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“For there to be betrayal, there would have to have been trust first.”

— The Hunger Games

Crypto's Trust Issues

Fraud is prevalent in finance because, well, that’s where the money is.

But also because that’s where the trust is — You can’t have fraud without trust, and much of finance is based on trust.

This, of course, is the core value-proposition of DeFi: finance without the trust!

So, it’s easy to think the events of this past week have made the virtues of DeFi — permissionless, trustless self-custody — more obvious than ever before.

Any incremental loss of trust in financial institutions (like FTX) and financial people (like SBF) should be an incremental win for the blissfully trustless, people-less world of DeFi — as we lose confidence in centralized finance, we should gain confidence in decentralized finance.

The real-world benefits of this logic are easily exaggerated, however. Some crypto money will move from CeFi to DeFi, sure.

But no new money of any size will go straight to DeFi — not right now, at least.

While DeFi enthusiasts, correctly, see FTX as a failure of centralization, most others will, unfortunately, see it as a failure of crypto.

And that is understandable: FTX failed because it was acting like a bank, yes. But not many are going to say, Yikes! Banks are risky. I'm moving my money to a blockchain!

Some brave souls will, but most everyone inclined to think that way is already all-in on crypto: Anyone inclined to self-custody their assets has already self-custodied them, surely.

So, the near-term benefit of DeFi winning the argument against CeFi is, in my opinion, limited.

What’s it mean for the long term?

It’s complicated.

Asset Reflux

Alameda Research, like Celsius and other failed borrowers before it, has returned the money it owed to DeFi protocols — because those loans were overcollateralized, it would be nonsensical not to.

As many have noted, that is a testament to the antifragile resilience of DeFi.

But how good is a financial system with only overcollateralized loans?

Not very.

This is known: Lots of smart people are trying to solve for undercollateralized lending on decentralized protocols.

But it’s not easy. Finance is about intermediating lenders and borrowers, and that entails holding assets against liabilities.

In DeFi, those assets are all crypto, and it may be that DeFi as a financial system cannot scale, because those assets are not fit for that purpose.

The intrinsic value of most every cryptocurrency is the belief in the token: Tokens are simply worth what people decide they are.

This makes crypto reflexive: Belief in any tradeable asset is largely a function of price, so when the price of a token falls, the intrinsic value of that token falls, too.

Banking is similarly reflexive: Banks are only liquid as long as depositors believe they are solvent.

So, crypto and banking are both reflexive — which makes crypto banking, well, reflexive-squared.

If you entrust your money to a crypto bank, you are taking on exposure to the general belief in that bank and also the belief in the crypto it holds as assets.

The “assets” listed by FTX were of particularly low quality: FTT, SRM, MAPS, OXY, and, most absurdly, TRUMPLOSE.

On the one hand, you might say, well, that’s just a bank that decided to hold really bad assets.

On the other hand, you might say, crypto tokens of any sort make for bad assets.

Banks, being reflexive themselves, should not be backed by reflexive assets.

Worse still: Crypto tokens may not be assets at all.

Every asset should be someone’s liability, and crypto tokens are not anyone’s liability in the same way, say, stocks and bonds are — tokens offer no claim on cash flows that a protocol might generate. Or assets it might hold.

If a bank holds, say, a mortgage bond that’s trading at 50c on the dollar, they might still be OK: A regulator might allow the bank to value the bond according to the net present value of future cash flows, rather than where it’s trading in the market on any given day.

Crypto tokens, however, are only worth what you can sell them for at any given moment.

They are purely reflexive. Which makes them ill-suited as assets in the inherently reflexive financial system.

So, yes, FTX and the ensuing contagion is mostly a mess of CeFi’s making.

But it's a peculiarly crypto mess, as well.

Trusting Times

An incident of financial fraud does not mean that finance is fraudulent.

Nor does crypto fraud mean that crypto is fraudulent.

In both cases, it’s simply fraud: Sam Bankrun-Fraud has not discredited crypto any more than Bernie Madoff discredited asset management. The two fraudsters only discredited themselves.

DeFi has the potential to take some, most, or all of the trust out of finance, lowering the risk of future Madoffs and SBFs.

But, we’re still only in the early stages of building out the infrastructure rails of that trustless financial system — and we may not ever get all the way there.

So, we can't just wish CeFi away: There’s now no way to scale DeFi without it.

Like the rest of finance, then, we’re going to have to continue to trust.

For now.

— Byron Gilliam

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Top Stories

GUSD Borrow Rates Spike From Brief Hysteria — Blockworks
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Crypto Lenders Keep Pausing Withdrawals Citing FTX Exposure — Blockworks

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What's Trending

The Definitive Thread on FTX (thread) — Jason Choi
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Ethereum fundamentals: Block Proposing and MEV-Boost (thread) — Haym

We're Watching

Genesis, crypto's largest lender, just froze withdrawals and new loan orginations.

Would a Genesis collapse have wider impacts than FTX's demise?

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Written by @bgilliam1982.

Produced by @gmmiguelcruz.