The Importance of Decentralization and Governance in Crypto

The past few decades have shown us, time and time again, that centralized financial systems are incredibly vulnerable. While held as pinnacles of security, a few certain events (detailed below) have shown us that this couldn’t be further from the truth.

Since 2008, we’ve seen individuals or corporations use the guise of centralism to pull off a fraud on huge scales. And, despite the public perception of the safety of this system, we’re currently approaching the third or fourth “once in a lifetime” economic disaster this decade.

Surely, something has to give.

Ponzi Schemes and Market Crashes

One of the first major turning points for centralized finance was Bernie Madoff’s Ponzi Scheme in 2008. Madoff was the chair of the Nasdaq and a leading pioneer in electronic trading. Over the course of around 17 years, he defrauded thousands of investors out of billions of dollars. Some reports demonstrate that the scam was even going on as early as the 1960s.

He attracted new clients by claiming to generate large returns for individual investors. He used a strategy that was known as a split-strike conversion, depositing all user funds into a singular bank account that he then paid out from. As the rocky circumstances surrounding the financial crash, cracks started to show, and he was unable to keep up with returns.

The actuality of the situation was that he simply collected all the user funds from across all of his partners, depositing them into a single account. From there, each year, the bank would make around $435 million from after-tax profits. Instead of actually doing any trading, he would simply collect the interest and fund their payouts from the account.

When markets fell and clients suddenly wanted to take their money out of the system, his scheme was exposed. Eventually, he was sentenced to 150 years in prison and forced to give up $170 billion in stolen capital.

This wasn’t the first event in centralized finance history where someone was exposed for playing the system and stealing user funds (nor would it be the last), but it was definitely one of the largest at the time.

The events set into motion by Madoff were then closely followed by the 2008 financial crisis. This crisis was caused by traditional financial institutions readily giving out huge mortgages and loans, not backing anything with assets and leaving themselves vulnerable. When the housing industry collapsed, finance came crashing down with it.

A few extensions by centralized financial players caused a knock-on impact that ruined the finances of millions around the globe and caused one of the worst economic downturns in history.

Traditional Finance Systems and Fraud - Sam Bankman Fried and FTX

In more recent centralized finance news, one of the biggest cryptocurrency platforms in the world, FTX, was found to be stealing billions of USD in user funds. Sam Bankman Fried, who was the active CEO of the company, was sending user funds to his sister company to bail out their bad investments. This was, of course, unbeknownst to the users that were having their money siphoned.

This occurred because FTX operated as a centralized financial system. All of the internal movements of user funds were hidden from the public. The only people that had access to the books were those internal to the company.

Without transparency into user funds, SBF had nothing stopping him from putting users’ funds to whatever causes he wanted. When his sister company made a series of bad investments and was facing back-claims, he used billions of USD to bail them out. This was discovered after a series of events in which one of the chairmen of Binance called into question the validity of the internal books of the company and pulled out from buying.

This sent a wave through the community, with people trying to withdraw their money. Of course, their money wasn't actually on the platform, causing FTX to freeze all accounts and stop any people from accessing their investments. Centralized finance once again proved that its method of operating without transparency is the perfect breeding ground for fraud.

SBF was recently taken into custody and will likely face criminal charges for his massive embezzlement operation. Interestingly, this comes almost exactly 13 years after Madoff was arrested on similar charges. The two cases have striking parallels, demonstrating that even with ample warning, centralized finance has made no progress over the last decade that can protect users from similar fates.

It’s time for a change.

What Can We Do About This Level of Fraud - The Movement Toward Decentralized Finance

Each of these downturns in economic history can be traced to a failure of one or two parts of centralized finance - a lack of transparency around internal movements of funds or the ability for a few individuals to hold massive control over entire systems. Decentralized finance proposes a direct method of overcoming these problems, offering a transparent system that is run on community.

Decentralized finance uses blockchain as its core technology. Within blockchain systems, every translation is stored on a public ledger, allowing users to trace funds and see where their money is going. This level of visibility instantly makes what happened with Bankman Fried and the Madoff Ponzi Scheme impossible.

As users can simply look up where their funds are deposited and the pathway they took to get there, the obfuscation of user funds simply cannot occur. Beyond this, decentralization as a concept often uses different governance systems than those used in centralized finance. Many leading decentralized projects use community voting as a way of guiding their systems.

At the extreme, there are Decentralized Autonomous Organizations (DAOs), which are completely led by community suggestions and voting systems. These allow the community to actively get involved with projects, building out systems that are user-first and always conscious of the end user.

A great example of this is Sweat Economy. As a Web 2 company that’s pushed into the world of Web 3 and included a range of decentralized features, they’ve become a shining example of adapting to this new economic system. Most recently, they had their very first community governance initiative.

The community outlined whether they wanted to burn $1M of SWEAT tokens, with the community voting in favor. Shortly after this community session, Sweat Economy made good on this promise and carried out the wishes of the community. While only their first step toward community decentralization, this demonstrates the willingness of blockchain companies to move toward a truly decentralized future.

Another example of this activity occurring within blockchain projects is from the Metaverse gaming company Decentral Games. Most recently, they hosted a community vote, pushing forward new features and allowing the community to decide if they would be incorporated into the in-game economy structure.

Out of all voters, 97.5% of users voted to accept and incorporate this new system, with the features being rolled out shortly. Giving users the power to shape the future of their entire projects again reflects the commitment of these projects to become user-driven and as transparent as possible.

Truly decentralized systems have a much greater degree of faith in them than centralized counterparts. Looking at the recent economic downturn and drop in faith in blockchain companies, the core projects that hold up this ecosystem are still going strong. While projects that fawn decentralization have fallen in value, many of the market leaders are those that uphold these values at their core.

Transparency, availability, and community participation are the pillars of decentralized projects. When committing to these systems, there is much less of a chance of massive fraud occurring, as we’ve repeatedly seen with centralized systems.

Final Thoughts

Centralized finance has ruled this industry for quite some time. Yet, as decentralized technologies improve and gain more community support, decentralized projects are rapidly growing and beginning to turn the tide.

The transparency that blockchain technologies offer promotes a healthier, fraud-free financial system. Instead of worrying about events from the past occurring, a full movement to decentralized finance will radically shift the entire industry. As community support grows and the extent to which decentralized finance companies reach media spotlight increases, we’re likely going to see a mass movement away from traditional finance and embracing of this new, exciting world.

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Image credits: Shubham's Web3.