FTX is the reason we need more DeFi

“The failure of FTX proves the failure of decentralized finance.” This phrase has been repeated by various Web3 skeptics over the past week amidst the shocking implosion of FTX and Alameda.

The White House reiterated that FTX is the reason why there is "a real need for prudential regulation of cryptocurrencies." In a tweet, Senator Elizabeth Warren summarized the crypto industry as one of "smoke and mirrors," arguing that the SEC should be pushed to pursue "more aggressive enforcement."

Not just politicians. As loyal followers, anti-DeFi Bitcoin supporters are seizing on the FTX debacle to promote their “why Bitcoin is only good” thesis.

But a distinction must be made between crypto participants following the rules of TradFi and those following the rules of DeFi.

FTX is not DeFi

If the FTX disaster really represented a failure, it represented a failure of the centralized financial mechanisms that DeFi has been trying to replace.

Consider where the troublesome root of the FTX disaster ultimately came from - FTX loaned out customer deposits instead of holding them as redeemable 1:1 deposits. Worse, they hold disproportionately large amounts of illiquid FTT tokens as collateral instead of safer assets such as stablecoins, over-leveraging their balance sheets. In short, FTX is trying to play the role of a bank where it shouldn't be, and it's playing it badly.

Both of the above scenarios are impossible for DeFi exchanges or banks.

DeFi is self-regulated

Take a look at the largest trading platform in DeFi: Uniswap.

Uniswap users will never lose sleep over Uniswap trading customer deposits for the simple reason that there are no personal "deposits" to begin with. Unlike FTX, users simply execute trades among hundreds of permissionless liquidity pools. In FTX, however, users are required to make a deposit before executing trades on the matching order book.

The funds in these pools are provided by liquidity providers/liquidity miners, and they also don't have to worry about Uniswap trading their deposits. These liquidity pools are managed by smart contract logic that does not change, making it impossible for Uniswap to do anything with their funds.

Uniswap cannot lend your funds to their friends, nor can you use these funds for personal transactions. Their hands are bound by the rules they make.

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The same goes for any lending/borrowing DeFi platform like Aave or Compound. If you take out a loan on Aave, you first need to deposit capital at a safe loan-to-value ratio. If the value of the collateral backing your loan falls below a pre-set threshold, Aave will automatically liquidate your loan - no arguments allowed, no questions asked. This is in stark contrast to the string of bad loans FTX issued to its sister hedge fund, Alameda, which were then used as collateral for loans elsewhere. This is similar to the Celsius and Three Arrows saga we have already witnessed.

The most competitive, market-tested DeFi protocols are full of these autonomous rules designed to avoid a situation like what is currently happening with FTX.

If you're not afraid of persuasion, look at another example. Before the fiasco, Alameda Research held an outstanding loan of 20 million MIM (Abracadabra’s stablecoin), collateralized by 5 million FTX’s trading token, FTT. Nonetheless, the debt was fully repaid on Nov. 9 amid turbulent markets.

Why would they honor this? Alameda didn't repay the loan out of good intentions. They pay that money because there is no Chapter 11 bankruptcy in the EVM world. If Alameda defaulted, their FTT collateral would be liquidated immediately and sold by the liquidator for about $17 at the time.

It is in their own best interest to repay the loan and regain FTT.

In short, DeFi succeeded.

And what about the stablecoin part of the DeFi world? The test of whether a stablecoin can really work is its peg to the U.S. dollar, which can come under pressure in times of market volatility. However, Maker's DAI worked fine in last week's test.

Even the MIM stablecoin, 35% collateralized by FTT, turned out pretty well. After briefly devaluing to $0.974 on Nov. 9, MIM regained its pegged value.

DeFi fails on the social layer

So when crypto skeptics blame DeFi for “failure,” one might rightly ask — in what sense is this true?

Are DeFi exchanges and lending protocols working as intended? Yes, they did. Are decentralized stablecoins depegged and crashing? No they don't.

Ultimately, cryptocurrency skeptics don’t seem to get the point. However, in a sense, DeFi may have failed.

DeFi fails because its community becomes complacent. We should have done proof of reserve a long time ago. DeFi failed because we did not anticipate the intention of SBF. We should have been more skeptical. DeFi failed because we accepted centralized intermediaries for convenience. Self-hosting is difficult, but trust in FTX has cost too many in the industry.

The fault lies not in the DeFi system itself, but in the fact that the crypto community has compromised too much and too often on the value of decentralized finance.