan called Mt. GOX. The exchange was run by a Frenchman named Mark Karpeles who listed his ginger cat Tibanne as his business partner and, inexplicably, took every media interview ponderously perched wobbling upon a giant, inflatable yoga ball. Farcical as all this may sound, it had the advantage that nobody but complete fools were sending money to Magic The Gathering Online Exchange, which is what the acronym stood for, under any illusion that they had a better than 50/50 chance of ever seeing that money again. Bets were placed accordingly.
Not so, unfortunately, with Karpeles's spiritual successor, the much-feted Sam Bankman-Fried, that great titan of industry, of Fortune Magazine cover fame, a modern-day John Pierpont Morgan and heir apparent to Warren Buffet, or so the press would have you believe. But, sadly, to paraphrase Mark Twain, there is nothing that is more dangerous than the illusion of safety. When Mt. Gox eventually and predictably collapsed it was a disaster for crypto at the time and a decade later account holders are still to see any of their funds returned. But as Vitalik Buterin put it, the collapse of FTX just "cuts deeper".
FTX, its incestuous sister hedge fund Alameda Research and even the carefully constructed otherworldly savant persona of Sam Bankman-Fried himself were all just an illusion. And when the market finally sensed weakness and pulled back the curtain, everybody realized they'd been fooled and that it was all just a mirage. The sheer brazenness of the con is almost unfathomable - which is probably what caught so many seasoned investors off guard, but the bigger the lie the more believable it becomes. Many books, films and tons of newspaper ink will be spilled in detailing the outrageousness of the scheme, so we won't dwell on the details here. Instead, we’ll reflect on what it means for the space moving forward.
All that glitters is not gold
FTX had the illusion of prestige - SBF was a "genius"; MIT physics graduate who worked at Jane St.; founded the seemingly invincible trading shop Alameda Research.
FTX had the illusion of legitimacy - the best VCs in the world invested. Sequoia was in, Paradigm was in, Blackstone and Softbank were in. Don't worry, somebody somewhere has done the deep due diligence, right?
Source: The Block
Institutional Investors Reported Losses or Exposure to FTX
Temask ………………………………………… $275 million
Sequoia Capital ……………..…………… $210 million
Softbank ……………………………………… $100 million
Ontario Teachers Pension Plan ... $95 million
Source: various news articles or press releases
FTX had the illusion of familiarity - for pensions funds looking to dip their toes into crypto, gaining indirect exposure via an investment in a traditional company must have seemed like less of a daunting task than investing in crypto directly. For the average person on the street - could anything endorsed by both Tom Brady and Shaq really be bad?
FTX had the illusion of innovation - FTX and Alameda had their tendrils in cool new blockchains like Solana and decentralized finance (DeFi) protocols like SushiSwap.
Finally, and most damagingly, FTX had the illusion of safety - SBF was the darling of Washington, seemed to be working hand in glove with the regulators, and was the second largest donor to Joe Biden's campaign.
They were all duped by a man whose inner psychological state, as revealed in a series of unguarded tweets, was that of a player whose remorse didn't extend far beyond that of a chess player ruing a blunder on the board. Describing the rival exchange operator who triggered the collapse as a "sparring partner" to be complimented on a game "well played", and seemingly oblivious to the suffering of his customers who were merely pawns to be sacrificed for his own ambitions. But what chance had the average retail investor when well-known funds got caught in the blast radius. They truly were lambs to the slaughter. And what of the regulators who dragged their feet on a crypto ETF for so many years. Failing to provide any clear guidance thus driving investors into the arms of unscrupulous operators. They must share some culpability, FTX is, too, a child of their half measures.
Faux Defi, Pseudo Defi, CeDeFi - fool's gold.
The bitter irony of all this is, harkening back to Satoshi's famous headline embedded in the bitcoin genesis block, "Chancellor on brink of second bail out for banks", that this is a very familiar failure of a trusted, centralized institution - the very thing which blockchain was supposed to solve! Unfortunately, the collapse of FTX will likely have ramifications for the whole of crypto space. Optimistically it may spur positive changes in the form of genuine regulatory oversight. Pessimistically, this may come at the cost of stifling innovation. Ideally regulators could do a genuine service by finally removing the illusion of safety first and foremost. It should be noted that true DeFi protocols have functioned flawlessly throughout the bear market of 2022, and all the major failures such as Celsius, BlockFi, and FTX are best categorized as belonging to that abomination of CeDeFi (Centralized DeFi). No amount of marketing can alter the fact that once the human enters the equation, then it's not DeFi anymore.
