Why the collapse of CeFi institutions proves crypto’s core pillars

The series of collapses of CeFi platforms have weeded out bad actors and unsound business models.

The crypto space endured a series of unfortunate events in 2022, beginning with the Terra debacle and ending with FTX’s chaotic death spiral. These events heightened consumer skepticism and hesitancy toward crypto platforms; yet, the industry is holding steady today. The market is even trending upwards at the time of writing.

Crypto’s current potential trajectory toward a recovery signals two key takeaways: The space is resilient and here to stay, despite multiple setbacks. Secondly, centralized, or CeFi entities (such as exchanges or trading and lending platforms), have proven they can be a weak link and we must find ways to address their shortcomings.

What happened?

Many factors played a role in the failures of centralized entities. While the market downturn and contagion played a role in many of these collapses, the root causes can be boiled down to two main issues: centralization and imprudent decision-making.

When users deposit crypto on a CeFi exchange, they are relying on the custodial services of that platform. In essence, they are giving up intrinsic control of their digital asset holdings and in certain instances are loaning their crypto to the CeFi entity. In such cases, users become “unsecured creditors,” meaning they are indirectly lending their money without receiving any collateral or protection.

These exchanges can use those funds for balance sheet operations, collateral for large loans, trading, etc., which is where firms such as FTX have proven to be extremely careless. The FTX implosion resulted from misappropriation of customer deposits and both irresponsible leverage and risk management.

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Earlier in the year following the 3AC collapse, it became evident that many highly respected funds and market makers had abused an era of low-interest rates and cheap money. A number of players found themselves exceedingly leveraged, taking on undercollateralized loans or posting illiquid digital assets as collateral. As the market continued to move higher, their collateral base could be marked up, enabling further leverage. But as the market turned, they were forced to swiftly liquidate large — and sometimes highly illiquid — digital asset holdings to meet collateral obligations and customer redemptions.

Evidently, where centralization was at fault was coupled with a “growth at all costs” mentality and an apparent absence of comprehensive risk management processes. This led to irresponsible management of funds and, subsequently, the quick demise of many major players. 

What does it mean?

Ultimately, the failures of centralized entities have made it clear that the industry should abide by its core principles of decentralization and — wherever possible — self-custody. If anything, these collapses have proven that the old adage “not your keys, not your crypto” holds true and that too great an interdependency among these platforms is dangerous. It can allow contagion to spread more quickly and with even more disastrous effects. 

Unlike these centralized platforms, decentralized entities can considerably reduce counterparty risk and provide greater transparency with regard to funds because these transactions are occurring on-chain and are immutable. One of the main challenges with the adoption of these entities is that they protect user anonymity, creating somewhat of a regulatory gray zone. While such obstacles may delay DeFi adoption, various solutions exist to overcome them.

Furthermore, in order to address both the issues with centralized platforms and the concerns that consumers have with decentralized ones, the crypto space needs tighter regulations in place. This will ensure that platforms handling billions of dollars worth of customer funds do not continue to find themselves in such high-risk and highly leveraged positions.

While these events have shaken consumer confidence and trust, they have not signaled the end of the crypto era. Rather, they have proven that the industry needs greater decentralization and regulation to keep platforms in check. At the end of the day, it is not crypto itself that was the problem. Thus, why should it take the fall for the reckless and illicit actions taken by growth-hungry decision-makers?

The series of collapses of CeFi platforms have weeded out bad actors and unsound business models. The remaining projects are those that will continue to drive and influence the ecosystem in the years to come. If they continue to focus on core infrastructure — maintaining the utmost levels of decentralization and refining sound technological standards — then they can thrive.

Anthony Georgiades is the co-founder of Pastel Network.

This article was published through Cointelegraph Innovation Circle, a vetted organization of senior executives and experts in the blockchain technology industry who are building the future through the power of connections, collaboration and thought leadership. Opinions expressed do not necessarily reflect those of Cointelegraph.

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