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What we must learn from FTX so that history does not repeat itself

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The aftermath of FTX’s collapse is significant. In terms of scale, the contagion from the event alone has a much larger impact than that of Terra, Mt. Gox, or any of the string of recent high-profile insolvencies plaguing the cryptoverse. To draw a comparison from the world of traditional finance — given FTX’s former status as the one-time second-largest crypto exchange globally — it would be as if JPMorgan announced tomorrow that they are going out of business. 

The abrupt nature of the collapse within mere days has also raised questions about why there were no warning signs. After all, FTX raised funds from a stellar investor lineup, including Temasek, Sequoia, Paradigm and BlackRock, so its sudden insolvency has definitely hurt confidence in the industry, which has long been trying to gain acceptance from mainstream and institutional players.  

The scale of damage, beyond the numbers, is almost immeasurable. It has set the industry back a couple of months, if not years, in progress, and has once again cast doubt from the mainstream about the crypto’s legitimacy.

Despite this challenge and a plethora of other drawbacks over the past decade, it bears repeating that blockchain technology and its applications for decentralized finance are here to stay. While we certainly hope that victims are able to achieve a resolution soon, it’s equally important to review how the FTX saga affects the direction of the industry, and make sure that we can learn from it so that history does not repeat itself.

Centralization begets regulation

Though we’re now seeing a gradual migration of user funds to decentralized exchanges (DEXes), the reality remains that prior to the collapse, almost 99% of all cryptocurrency transactions went through centralized exchanges (CEXes) like FTX, owing to their accessibility and user-friendliness. Going forward, it is clear that regulatory scrutiny will have to increase for these CEXes if they are to remain widely used, starting with the current push for new licensing, audit and reserve requirements to ensure compliance.

But greater regulation forms only one part of the industry’s journey toward recovery. As the public re-negotiates its relationship with digital assets, the existing exchange model will have to adjust accordingly, from the potential dissolution of mega exchanges to the mass deviation of user funds toward licensed custody, or secure “third-party” accounts, separate from exchanges entirely. This would mean that even if exchanges encounter difficulties in the future, user funds are still held safely in custody.

With that said, there will likely still be a space for less regulated exchanges to either serve a risk-taking, highly-speculative segment or perhaps more in the vein of professional commodity exchanges, to cater to a group of companies that trades for their own needs rather than to speculate.

Decentralization will rise again

Amid the potential growth in demand for decentralized finance solutions, where customer funds are separated from exchanges, for one, there is a new opportunity for decentralized players to demonstrate their value and challenge the centralized incumbents. As these DeFi solutions enable peer-to-peer interactions on the blockchain directly, they automatically address the two greatest concerns that have arisen out of FTX — custody and transparency.

This is an exciting proposition as it is now perhaps the greatest use case of blockchain in the real financial world at a large scale. One such example would be automated market makers (AMMs), the underlying protocol behind many decentralized financial services compared to the traditional order books typically used by CEXes. However, as DEXes converge to become more like CEXes in terms of accessibility, utilizing a system of order books may actually be the necessary next step for decentralized players to provide customers with a truly seamless experience while balancing compliance and security. Particularly, an order book system that is robust, reliable and has a strong track record of performance. It is exciting to see new innovations built on this hybridized framework of order books within decentralized exchanges. dYdX is one such entity that is experimenting while also building a new version using Cosmos’ SDK, with Polkadex using the substrate. 

Best of both worlds

The changing crypto landscape will lead to growth for peripheral products and services that can demonstrate value in enhancing custody, compliance and customer experience. Staking is one such service, and it has already been a preferred tool for many institutions due to its security and sustainable yield. In the past, token holders have been more inclined to gain yield through trading rather than staking, as the latter tends to generate slower, though much more reliable returns, as well as impose minimum lock-up periods. However, new technical developments such as liquid staking alleviate the latter problem by allowing token holders to unleash the liquidity of their staked assets, allowing them to simultaneously tap into the benefits of staking and DeFi at any given time.

Ultimately, to have the seamless familiarity of a centralized exchange, decentralized players will need to find appropriate self-custody earning functions. Decentralized players must also adopt a multi-chain approach and incorporate new privacy-centric technology solutions such as zero trust and multi-party computations into their services. 

This requires collaboration, at times from competing entities to make it work. If we can get over this hurdle, it is practically, if not theoretically possible for users to enjoy a regulated but decentralized offering and have the best of both worlds.

RockX is an ecosystem partner with various blockchain projects, including Cosmos and Polkadex.

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