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November 22, 2022

Learnings from Digital Asset Week – what has FTX taught us?

Welcome to Swarm Markets’ media memo. This weekly update provides comments from Swarm Markets’ co-founders, Philipp Pieper and Timo Lehes, on key industry news that has caught our eye, plus our own developments. 

Comments available on the following news items:

  • Digital Assest Week London Special: comments from Timo and Philipp on the market cleansing effect of FTX, why self custody is so crucial to the sector’s future, and how regulation and institutional adoption will be the making of DeFi.

Regulation and institutional adoption will save crypto – but the sector must learn lessons first

The problem at the heart of the current issues in crypto is that the market has coalesced around centralised players. This has happened because these platforms have created the most convenient environments for users be they private or institutional. But the trust put into these exchanges is now badly shot through.

The reality is that CeFi exchanges have operated in a similar way to TradFi platforms – just without regulated assets that can give users anything like the long-term confidence needed to become sustainable. 

To bring confidence back to the sector, trust will have to be built through regulatory frameworks that protect market participants and by truly transparent DeFi infrastructure. In many ways the FTX saga will be a cleansing moment for the industry, that although painful, is now clearly needed to move forward. 

One route to a mature, stable crypto market is through institutional participation. Major firms such as Fidelity point out the lack of institutional players causing higher volatility and extreme market reactions dragged along by events. But to attract that institutional capital, DeFi must provide sophisticated products, and this all needs to be underpinned by high quality regulation.  

While regulatory clarity is growing, over-regulation could destroy innovation. This would be fatal to a sector driven by technological problem solving. But institutional-grade risk management, familiar taxonomy and a grown-up approach to developing offerings can be a game-changer for institutional adoption

DeFi actually is battle-proven technology that gives people confidence through transparency. DeFi allows us to create programmable marketplaces that can be developed on the institutional side and bring real world assets into that realm, which will fundamentally change current trading practices.

Transparency, self-custody and permission the only way forward for crypto

There is a wide misunderstanding about what DeFi is, how it works and its institutionalised nature. This comes down to a blurring of the lines caused by DeFi-in-name-only projects that rely on centralised functions and simply masquerade as “fully” decentralised. Certain projects have patently concealed centralised functions that go against the nature of real DeFi. 

The events of the last two weeks highlight the lack of transparency as a centralised phenomenon. It was those monitoring on-chain activity who pointed out strange ongoings with FTX wallets combined with delayed withdrawals, prompting the rumour mill on Twitter to proliferate, putting pressure on the FTX team for answers. Had there been more transparency and oversight around FTX’s operations, this could have exposed transfers between FTX and related entities earlier, thereby mitigating the losses incurred.

But we’d never have gotten into this position had the users of the FTX exchange had self-custody underpin their participation in the market. Holders trusted a centralised exchange to custody their assets and this failed spectacularly. The events of the last two weeks could signal a Cambrian moment, spurring a new direction for financial market innovation and architecture that is based on self-custody.

Moving on from this debacle, as a sector we need to adopt essential protocols to protect users and the whole market from the kind of disruption caused in the past two weeks. This means DeFi activity for certain types of capital, be it lending or decentralised over-the-counter trading, has to be performed in a credible jurisdiction and must be permissioned for regulated activities. For unregulated activities, the code is law.

Permissioned DeFi does not have to be intrusive for the user. Asset owners can still use their custody provider of choice, for example, and a permissioned DeFi environment opens up an aspect of the market that hasn’t been there before.

Crypto markets are currently offering lower lending returns than traditional markets, but this will change when interest piques again – there are many ways to slice the digital asset world depending on which capital you’re trying to attract. But the high correlation in the crypto markets and “print-out-of-thin-air” nature of some crypto assets doesn’t make it good collateral. We need to bring real world assets on-chain to solve this.