2022 has so far been a year to forget for the crypto sector. Terra Luna crash, Three Arrows Capital bankruptcy, Celsius bust, Nuri bankruptcy, mass layoffs across crypto space. There are also countless DeFi hacks costing investors billions. As a cherry on the cake, Binance reveals the unfortunate financial situation of its competitor FTX, hints at a takeover and lets it burst the next day.
All in all, enough drama to make a series out of it. But why is it that the crypto sector announces one bad news after another? Where do the threads connect and is there a solution to the problems?
One powder keg after another bursts in rapid succession. The authors of the annual reviews will fill many pages to shed light on all the bankruptcies, crashes and mishaps of the crypto space. It appears that a cleaning process is taking place in both CeFi and DeFi environments.
After an escalating flow of loose investments in the billions, the resulting wave washes the unstable providers out of the market with all its might. In this seething tide, some of the largest CeFi deposits perished. As the eventful year of 2022 draws to a close, we break down how the sometimes disastrous events unfolded.
A dramatic battle in the crypto space
Away from the financial markets, which are shaken by global and interest rate policy turmoil, the crypto area is also teetering in the corner. Once a right hook is digested, the left seems to swing right after it. In May, the crypto market had to digest the crash of the cryptocurrency Luna and the entire Terra ecosystem. About 50 billion US dollars shot out of the wallets of crypto investors through this punch alone. The bankruptcy triggered a domino effect that took down entrenched and stalwart crypto giants like Three Arrows Capital, BlockFi and Celsius. Several billions fell with it.
As if that was not enough, the institutional partners of these crypto giants also took to the stage. Because several big investors and crypto services are betting big sums on their favorites. Apparently, the central crypto service providers sometimes even used customer funds for this. In the end, the companies indirectly affected also got started. Prominent example: Nuri Bank, which is closing its doors in December this year.
So we decide: Key service providers in the crypto sector are on shaky ground. Due to partnerships, networks and service contracts, an opaque service network was created. A braid that threatened to tear should tear a strand. And so it finally happened. Even billionaire companies thought the safe went up in smoke. And the fuse doesn’t seem to have blown yet.
The decentralized finance sector (DeFi) is entering the arena
It seems time to take a look at the grassroots of the blockchain and crypto sector. There is the top dog: Bitcoin. As the origin of a digital money system based on a unique combination of mathematical and cryptographic applications, it shows the problem of the core crypto applications. And that’s just in the headline of the 2008 white paper, which says: “Bitcoin: A Peer-to-Peer Electronic Cash System”. Peer-to-peer, that is, it is a monetary system without a central intermediary.
While Bitcoin redefined the payment system and the concept of store of value, Ethereum laid the foundation for decentralized executed financial services in 2013. Not least because of his white paper “A Next-Generation Smart Contract and Decentralized Application Platform”, Ethereum creator Vitalik Buterin still enjoys fame and recognition today.
Because thanks to the birth of smart contracts, the DeFi sector gradually developed. In 2016, the first decentralized autonomous organization (DAO) emerged as a community-led investment fund that met its spectacular end in a hack.
The stone began to roll: In addition to the exchange of crypto-values through decentralized exchanges, financial services such as loans and lending, insurance, forecasting markets and games such as lotteries are gradually settled in the Ethereum network. All without intermediaries that slow down processes or require trust.
Is DeFi the savior in times of need?
So let’s finally turn our attention to whether DeFi is the savior of the crypto sector. To do this, we first track the weak points of the key players.
First of all, we know from Andreas Antonopoulos: “Your keys, your bitcoin. Not your keys, not your bitcoin.” And the same goes for all other crypto assets. If you put your private key, the access to your wallet, in someone else’s hands, you give up the power over your coins and tokens. Welcome back to the centralized system.
If central, large crypto exchanges now store the keys of all their customers centrally, they have correspondingly great power. For example, you can put the crypto assets in financial products that are believed to be safe, such as the loan provider Celsius. And without any explanation or information to the users. Or they jeopardize the decentralization of DAO projects by using the tokens stored in their own crypto exchange to collect voting power.
