Centralized Exchanges Like Sam Bankman-Fried’s FTX Aren’t Needed For Bitcoin To Thrive

It’s been a story almost as old as bitcoin itself: centralized exchanges failing and taking away with them faith and trust in bitcoin, as well as the assets of people who thought they were holding bitcoin in the first place. It started with Mt.Gox, which failed, leaving many bitcoiners from years ago claiming that they were “Mt.Gox creditors”. Now FTX has come to the fore, leading some pundits to decry that an “Enron”-like failure might sink all of bitcoin and cryptocurrencies into a near-permanent bear market.

We’ve seen failures of exchanges and exchange-like type intermediaries across the board. FTX is a prominent example of a centralized exchange that ended up holding more “paper” than bitcoin for its clients. After a lengthy and protracted bankruptcy process, it is unlikely asset-holders will find much in the way of recovery. We’ve seen centralized exchanges fail because of too much leverage on their part, because they’ve been hacked under mysterious circumstances, or because important stakeholders, such as the founder, died.

What is a centralized exchange?

Centralized exchanges are a way to trade bitcoin for fiat and sometimes, bitcoin for other cryptocurrencies. If they’re centralized, they run similar to a traditional corporation, with a headquarters somewhere in the world, a dedicated team, and most importantly, custodial responsibility for their users.

Instead of buying bitcoin directly from a peer who sends it to your wallet (though perhaps in an escrow system), your holdings are tracked digitally by the exchange’s own ledger: in effect, this serves as a banking layer for bitcoin, with the exchange handling custody/security of assets and in return, giving you a claim on a certain amount of bitcoin/cryptocurrency that you can then withdraw into a wallet if you choose — provided the banking layer is still solvent. You are trading a digital asset with a future-forward fashion of thinking about the world — a world that relies on peers and nodes that link up together rather than the relic of intermediary-based trust.

This is important because the one key thing a centralized exchange does is act as a custodian of your funds. When you have a balance at a centralized exchange like Coinbase or Binance, you don’t actually “own” the private key to a wallet that holds the bitcoin or cryptocurrency in question, but rather, you own a claim to a large amount of bitcoin held by an exchange.

Centralized exchanges are a necessary evil, the way for most people to buy bitcoin at scale without having to meet up with someone physically, or subject themselves to the high costs and fees of bitcoin ATMs. Not many are able to get access to directly mined bitcoin, or have the scale as an individual investor to negotiate deals for themselves as they can get on exchanges.

Some may not want to bother with the security and privacy implications of self-custody, because they see it as too complicated versus the product-driven and marketing-refined onboarding funnels in centralized exchanges.

This is especially since exchanges, being virtual businesses, are able to advertise at scale as well, and offer cheap onboarding fees and other inducements (such as trading options) to get users across the board — a playbook both Binance and FTX followed to grow as rapidly as they did.

What does all of this mean for the future of bitcoin, and are there alternatives to centralized exchanges?

While centralized exchanges and transactions done within them have certainly helped the bitcoin ecosystem grow, bitcoin has never truly needed centralized exchanges.

There are now various options available, from Lightning (which allows for peer-to-peer transfer of bitcoin in a much more seamless and cost-efficient manner) to the developing Fediment standard that helps try to put custody of bitcoin into more hands without needing centralized exchanges.

There are also more peer-to-peer exchanges such as Paxful, where users directly trade bitcoin and other cryptocurrencies with each other and the intermediary doesn’t trap them in their own custody but rather takes a listing fee of sorts. Others like Bisq have organized themselves in a DAO-like fashion and tried to not only implement peer-to-peer trading at scale, but also organize themselves in a way that gets them away from being an intermediary at all. By being built on a network of nodes that run free, open-source software (similar to bitcoin), Bisq offers the opportunity to trade bitcoin on a peer-to-peer network-like state similar to bitcoin itself.

You still can’t pin bitcoin to its creator Satoshi: yet you can’t go anywhere without seeing Sam Bankman-Fried in the flesh paired with FTX. Maybe there isn’t a better visual representation of the difference than that.

A large ecosystem of exchanges have offered everything from yield to many different cryptocurrencies to attract people into the ecosystem. Yet, the staying power of these offers has proven to be limited. Those that offered a ton of trading options and leverage/yield for bitcoin look suspect after the collapse of FTX and Celsius
CEL
Network. And the option to dabble in many cryptocurrencies seems to be more of an investment hazard than opportunity these days.

Centralized exchanges are a way for many people to get comfortable with bitcoin, but they have propped up speculation while network activity has grown (at least when seen from a multi-year view) in terms of mining, nodes, and Lightning usage. These are the determinants of the future success of bitcoin — adoption and usage by stakeholders from around the world.

Subjecting bitcoin to the same fiat-driven logic of idle capital-holding and speculation helped bitcoin make a name for itself. But now many confuse trading activity with the meaningful building that needs to happen across the ecosystem. It is a “bear market”, yet the appetite for innovation across the board has never been higher for bitcoin.

With the adoption of more decentralized exchanges, Chaumian mints such as those proposed by Fediment and more peer-to-peer ways to transact bitcoin, the need for centralized exchanges fades with each new innovation. Centralized exchanges were a big reason for bitcoin’s initial success: after all, price action did drive interest and turned what had a been a hobbyist interest into a mainstream financial option. Yet what took bitcoin to its first stages of growth may not be what it takes to sustain the network in the future.

There may be a role for centralized exchanges in the future of bitcoin — but it is not likely to be as central as it currently is, and certainly, bitcoin can survive, and even thrive, without centralized exchanges like Sam Bankman-Fried’s FTX.