On Friday, November 11th, cryptocurrency exchange FTX Trading Limited (鈥淔TX鈥) and its sister cryptocurrency trading firm Alameda Research (鈥淎lameda鈥) filed for Chapter 11 bankruptcy. Just a week earlier, on Monday, November 7th, Sam Bankman-Fried, founder of both companies, had tweeted, 鈥淔TX is fine. Assets are fine.鈥
How exactly FTX and its sister company crashed is still being uncovered. FTX had been valued at $32 billion just a few months ago. There is alleged fraud. Many retail and institutional investors may not recoup their assets currently frozen on FTX. Some 鈥 including Sequoia Capital, BlackRock, and Ontario Teachers鈥 Pension Plan 鈥 had invested in FTX. Meanwhile, FTX and Alameda Research had invested in聽聽building out decentralized finance (DeFi), cryptocurrency, and blockchain ecosystems.
Many are understandably shocked, dismayed, infuriated, and feel Sam Bankman-Fried deceived them.聽However, some reactions reflect misconceptions about fundamental concepts, including decentralization, cryptocurrencies and blockchains.
These umbrella terms house many different kinds of technologies, people and processes that investors must navigate in order to appropriately assess potential risks and rewards.
1. 鈥楾his Shows Why We Need Decentralized Finance鈥
Some are rejecting centralized finance writ large by its association with FTX, a centralized cryptocurrency exchange that requires users to trust their money with a third-party (Sam Bankman-Fried and team). Many are instead turning to DeFi in response.
DeFi comes in many forms. Some forms require trusting third-party actors. The term 鈥渄ecentralization鈥 can refer to 1) technology and/or 2) governance. This is a critical distinction. Investors who mistakenly conflate decentralized technology with decentralized governance may unwittingly be trusting third-party actors.
Figure 1: Nominally 鈥淐entralized鈥 and 鈥淒ecentralized鈥 Technology vs. Governance
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Additionally, decentralization and centralization are not black-and-white concepts; they represent the ends of a wide spectrum. For example, blockchain is generally regarded as a decentralized technology, but there are ongoing debates about the extent to which certain blockchains are decentralized in governance (see section 3 on blockchain technology below).
There are two primary questions to ask when assessing to what degree an entity/exchange/project (鈥渆ntity鈥 hereafter) is聽:
- What technology do they use, and to what degree is the聽technology decentralized?
- Who makes decisions about the future of the entity, and to what degree is the聽decision-making process decentralized?
There are聽many cases聽where DeFi entities use decentralized technology but have arguably centralized leadership teams. Serum, a 鈥渄ecentralized鈥 cryptocurrency exchange on the Solana blockchain, describes itself as a decentralized autonomous organization (DAO). DAOs聽are member-owned organizations with built-in rules enforced by code stored on blockchains. The built-in voting rules can lend to a high degree of centralized decision-making. Serum鈥檚 built-in voting rules enabled a single wallet 鈥 allegedly controlled by Alameda 鈥 to pass proposals.聽
Centralization does not necessarily lead to bad outcomes, and decentralization does not necessarily lead to good outcomes 鈥 and vice versa. Investors turning to DeFi in reaction to the downfall of FTX must specify which components of DeFi they want to embrace.
2.聽聽聽聽 鈥楥rypto Is Dead鈥 Vs. 鈥楥rypto Is the Future鈥
Some argue that 鈥淐rypto is dead,鈥 whereas others argue that 鈥淐rypto is the future.鈥澛
Not all 鈥渃rypto鈥 is equal. For example, BTC, ETH, and FTT do not share the same underlying objectives, technologies or governance structures. They may diverge even further when regulatory classifications emerge.
Figure 2: Comparison of Different Cryptocurrencies: BTC, ETH, FTT
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In the aftermath of FTX, many cryptocurrency investors are concerned about how third-party activity may impact the price of cryptocurrency assets.聽
A key question to ask when investing in cryptocurrencies:聽Is there a central entity commonly perceived as the 鈥渓eader鈥 in association with the cryptocurrency?
