Post-FTX: Navigating decentralization, cryptocurrencies, and blockchains
On Friday, November 11th, cryptocurrency exchange FTX Trading Limited (“FTX”) and its sister cryptocurrency trading firm Alameda Research (“Alameda”) filed for Chapter 11 bankruptcy. Just a week earlier, on Monday, November 7th, Sam Bankman-Fried, founder of both companies, had tweeted, “FTX is fine. Assets are fine.”
How exactly FTX and its sister company crashed to bankruptcy is still being uncovered (for now, two quite different perspectives can be found here and here). FTX had been valued at $32 billion just a few months ago. Sam Bankman-Fried’s estimated net worth of more than $20 billion is considered gone.
There is alleged fraud. The full extent of the damage is still being uncovered. Many retail and institutional investors may not see large sums of their assets currently frozen on FTX. Some – including Sequoia Capital, BlackRock, and Ontario Teachers’ Pension Plan – had invested in FTX. Meanwhile, FTX and Alameda Research had invested in more than 250 startups in sectors ranging from Decentralized Finance (DeFi) and NFT to cryptocurrency and blockchain.
Many are understandably shocked, dismayed, and infuriated. Many have lost a lot of money, and feel Sam Bankman-Fried deceived them.
However, some reactions reflect some big misconceptions about some fundamental concepts, including:
Decentralization
Cryptocurrencies
Blockchains
These umbrella terms house many different kinds of technologies, people, and processes.
In traditional finance, subprime mortgages have very different risk profiles from prime mortgages - despite belonging to the same umbrella term, “mortgages.” Similarly, not all entities that claim decentralization are the same, not all cryptocurrencies are the same, and not all blockchain technologies are the same. For investors, understanding the different and diverse components of each umbrella term is crucial to assess potential investment risks and opportunities appropriately.
Here are three general categories of reactions I have observed over the last few weeks and my thoughts in response.
1. “This shows why we need decentralized finance”
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 his team). Many are instead turning to decentralized finance (DeFi) in response to the FTX downfall.
DeFi comes in many forms and can still come with the need to risk trusting third-party actors. The term “decentralization” 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 “centralized” and “decentralized” technology vs. governance
Additionally, decentralization and centralization are not black-and-white concepts; they represent the ends of a wide spectrum for both technology and governance. For example, blockchain technology 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 (“entity” hereafter) is decentralized or centralized:
What technology do they use, and to what degree is the technology decentralized? [1]
Who makes decisions about the future of the project/entity, and to what degree is the decision-making process decentralized? [2]
There are many cases where DeFi entities/exchanges/projects (“entities” hereafter) use decentralized technology but have arguably centralized leadership teams that decide the future of the DeFi entity. Examples include:
SushiSwap, a “decentralized” cryptocurrency exchange. SushiSwap’s original developer committed what some believe was a rug pull scam – taking investor funds – a week after its launch. Sam Bankman-Fried donated to and took control of the “decentralized” SushiSwap project and became heralded as SushiSwap’s savior.
Serum, a “decentralized” cryptocurrency exchange running on the Solana blockchain. Serum’s nominal governance structure comes in the form of a decentralized autonomous organization (DAO). DAOs are member-owned organizations with built-in rules enforced by code stored on blockchain technology. DAO members can vote on decisions related to how they are governed. But the degree to which these governance decisions are centralized or decentralized depends on the built-in voting rules. In the case of Serum, the built-in voting rules enabled a single wallet – allegedly controlled by Alameda – to pass proposals. There are many other instances of DAOs that ascribe to being “decentralized” and yet allow a single voting wallet to make governance decisions.[3]
Centralization does not necessarily lead to bad outcomes, and decentralization does not necessarily lead to good outcomes - and vice versa. For investors turning to DeFi in reaction to the downfall of FTX, it is essential to be clear about what specific components of DeFi they want to embrace.
2. “Crypto is dead” vs. “Crypto is the future”
Some argue that “Crypto is dead,” whereas others argue that “Crypto is the future.”
