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Centralization: A High-Risk Game of Trust?

By Sunny T.
7 Feb 2023
10 min read

Akin to the fiat world, centralization in the crypto world also entails the predominance of cost and monopoly. So, by pursuing a centralized blockchain, we must continue to rely on a central authority we can trust.

But the whole point of the blockchain is to solve a social problem and not a technical one. And this social problem is, in fact, that of trust. Then, does centralization negate the very solution for which cryptocurrency came about?

Let’s dig deeper.

For starters, let’s talk about the infamous FTX crash.

For the uninitiated, FTX Trading Limited is a (now-defunct) cryptocurrency exchange founded by Sam Bankman-Fried and Zixiao “Gary” Wang in 2019. Between 2021 and 2022, FTX raised capital to the tune of $1.4 billion from leading investors like Softbank, Sequoia Capital, and even CEO Changpeng Zhao (aka CZ) of its rival exchange Binance, among ~60 other investors. Then, in November 2022, FTX Ventures went offline and filed for bankruptcy.

The crash was triggered by suspicions that FTX did not have enough liquidity to back transactions and stay afloat, leading to $5 billion in withdrawals on November 6. Accordingly, CEO Sam Bankman-Fried was arrested for 8 criminal charges, including wire fraud and conspiracy to defraud investors.

According to the complaint filed by the Securities and Exchanges Commission (SEC), Bankman-Fried used customer funds as a “personal piggy bank” to make private investments including real estate and political campaign donations.

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On November 7, 2022, Changpeng Zhao announced on Twitter that he was planning to sell off Binance’s stock of FTT (the FTX token), referring to Coindesk’s report of FTX’s blurred funds.

November 11 is when FTX declared bankruptcy, and on the same day, all FTX wallets were emptied in a “hack”. As per a CoinDesk report, more than $600 million was drained from the wallets.

On November 17, John Ray, infamous for handling the liquidation of fraudulent energy giant Enron in the last decade, stated in his court filing that FTX had not been keeping "appropriate books or records, or security controls, with respect to its digital assets."

The aftermath?

FTX owes its customers billions, with a substantial portion of its assets reported “missing or stolen”.

Bitcoin’s price dipped below $16,000 on November 9, and $3.2 billion in Bitcoin was taken off the exchanges by November 15.

Ethereum’s price dipped below $1,100, and Solana dipped below $13.

Even Tether USD depegged from the US dollar by 3% on November 10.

Albeit the most highlighted fiasco of the year, FTX was not the only high-profile insolvency of 2022.

Gemini


After the FTX crash let the dogs out on the crypto space, US-based digital asset exchange Gemini’s leading yield partner Genesis announced that it had $175 million locked in with FTX. 6 days after this, Genesis paused withdrawals from Gemini’s Earn program on grounds of “extreme market dislocation” and “loss of industry confidence caused by the FTX implosion”. Subsequently, Gemini announced to its customers that they would not be able to withdraw their funds until further notice.

Celsius


Much before the FTX crash, crypto lending platform Celsius Network — once a leading player in the centralized cryptoverse — filed for Chapter 11 bankruptcy on 13 July 2022. Thereafter, the company froze customer accounts, citing “extreme market conditions”.

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In its statement, the company said that it had “decided to pause withdrawals, swaps, and transfers on its platform to stabilize its business and protect its customers.” Court filings revealed that the company was around $1.2 billion in the red, with $5.5 billion in liabilities, of which ~ $4.7 billion represent customer holdings.

Voyager


Voyager — a staking and lending services provider which, at its peak, served 3.5 million customers and managed $5.9 billion in assets, also fell prey to the crypto-lending black hole that opened up after the 2020-2021 bull run ended.

It started with Voyager implementing a daily withdrawal limit of $10,000 per user as an emergency measure. However, when Celsius halted withdrawals on its platform, it triggered a series of bank runs at other similar lenders, including Voyager. As a result, Voyager was unable to stop the issue; by the end June 2022, the company's fate was sealed. Accordingly, Voyager lost control over the issue & had no choice but to pause withdrawals. This happened on 1st July 2022, reportedly due to the excessive trust Voyager had placed in its creditors.

Through the crypto boom of 2021, Voyager allowed the now-infamous hedge fund Three Arrows Capital (3AC) to undertake gigantic loans without providing the capital required. In turn, 3AC made a huge gamble on Terra’s UST stablecoin, and when its price depegged and precipitated and market-wide crisis, the house of cards fell in one big sweep. Shortly after, the situation evolved into a chapter 11 bankruptcy filing. Luckily, however, this was initiated primarily for reorganization and restructuring, versus leading into a liquidation timeline.

In August 2022, after the release of its funds from the Metropolitan Commercial Bank (MCB), Voyager was granted permission by the court to return $270 million in cash to creditors.

Remember how we said earlier that blockchain tech primarily came about to eliminate the need to trust a central authority?

As the first decentralized digital currency, Bitcoin revolutionized finance by enabling peer-to-peer (P2P) transactions without the need for a central intermediary (“banks”). This unveiled the potential to significantly reduce transaction fees and increase financial inclusion by allowing all individuals to participate in the global economy — even those without a bank account. And with its blockchain technology — which serves as a public ledger for all transactions — it has made financial transactions transparent, tamper-proof and secure.