Contrast this with a true DeFi protocol like MakerDAO. Maker allows users to lock up collateral in a smart contract and generate a stable coin (DAI) pegged to the US dollar in return. DAI can only be generated via this mechanism and by auditing the blockchain anybody can check that the assets are sufficient to back all outstanding DAI. Should the collateral value fall below the required multiple of outstanding DAI, the smart contract will automatically liquidate held collateral to keep the system fully collateralized. The entire code controlling the Maker system is open source, the smart contracts themselves can be viewed on chain, and as well as all the assets. Whereas, despite the apparent comfort of familiarity, it seems like nobody has the full picture on what was going on inside FTX. In released court documents filed on November 17, the new CEO John J. Ray III stated, “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” That’s the same John J. Ray that was called in to mop up after Enron.
So where do we go from here? The 2008 Global Financial Crisis had the effect of massively changing the finance industry, in particular in adjustments to valuation to account for counterparty risk. For the nascent crypto industry, the fall of FTX will likely have similar consequences. Here we explore some possible outcomes and solutions.
First Principles for Getting Back on Track
While all this is admittedly hard for the casual investor to assess and process, let’s be honest – many of the entrants in this space in the recent years are not casual participants. The cohort consists of institutional managers, venture capitalists, risk managers, accountants, and experienced regulators. It behooves all of us to grok the permissionless, trustless aspirations of a public blockchain; the distinction between decentralized and centralized platforms; the primacy of privacy in peer-to-peer interactions in a free society. Additionally, we shouldn’t forget the lessons that we’ve learned about from traditional financial and governance systems and leave those best practices behind. Users shouldn’t have to choose between using a centralized or a decentralized platform but rather, have access to both platforms and choose the one that is most appropriate for their transactions. As we build and move forward, we think these are the first principles we should pay attention to.
Transparency. Whether we talk about [centralized] corporations, government organization, or decentralized platforms, we want transparency. Across most global democratic jurisdictions, governments demand this of corporations. Businesses are required to issue financial statements, disclose their activities, catalog their risks, and provide forward looking statements. Citizens demand transparency on government spending and seek to have a voice in policy before they are cast in laws. DeFi platforms readily offer up their source code for inspection and public blockchains readily provide information such as total value locked on automated exchanges and lending platforms. We should relentlessly demand the same of new entities, be wary of those which decline to provide this, and steer capital accordingly. Government regulators should continue to provide oversight on centralized corporations. Self-regulatory bodies and decentralized autonomous organizations (DAOs) should be allowed to govern decentralized platforms. A vibrant exchange of the two will be needed for hybrid organizations. Calls for Proof-of-Reserves are being made for CeDeFi platforms. While information is transparent for decentralized platforms, the user experience to gather and evaluate this information leaves much to be desired. One still needs to be technically proficient at digging through blockchains and public addresses to piece together a complete picture. Across the globe, corporations with listed securities are mostly required to follow one of two accounting standards, GAAP or IFRS. Perhaps we can take a page from this practice to come up with reporting standards for, at least, CeDeFi platforms.
Primacy of Privacy. To build platforms that allow for more permissionless and trustless peer-to-peer transactions, privacy needs to be protected. At the risk of being pedantic, without privacy, any transaction, be it a communication or a financial exchange, may be censored intentionally or inadvertently due to shifting policies and preferences by centralized authorities. Technology, such as zero-knowledge (ZK) proofs, exists today to protect this privacy. On the other hand, there is certain information we may want to provide to the other party or to regulatory bodies. For example, the ability to ascertain that the parties are regular tax-paying citizens who have not engaged in money laundering in the past is important to recognize the transaction was not initiated by bad actors. ZK proofs allow for this validation while keeping the identities of the parties and details of the transactions private.
Regulation vs Code is Law: “Six of One, Half a Dozen of the Other”. The centralized agents don’t trust the decentralized community because they have a paternalistic view that community is incapable of effective governance, enforcement, and punishment. Meanwhile the decentralized community is distrustful of centralized agents for concentration of power, actual and potential abuse of power, and agents with bad intentions. We all agree that a well-functioning society needs an adequate set of rules to promote economy, exchange of ideas, and protections from abuses. We just disagree on the degree of the concentration of that authority. To arrive at practical outcomes, we will likely have to experiment. Centralized platforms should probably continue to operate under existing government regulations. Truly decentralized platforms should be allowed to experiment with law being code, with the note “caveat emptor” brightly plastered. Hybrid platforms, of which there will be many, may require some sort of regulatory sandbox that allows for developers to find the right balance.
Crypto has just had its KT extinction level event, the asteroid that wiped out the dinosaurs. Over the coming weeks we will learn who has survived, and as difficult as the experience has been, it is the birthing pangs of a new industry. Just as that catastrophic asteroid cleared the way for the primacy of mammals and ultimately the human race, crypto too will evolve, build back stronger and more resilient than before. And as John J. Ray III starts to sift through the wreckage that once was considered the most exciting and innovative exchange in the space, we may find ourselves realizing that perhaps we had strayed too far from the path and allowed the worse practices of the past to creep in and infiltrate our fledging new industry. Many are still left asking ourselves the wrong question, “whom, now, should we trust?” Ultimately, if the true promise of blockchain is to be realized, then the answer is still nobody.