An example is provided by the latest case in the FTX case: FTX and Alameda CEO Sam Bankman-Fried’s statement in 2021 talking about “complete transparency” with centralized crypto exchanges seems like a farce. SBF publicly criticizes unreported payments by traditional financial services providers in the wake of the 2008 financial crisis. Now he himself is said to have transferred $4 million of FTX client funds to Alameda. Thus, he himself feeds the fear of a “Lehman moment” among crypto investors. And then again and again it turns out to be true: wrong behavior is deeply rooted in human existence!
The staggering impact of these errors is reflected in Bitcoin’s price history. And then we look forward to the news in the near future, how far the threads in FTX reach.
DeFi applications, on the other hand, are free from such wrong decisions by human-controlled powerhouses. Here, the investor himself keeps his keys, which means that not only the power over their own crypto values is in the hands of the users, but also the responsibility for the assets. The traditional financial system has trained us to assume this responsibility over the years. It seems like a trade-off – taking responsibility to gain freedom.
About the Saviour’s vulnerabilities, decentralized economy
So far, it sounds like DeFi can negate the disadvantages of the main crypto service providers. Code is law and self-storage of access keys creates a global financial system with no central repository or intermediary. But it is not without reason that Total Value Locked (TVL) in DeFi applications started to decline this year after a sharp increase since 2021.
Numerous hacks, carpet pulling and regulatory uncertainties brought turmoil to the DeFi sector. Flaws in the smart contract – human error – have increasingly led to exploits in recent months. Hackers captured more than 2 billion US dollars through DeFi cross-chain bridge attacks alone. Overall, crypto users still feel too insecure in the DeFi environment. In addition, the usability of the decentralized applications (DApps) leaves much to be desired. Therefore, users often prefer centralized services over DeFi.
To fix vulnerabilities in DeFi applications, high-quality standardized audits should assess market maturity. Finally, users use real values to use financial services in the DeFi space. There must be a certain level of security.
As we know, the DeFi space is still in its infancy and still suffers from certain infantile diseases. A treat for scammers and hackers. It is all the more important to make the ecosystem safer through regulations. Only then can DeFi services expect mass adoption.
“DeFi is a logical evolution of the financial sector, but it comes with significant technological and cultural disruptions. There are still many regulatory questions to be answered,” said Thomas Dünser in an interview with BeInCrypto.
What we learn from it
Both traditional finance (TradFi) and central crypto services (CeFi) and DeFi have strengths and weaknesses. The slow traditional financial system excludes parts of the world, requires an intermediary authority and is centrally managed. However, a comprehensive legal framework has been developed over the years, which includes a functioning system.
DeFi, on the other hand, is considered the “Wild West” of the financial world.. While the code does what it’s supposed to, the code can always be buggy. As a regulatory and procedural compromise, CeFi continues to offer the possibility for central authorities to embezzle accumulated customer funds and exercise power.
Most recently, CZ, the CEO of Binance, called for a “proof of reserves” with which central crypto exchanges would have to prove the size of their financial reserves. A step in the right direction and further proof that the sector learns from mistakes. So far, the main crypto exchanges OKX, KuCoin, Crypto.com, Polonix and Huobi have voluntarily joined the proposal.
It appears as if the rules in the crypto space evolved partially independently through normal market economics. Users resort to the services that offer the greatest security, and then the providers develop in the desired direction. That means: A secure, user-friendly, versatile, trustless DApp with an attractive design.
The final goal should be to bring together the strengths of the respective systems. By meeting an individually managed peer-to-peer payment system with up-to-date and sensible regulation based on ethical core values. And if the users of decentralized financial instruments use extensively checked and tested DApps, we get closer and closer to a good solution. Where the development will take us remains to be seen. In any case, it also has its good side, when the market automatically washes itself away from bad services and learns from the mistakes.
The final appeal: Let’s not let human error and power centers crush the possibility of a globally inclusive, cheap and fast – in a short time – financial system with P2P payments.
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