Centralized leadership can inordinately influence an asset鈥檚 price. FTX, for instance, would regularly repurchase and destroy some of its FTT tokens in circulation, directly driving up the price. The fall of FTX has directly sent the price of FTT tumbling.
The current lack of regulatory clarity makes it challenging to use more precise terminology to help distinguish different kinds of cryptocurrencies. For instance, it remains unclear whether some cryptocurrencies, including Ether, will be classified as a security or a commodity.
The value of any cryptocurrency 鈥 and fiat currency 鈥 is ultimately a social construct. If enough people believe a currency is valuable, that currency becomes valuable. For cryptocurrencies, their primary objectives, underlying technology, associated leadership and regulatory classification will likely shape their respectively perceived values. A cryptocurrency whose primary objective is to facilitate profitability for a centralized exchange whose leadership is dishonest and disorganized is unlikely to be perceived as valuable over time.
Time will tell which cryptocurrencies will continue to be valued long-term.
3. 鈥楾rust Only the Immutable Blockchain, Instead of Humans鈥
Blockchains 鈥 as with any technology 鈥 are only as trustworthy as the people who build and operate them (see聽here聽for a primer on blockchains, which are digital record-keeping systems). Blockchains also come in many different forms.
There are two primary questions to ask when navigating different blockchains:
- What kind of blockchain is it 鈥 private or public?
- What is the underlying consensus mechanism?
First, while all blockchains use decentralized networking technology, not all blockchains are decentralized in governance. A key distinction lies in private versus public blockchains:
- Private blockchains聽typically have more centralized governance than public blockchains and require placing trust in a third-party authority that owns the network. Private blockchain networks are sometimes referred to as 鈥減ermissioned鈥 because individuals require authorization from a centralized body to participate and transact.
- Public blockchains聽allow anyone with access to the internet to transact while maintaining聽anonymity and are sometimes referred to as 鈥減ermissionless.鈥 Public blockchains tend to have more decentralized governance than private blockchains.聽However, public blockchains differ significantly in the degree to which they employ decentralized governance. Consensus mechanisms are key differentiators. 鈥淐onsensus mechanism鈥 refers to the decision-making process governing what information gets officially recorded on a blockchain. Today there is heated debate about whether proof-of-work or proof-of-stake, the two predominant consensus mechanisms used in public blockchains, can provide more decentralized governance.
Second,聽blockchains are not actually immutable. 鈥淚mmutable鈥 suggests that records on blockchains cannot be changed or deleted without exception. All blockchain ledgers can technically be changed. The same consensus mechanism used to create blocks can be used to modify/undo. Typically, adding new blocks is intentionally made difficult for security reasons; the more difficult it is to do, the more difficult it is to undo. For example, to change official records on the Bitcoin network, one would need to amass 51% of the computing power on the network. To change official records on the Ethereum network, one would need to amass 51% of ether staked by validators. Numerous instances of 51% attacks have successfully reorganized transaction history, leading to聽.
Decentralization, Cryptocurrencies, and Blockchains Come in Diverse Forms
Since the downfall of centralized exchange FTX, its token FTT, and its former CEO Sam Bankman-Fried, some investors are seemingly putting trust in nominal opposites 鈥 DeFi and blockchain technologies. Some have been quick to dismiss all cryptocurrencies. Yet, DeFi, cryptocurrencies, and blockchains come in many shapes and forms.聽
In traditional finance, subprime mortgages have very different risk profiles from prime mortgages 鈥 despite belonging to the same umbrella term, 鈥渕ortgages.鈥 Similarly, not all entities that claim decentralization are the same, not all cryptocurrencies are the same, and not all blockchain technologies are the same. Understanding the different and diverse components of each umbrella term is crucial to assess potential investment risks and opportunities appropriately.
This article originally appeared on聽