The largest scandal in crypto history happened this month when FTX — once the third-largest cryptocurrency exchange — filed for bankruptcy after it was discovered to be insolvent.
According to CBC, at least $1 billion US of customer funds vanished from the platform, and FTX founder Sam Bankman-Fried transferred at least $10 billion of customer funds to his trading company, Alameda Research. Other news outlets report that senior FTX employees spent hundreds of millions in customer money on personal vacation properties — behavior that suggests unprecedented fraud in addition to a woefully mismanaged balance sheet.
News of the FTX downfall has already created an industry-wide ripple effect. A growing list of crypto firms, such as BlockFi and Genesis, halted withdrawals and even caught scrutiny from regulators over the past few weeks.
While this news undoubtedly delivers a reputational hit to Web3, it’s also a perfect case study into why decentralization matters. Crypto investors, understandably disillusioned, are now remembering the original intention of blockchain and looking for decentralized alternatives to lending, staking and storing their digital assets. According to stats from DeFi data aggregator DeFi Llama, trading volumes on decentralized platforms are up 68% since FTX went bust — the highest since May.
But why does this matter? Let's dive into the history of blockchain and learn why the crypto community’s allegiance to the principle of decentralization is relevant today.
Bitcoin, the original cryptocurrency, is perhaps the gold standard of decentralization. The Bitcoin blockchain and its native currency, bitcoin, were first conceptualized in 2008 and minted in 2009 — just one year after the 2008 financial crash that resulted from the U.S. housing bubble. Bitcoin’s creator was the anonymous Satoshi Nakamoto, who published a famous whitepaper outlining the concept of decentralized peer-to-peer money system run and managed by computers.
Prior to Bitcoin’s debut, banks and lending institutions were giving low-interest rates on mortgages while encouraging new homeowners to take out loans they couldn’t afford. As foreclosures skyrocketed and many banks were forced to declare bankruptcy, The United States passed the American Recovery and Reinvestment Act of 2009 which allowed for bank bailouts and mergers and took action to energize economic growth.
With the creation of Bitcoin, which is backed by blockchain technology, there was hope for a decentralized future where no third party (like a bank) would have control over individual finances. Instead of needing to be pre-approved or wait days for a bank to approve a transfer, a person could send or receive money in minutes through cryptocurrency.
Years later, decentralized finance (DeFi) has blossomed into the industry we see today. But even though new DeFi platforms, products and companies are being launched every day, not all cryptocurrency institutions or blockchains are fully decentralized or independent of incumbent financial institutions. Mega crypto exchanges, like FTX, are centralized. They are often funded by private investors and run by a corporate board, which gives control to the individuals in charge of the exchange and leaves them subject to human error.
“[Many] centralized exchanges have either become insolvent, committed fraud or been hacked,” said said Cat McGee, Developer Relations at Hype Partners, a Web3 marketing agency. “Crypto is supposed to be anti-bank, but these guys function as a bank.”
When you put your money into a CEX, McGee explained, you’re putting it into an unregulated banking institution that is dependent on volatile assets. Unlike most licensed, U.S.-based FDIC-insured banks, crypto institutions are subject to varying regulations given the novelty of the industry and the fact that many of them are incorporated in offshore locations.
Often, centralized exchanges (CEXs) serve as popular onramps that make it easy for individuals to buy crypto with their debit or credit cards. CEXs are one of the most common ways consumers first start using cryptocurrency and exploring the concept of DeFi.
This has created a bit of a fallacy: Even amid the volatility of crypto, centralized exchanges have earned a reputation for being “too big to fail.” And as we saw with FTX — once the third-largest crypto exchange by volume — millions of users trust CEXs to hold massive amounts of cryptocurrency.
Beyond trust, CEXs also provide financial incentives to encourage users to use their platform for decentralized finance (DeFi) activity like lending, staking, trading and swapping. Collectively, these DeFi positions are often called yield farming because investors can leverage their assets on an exchange in order to earn additional assets as interest or rewards. (Interestingly, FTX’s Sam Bankman-Fried put forth a definition of yield farming back in April that sounded suspiciously similar to the definition of a Ponzi scheme.)
In this way, CEXs operate somewhat like banks. When you deposit money into your bank account, the bank uses your cash to give out interest-bearing loans or even make financial trades. The difference, of course, is that banking is highly regulated, while crypto companies are not.
“A cryptocurrency exchange is NOT a bank,” says Paul Sibenik of Cipherblade, a blockchain investigation agency that tracks cryptocurrency in cybercrime cases. “You aren’t paying the exchange to compensate you against theft in the event your own account is breached.”
As we’re seeing, there are still few protective measures in existence for when CEXs fail. On the contrary, users in an FTX Telegram group with more than 77,000 members reported being unable to access funds or the exchange when chaos ensued a few weeks ago.
“FTX is a case study of why we need DeFi,” says Phil Johnston, BD content Lead at Unstoppable Domains, a web3 domain service. “Transparent, decentralized controls would have made it much harder for someone to move billions around without being noticed. This wasn’t a case of DeFi failing — it was failing to DeFi.”
If there’s one takeaway from the FTX meltdown, it’s that decentralized storage is of utmost importance. Never leave more crypto on a CEX than is necessary for whatever your goal outcome may be. Any cryptocurrency that you keep on an exchange should be done so at your own risk and preferably only for short periods of time, as it could one day become the property of the exchange in a bankruptcy hearing.
And when you do amass a significant amount of crypto on a CEX, most experts recommend transferring it to a self-custody wallet where it can be more secure.
To learn more about how to get started with a self-custody wallet, read BFF’s guide to crypto self-custody.
Read More: BFF's Guide To Crypto Self-Custody
If you have lost crypto due to fraud you can seek justice, says Sibenik. In general, your country's laws are always going to be applicable, whether theft occurred on blockchain or in the traditional banking system. Bad actors can prosecuted to the fullest extent of the law, and blockchain provides a convenient ledger with proof of all transactions. According to one of Sibinek’s blog posts, “going after the thief in question isn’t just practical; it’s also the most likely to lead to the successful recovery of stolen bitcoin or cryptocurrency.”
However, law enforcement agents — like many of us — are still catching up to crypto. Legal proceedings may take months or years to play out, and the rules may be fuzzy depending on where the crypto institution is licensed and under whose jurisdiction the investigation falls. “Reporting the incident to law enforcement may prove fruitless,” says Sibenik. “They may lack the resources, understanding, and skills to investigate such cases.”
Carlee is a content writer and copywriter working in the Web3 space. Connect with her on Twitter @punchingthekeys.
This article and all the information in it does not constitute financial advice. If you don’t want to invest money or time in Web3, you don’t have to. As always: Do your own research.
