Centralized Exchanges vs. Decentralized Finance: Understanding the Risks and Benefits
FTX’s bankruptcy reduces trust in centralized exchanges. Stably Ramp offers a safer, efficient alternative to access DeFi.
The blockchain industry was initially established to decentralize various industries, increase efficiency, and trust while protecting users from centralized firms. However, the recent collapse of Sam Bankman-Fried’s centralized exchange FTX has caused widespread fear in cryptocurrencies, reducing trust, and potentially contributing to more bankruptcies.
Centralized exchanges (CEXs) like FTX aggregated and simplified DeFi services, making them widely used through large marketing campaigns. They remain too close to the traditional finance (TradFi) world, exposing users to similar counterparty risks. Moreover, CEXs often operate in regulatory grey areas, unlike Decentralized finance (DeFi), which provides users with true control over their funds, effectively minimizing risk.
CEXs are attractive to users due to their ability to aggregate various services, execute transactions off-chain, large liquidity networks, and quick transaction settlement times. They dominate the world of blockchain, with an estimated 99% of crypto transactions occurring through CEXs. Nonetheless, they also have some disadvantages such as reduced user privacy, bankruptcy risk, and a lack of potential asset and service variety. CEXs represent a centralized point of failure that is easier to target by hackers, unlike decentralized networks.
Moreover, regulatory oversight is a significant drawback since these centralized establishments typically operate offshore, where different levels of oversight exist. For instance, FTX operated in the Bahamas and was not subject to the same regulatory oversight as its U.S. division, FTX U.S. Similarly, Binance has separate legal entities, with Binance itself operating abroad in less regulated jurisdictions than its Binance U.S. division. Bitfinex is headquartered in the British Virgin Islands, and many other centralized exchanges have similar setups. In contrast to heavily regulated banks, CEXs operate in regulatory grey areas without providing adequate consumer protection, leaving customers vulnerable in case of bankruptcy.
Counterparty risk is another significant concern. Centralized exchanges expose users to the same risks present in the traditional finance world, including the possibility that the other party in a financial investment or transaction may default on contractual obligations. The increasing awareness of these risks has resulted in users rapidly withdrawing their funds from centralized exchanges.
We believe that centralized exchanges are ultimately too close to the world of TradFi, with counterparty risks and minimal consumer protection.
FTX is not the first large bankruptcy in the blockchain industry, with several other prominent ones having occurred. For instance:
- In 2013, the centralized exchange Mt. Gox held approximately 70% of all global cryptocurrency funds before being hacked in 2014 for approximately 850,000 BTC, highlighting their weakness as a centralized point of failure.
- Cred, a crypto lending platform, filed for bankruptcy in 2020 after funds were misappropriated into risky hedging strategies.
- Cryptocurrency lender Celsius Network filed for bankruptcy protection in July 2022, with a balance sheet deficit of around $1.2B. They offered unsustainable returns by engaging in risky endeavors with client funds, which they were unable to pay back.
- Canadian broker and lender Voyager Digital went bankrupt in mid-2022 due to contagion caused by the collapse of Luna Terra, which included them losing a $650M loan to bankrupt firm Three Arrows Capital.
In several situations, high yields for consumers were promised while engaging in risky undertakings lacking adequate protection for users. Their transactions were off-chain, hidden from users. Custodied by these centralized firms, funds were at risk from the moment a client deposited them until they withdrew them to a non-custodial wallet such as Metamask. Funds could be stolen during conversion from fiat to a cryptocurrency, misappropriated during custody by the centralized party, or incur a similar issue while off-ramping from the platform.
CEXs suffer from the same counterparty risks present in traditional finance, making them too close to the traditional finance world. The famous quote “not your keys, not your funds” captures this issue perfectly, unfortunately proven true many times throughout the history of blockchain, often to the detriment of those in developing nations.
The safer alternative is to hold funds oneself, using an on-ramp directly into a non-custodial wallet. This minimizes the time in which funds are at risk, increases transparency, and trust in the system – the original objectives of blockchain. Many users are already doing this, as evidenced by the amount of funds leaving centralized exchanges.
Ramps as an Alternative:
An on-ramp puts a user’s funds at risk only during transit. During this process, a user pays via their preferred payment method, and the funds are directed via their fiat bank account. Once the funds arrive in their self-custody wallet, they are secured via cryptography, meaning that no one else can access their funds unless they somehow obtain the user’s private key. This private key is typically generated via the SHA-256 algorithm, which generates a random 256-bit string, resulting in 2^256 possible combinations, which is an incomprehensible amount. Therefore, the on-ramping part poses some risk, but as this is done in partnership with regulated banking institutions, generally, the worst that happens is a failed transaction that is refunded.
Once funds reach a non-custodial wallet, users can custody their funds rather than trust an external party. They can then engage in the same services that a CEX provides, such as using a decentralized exchange to swap funds or a liquid staking protocol for staking. However, these are relatively new protocols that can be confusing to use at times, making it challenging for the average user to use seamlessly. Nonetheless, they have transparency and safety built from the ground up, and their user experiences are rapidly being simplified. These DeFi protocols use open-source code that anyone can improve, with all transactions being viewable on the blockchain, and counterparty risk being minimized in turn.
So, how does the on-ramping process work?
When users on-ramp or off-ramp, they convert fiat (e.g., USDs or Euros) into some types of cryptocurrency (e.g., a stablecoin or BTC). If they choose to convert to a volatile cryptocurrency asset, they may be subject to rapid fluctuations in value. Instead, it makes more sense for users to on-ramp into stablecoins like USDC, which are essentially digital cash and hold their value in line with the underlying asset, generally USD. Stablecoins are the best intermediary between TradFi and DeFi, as they enable users to seamlessly transfer liquidity without worrying about price fluctuations. Additionally, USD-backed stablecoins are legally compliant and integrated into the banking system, resulting in optimal pricing and efficient transfers.
Despite the enormous benefits of decentralized finance (DeFi), moving funds between one’s bank account and DeFi is currently far too complicated, costly, slow, and full of friction.
Historically, access to cryptocurrencies has been driven by centralized exchanges that suffer from these problems as well. However, centralized exchanges do not provide true control over one’s funds and often make it challenging for users to move funds to their own external wallets to keep the funds within their ecosystem.
Stably Ramp provides a seamless, low-cost, and legally compliant solution for global users wanting to partake in Web3 and have true control over their funds. This is achieved by designing the on and off-ramping experience from the ground up, focusing on what matters when users want to get into DeFi lending or swapping.
- Fiat Rails agnostic: a wide variety of payment methods means the lowest rates for users.
- Stablecoin agnostic: any popular stablecoin may be purchased, with many more coming soon.
- Application agnostic: any Web2 or Web3 projects may integrate Stably Ramp.
The result is that users can safely and securely transfer value between a variety of DeFi ecosystems and their bank accounts, where they subsequently hold their own funds without worry of any counterparty risk. Ramps will in turn help to reestablish trust in the system by enabling more users to access DeFi services safely, without needing to trust centralized firms.
The collapse of FTX highlights the need for more trust in DeFi and Ramps. These alternatives offer users true control over their funds, minimizing counterparty risk. Stably Ramp provides a low-cost, legally compliant solution for global users to access DeFi services safely. The on-ramping process only poses a small risk, limited to the transit period, and the use of stablecoins is the best way to bridge the gap between TradFi and DeFi. Users should consider transferring funds from CEXs to self-custody wallets to hold funds safely.
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