Not all “Crypto” is equal. For example, BTC, ETH, and FTT do not share the same underlying objectives, technologies, or governance structures. And, they may diverge even further when regulatory classifications emerge.
Figure 2: Comparison of different cryptocurrencies - BTC, ETH, FTT
In the aftermath of FTX, many cryptocurrency investors are concerned about third-party risk; how hidden/unknown third-party activity may impact the price of cryptocurrency assets.
A key question to ask when investing in cryptocurrencies: Is there a central entity commonly perceived as the “leader”?
Centralized leadership can inordinately influence an asset’s price. The FTX exchange, for instance, would regularly repurchase and destroy some of its FTT tokens in circulation, directly driving up the price. The fall of FTX’s leadership – i.e., Sam Bankman-Fried – has directly sent the price of FTT tumbling.
The current lack of regulatory clarity contributes to the lack of more precise terminology to refer to 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 – and fiat currency – 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 transactions and derive 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. “Trust only the immutable blockchain, instead of humans”
Blockchains – as with any technology – are only as trustworthy as the people who build and operate them (see my article explaining blockchains, which are digital record-keeping systems). Blockchains also come in many forms.
There are two primary questions to ask when navigating different blockchains:
What kind of blockchain is it - 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 vs. public blockchains:
Private blockchains typically have more centralized governance than public blockchains and require placing trust in third-party entities. Private blockchains allow only individuals with permission from the authority that owns the private blockchain network to transact. Private blockchain networks are sometimes referred to as “permissioned” because participants require authorization from a centralized body.
Public blockchains allow anyone with access to the internet to transact while maintaining anonymity. Public blockchain networks are sometimes referred to as “permissionless” because anyone can join. Public blockchains tend to have more decentralized governance than private blockchains. However, there are significant differences in the degree to which various public blockchains are decentralized, which depends on the underlying consensus mechanisms (e.g., Proof-of-Work, Proof-of-Stake, Proof-of-Elapsed-Time, etc.). “Consensus mechanism” 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 today, can provide greater decentralized governance.
Second, blockchains are not actually immutable. “Immutable” 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. Adding new blocks is more or less difficult, depending on the consensus mechanism. 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 stolen funds.
Decentralization, cryptocurrencies, and blockchains come in diverse forms
“Benevolent,” “Hero,” “Leader,” “the JP Morgan of crypto,” and “the next Warren Buffett” are some of the accolades many in the cryptocurrency community had ascribed to Sam Bankman-Fried. One man was able to shock the cryptocurrency community because of the trust that the community had mistakenly or unwittingly given him.
Since the downfall of centralized exchange FTX, its token FTT, and its former CEO Sam Bankman-Fried, some are seemingly putting trust in nominal opposites - DeFi and blockchain technologies. Some have been quick to dismiss all cryptocurrencies. Yet, DeFi, cryptocurrencies, and blockchains come in many shapes and forms. It is essential to understand and navigate the different subcomponents of these umbrella terms.
[1] In the context of technology: Decentralization often refers to peer-to-peer (P2P) networking technology, which allows all participating network entities (e.g., computers) to request and send data directly to one another without relying on a third-party entity. Blockchain technology leverages P2P technology (see my guide to blockchain technology here). Centralization often refers to client-server networking technology, which uses a hierarchical network structure where one central computer (“server”) maintains records and other computers on the network (“client”) must make requests. The server controls access to its data.
[2] In the context of decision-making: Decentralization refers to organizational structures where decision-making is distributed across many groups or individuals; there is no top-to-bottom hierarchy. Centralization refers to command and control, hierarchical organizational structures in which a minority group holds decision-making power.
[3] See my article on how Solend, a self-described “algorithmic, decentralized protocol for lending and borrowing on Solana,” unilaterally tried to take over a user’s account)
This article was prepared by Jaymin Kim in her personal capacity. The views and opinions expressed in this article are those of the author and do not necessarily represent the views and opinions of Marsh McLennan.
About the Author: Jaymin Kim is a Director at Marsh McLennan and drives global commercial strategy with a focus on cyber and digital. In her role, Jaymin explores longer-term commercial opportunities in the areas of risk, strategy, and people.