Decentralized vs Centralized Exchanges: Insights into the FTX Fallout

Introduction

In our previous discussion on Decentralized Exchanges (DEXs), we examined the core functionalities of a decentralized exchange, exploring its benefits, potential risks, and the primary protocols currently leading the sector.

The FTX debacle has brought the topic of centralization and regulation to the fore, prompting questions about the security of centralized exchanges. This incident, amplified by the resulting fear, uncertainty, and doubt (FUD), prompted a user migration to decentralized exchanges, reinforcing the narrative of DeFi's emerging dominance. This was particularly evident when Uniswap surpassed Coinbase, the leading US-based CEX, in terms of trading volume.

This article will offer a concise overview of both CEXes (centralized exchanges) and DEXes (decentralized exchanges), delve into the FTX incident and its repercussions on the crypto market, and help guide you toward choosing the most suitable option for your needs.

Centralized Exchanges

CEXes operate much like traditional stock exchanges such as the NYSE, NASDAQ, or the London Stock Exchange. They are centralized entities where traders provide liquidity through an order book model. The exchange retains custody of the cryptocurrencies being traded (e.g., Coinbase, Binance).

The chief appeal of a centralized exchange lies in its user-friendliness. The user experience (UX) on these platforms generally surpasses that of DeFi, making them more appealing to a broader audience. However, many people still find blockchain technology daunting and struggle with safe interactions on DeFi platforms, which, for now, is why centralized exchanges tend to attract more volume and users as the ecosystem expands.

Decentralized Exchanges

Decentralized exchanges serve the same function as CEXes, providing a platform for cryptocurrency trading. However, DEXes leverage blockchain technology, eliminating the need for intermediaries. All that traders require is to connect their wallets with the protocol and proceed to trade. All that traders require is to connect their crypto wallets with the protocol and proceed to trade according to its functionalities.

This decentralization, while a significant advantage, can also be a disadvantage, depending on the user. Blockchain and decentralized systems allow users to retain custody of their digital assets independently of banks or financial institutions. While this streamlines money transfers and asset trading, the sector's lack of/low regulation means there's little recourse for users who make costly mistakes.

Given the novelty of this technology and its applications, the UX isn't particularly user-friendly, which deters many potential users from engaging with decentralized applications.

Now, let's delve into the FTX incident and explore why many people are shifting towards DEXes and self-custody.

The FTX Fallout

FTX, a centralized exchange founded in 2019, declared Chapter 11 bankruptcy in November 2022. Its former CEO, Sam Bankman-Fried, was arrested in December and is currently facing criminal charges for wire fraud and conspiracy to defraud investors.

Two key points aid understanding of the FTX bankruptcy:

• Sam Bankman-Fried also ran Alameda Research, which served as a market maker for its sister company, FTX.
• FTX created its own token, FTT, which it could issue freely. This token offered benefits for FTX customers, who could stake them for discounts and other platform benefits.

FTX covertly used customer assets to finance Alameda Research, thereby bolstering their trades and market-making capacity. While the market was bullish in 2021, the company yielded significant profits, particularly from ventures like Solana.

However, using FTX customer funds to back Alameda was problematic, further exacerbated by issues surrounding the FTT token. Alameda Research and FTX Ventures frequently used FTT to secure loans and fund projects. In essence, they were operating like a central bank, minting tokens arbitrarily and deploying them in the market.

For those keeping an eye on the financial markets in 2022, it's well-known that it was a challenging year for cryptocurrencies and risky assets in general. This was due to a combination of factors including high inflation, rising interest rates, the conflict in Ukraine, and China's stringent COVID-19 policy.

These circumstances resulted in a rapid decline in prices, with FTT being no exception. A revealing article by Coindesk stated that Alameda Research's balance sheet was a staggering $14.6 billion, with FTT, a token issued by their sister company FTX, as their largest asset.

This is already massive, but it gets worse: the third-biggest asset was FTT used as collateral to a number of loans that counted a total of U$7.4 Billion of liabilities.

Adding to the concern, the third most substantial asset was FTT used as collateral for loans amounting to an alarming $7.4 billion in liabilities. To simplify for those less familiar with finance, a significant portion of the money listed on Alameda Research's balance sheet was tied up in FTT. Therefore, if the value of FTT plummeted, Alameda would have to either increase their margin or face substantial losses. Essentially, Alameda Research was leveraging its positions with capital generated by FTX.

Upon Coindesk's publication, rumors began circulating that FTX was insolvent, leading many alarmed customers to rush to withdraw their assets. The situation escalated when Changpeng Zhao, CEO of Binance, announced via Twitter that the company intended to offload all its FTT holdings

The ensuing panic saw the price of FTT plummet, creating a significant problem for Alameda Research, which was responsible for a large portion of FTX customer funds. A full-blown bank run ensued, with everyone rushing to withdraw from FTX. Unfortunately, the exchange was unable to cope with the demand and suspended withdrawals, leaving those who had trusted the platform with lost funds.

FTX filed for Chapter 11 bankruptcy mere days after suspending withdrawals. As it stands, customers are still anxiously awaiting clarification on whether they will ever recover their money.

Deciding the Best Option for You

The FTX incident sent ripples through the entire crypto market, leading to price drops and numerous company bankruptcies. However, it also opened regulatory bodies' eyes to the practices of crypto companies.

FTX, based in the Bahamas, had exploited certain loopholes, conducting questionable practices behind the scenes. This scandal sparked a demand within the crypto community for on-chain proof-of-reserves from all centralized exchanges, ensuring their solvency and the safety of customer funds.

These events signify a maturing market. Regulatory authorities are now more involved, and centralized entities must work harder to earn their customers' trust. This shift is positive for the ecosystem, as regulation can attract new users and companies to the space, thus expanding the market.

Even though the crypto market is getting safer, it’s very important to know how to make your own custody in a safe way.

Major exchanges such as Binance, Coinbase, and Kraken have demonstrated their ability to securely manage customer funds and are working with regulators to enhance safety in the space. However, this doesn't negate the possibility of future incidents, particularly in the short term, while regulatory frameworks are still in development.

If you're new to the crypto sphere, it's advisable to start with a centralized exchange due to its user-friendly nature. As you expand your knowledge and gain confidence, we recommend transitioning to self-custody of your crypto assets. This approach will shield you from unforeseen events and policy changes that might impact CEXes in the future.