A key component of blockchain tech, smart contracts are self-executing contracts with the terms of agreement written directly in code. Accordingly, a smart contract can execute the terms of an agreement automatically when its conditions are met. Further, smart contracts are stored on a decentralized blockchain network, which makes them 100% tamper-proof and easily verifiable. But more importantly, smart contracts can reduce the need for intermediaries, such as lawyers and banks, which can speed up and simplify the contract execution process.

Uniswap, for example, allows users to trade cryptocurrencies through smart contracts, i.e., without the need for a centralized intermediary. Its decentralized format of governance enables all holders of the UNI token to vote on proposals for improving the platform, such as changes to the protocol’s fee structure, adding new tokens to the exchange, and other upgrades. Proposals are submitted by community members, then voted on by token holders. And if a proposal receives enough votes, it is implemented on the platform. Overall, Uniswap’s governance system is designed to be decentralized, thus effectively leveraging the pros of blockchain tech.

Another such community-run decentralized platform MakerDAO allows users to borrow the DAI stablecoin — which is pegged to the value of the US dollar — using Ethereum (ETH) as collateral. The interest rate for borrowing DAI is determined by the community, thus protecting the stability of DAI against market fluctuations and fostering a community-driven (decentralized) style of governance.

Further, to automate liquidations and maintain the overall stability of its ecosystem, MakerDAO manages collateralized debt positions (CDPs) using smart contracts. When the value of the collateral in a CDP falls below a certain threshold (“liquidation ratio” – 150% to 165%), the CDP smart contract triggers an automated liquidation of the collateral. The liquidated collateral is then sold on the open market to repay the debt. This measure alone, however, does not cover the entire cost of debt. So, simultaneously with the liquidation, the smart contract also triggers a “debt auction”, wherein the debt is sold to the highest bidder at a discount. The proceeds from this sale are used to repay the debt, and the remaining assets are returned to the owner.

There is no doubt, however, that getting liquidated sucks because the borrower loses their collateral. Thus, to safeguard the interests of its community of borrowers, MakerDAO uses a system of “Keepers" — autonomous agents (bots) that monitor the value of collateral assets in real-time and bid on CDPs that are at risk of liquidation.

Keepers are incentivized to bid on risky CDPs through a combination of rewards and penalties: Every time a keeper successfully closes a CDP that might be at risk of liquidation, it is rewarded with a “stability fee”, which is a small percentage of the total debt in every CDP. Conversely, when a keeper fails to protect a CDP from liquidation, a “liquidation penalty” is imposed on it. This mechanism is designed to discourage liquidations, thus further protecting borrowers from losing their collateral and maintaining the stability of the MakerDAO ecosystem.

Measures such as this – designed specifically to safeguard the interests of its community and the stability of its ecosystem – paired with its community-driven approach to governance are essentially what separate MakerDAO from “centralized providers of DeFi” like Celsius or Voyager.

Another DEX Curve.fi (built on Ethereum) manages liquidations similarly, through a process called "impermanent loss protection”. This mechanism protects liquidity providers from losses due to changes in the relative value of the assets for which they have provided liquidity.

How it works
When liquidity providers provide assets to a pool, they receive a share (“pool token”) of the pool's total assets in return. The value of this token is determined by the relative value of the assets in the pool. To mitigate risk, Curve.fi uses a system of "liquidity protection pools" which enables automated purchases and sales of assets. This helps with maintaining the relative value of the assets in the pool, thus keeping the value of the pool token stable and reducing the risk of impermanent loss for liquidity providers.

To further maintain the balance of the pool and reduce risk, Curve.fi has an automated threshold liquidation system to liquidate an asset whose value dips below a certain threshold and use the proceeds to buy more of the other assets in the pool. This helps to maintain the overall balance of the pool and reduce the risk of impermanent loss for liquidity providers.

In a nutshell, a “truly decentralized” environment has no central authority that its participants need to trust.

We’ve established already that too much reliance on specific governing authorities, as seen in a centralized environment, can lead to systemic failures that can impact both investors and the market, directly or indirectly. So, that’s that.

Further, decentralized crypto wallets are non-custodial. This means you have full control over your money in a decentralized wallet, and a collapse such as the FTX fiasco would have no impact whatsoever on the liquidity of your holdings.

Metamask is an open-source, non-custodial digital wallet and browser extension that allows users to interact with decentralized applications on the Ethereum blockchain. Although built by a for-profit company called ConsenSys, the governance of Metask continues to remain decentralized, and ConsenSys has assured that its role is only to support the community-driven governance process.

Then why are the majority of investors still using centralized exchanges?

Well, because our incumbent decentralized platforms are not particularly investor-friendly. Using these exchanges requires high technical know-how, and accordingly, investors often feel intimidated by the steep learning curve they must conquer to segue into DeFi.

But somebody needs to bridge the gap, yes?

Dyor is an investor-friendly decentralized platform built to help you navigate and invest in Web3 and DeFi easily. With its unique Swipe-to-Invest interface, access to real user-generated data, an active community of investors & contributors, and tokenomics that are designed to democratize the evolution of its protocol through community-led governance, Dyor is driven to simplify access to DeFi for all.

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