Centralized exchanges like Sam Bankman-Fried’s FTX are not necessary for Bitcoin to thrive

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

We have seen mistakes in exchanges and intermediaries of the exchange-like type across the board. FTX is a prominent example of a centralized exchange that ended up holding more “paper” than bitcoin for its customers. After a long and protracted bankruptcy process, it is unlikely that assets will find much in the way of recovery. We have seen centralized exchanges fail due to too much influence on their part, because they have 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 are centralized, they operate in the same way as a traditional company, 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 colleague who sends it to your wallet (but perhaps in an escrow system), your holdings are digitally tracked by the exchange’s own ledger: in effect, this acts as a banking layer for bitcoin, with exchange management custody/security of assets and in return, gives you a claim to a certain amount of bitcoin/cryptocurrency which you can then withdraw to a wallet if you choose — provided the banking layer remains solvent. You trade a digital asset with a forward-looking way of thinking about the world – a world that relies on peers and nodes connecting instead of the relic of intermediary-based trust.

This is important because the only important thing a centralized exchange does is act as a depository for your funds. When you have a balance on a centralized exchange like Coinbase or Binance, you don’t actually “own” the private key to a wallet containing 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 on a large scale without having to meet someone physically, or incur the high costs and fees of bitcoin ATMs. Not many are able to access directly mined bitcoin, or have the scale as an individual investor to negotiate deals for themselves that they can get on exchanges.

Some may not care about the security and privacy implications of self-storage, seeing it as too complicated versus the product-driven and marketing-sophisticated onboarding funnels of centralized exchanges.

This is especially so since exchanges, being virtual businesses, are also able to advertise at scale, offering cheap onboarding fees and other incentives (like trading options) to get users across the board – a playbook both Binance and FTX followed to grow as fast as they did.

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

While centralized exchanges and transactions conducted in them have certainly helped the bitcoin ecosystem grow, bitcoin has never really needed centralized exchanges.

There are now different options available, from Lightning (which enables peer-to-peer transfer of bitcoin in a much more seamless and cost-effective way) to the evolving Fediment standard which helps try to put custody of bitcoin in multiple hands without the need for centralized exchanges.

There are also several peer-to-peer exchanges like Paxful, where users directly trade bitcoin and other cryptocurrencies with each other and the middleman does not hold them in their own custody, but rather takes some sort of listing fee. 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. Being built on a network of nodes running free, open source software (similar to bitcoin), Bisq offers the ability 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 alongside FTX. Perhaps there is no 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 who offered a ton of trading options and leverage/returns for bitcoin look suspicious after the collapse of FTX and CelsiusCEL
Network. And the opportunity to dabble in many cryptocurrencies seems to be more of an investment risk than an opportunity these days.

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

Exposing bitcoin to the same fiat-driven logic of idle capital stock and speculation helped bitcoin make a name for itself. But now many are confusing trading activity with the meaningful building that needs to happen across the ecosystem. It’s a “bear market,” but the appetite for innovation across the board has never been higher for bitcoin.

With the introduction of more decentralized exchanges, Chaumian coins like those proposed by Fediment, and more peer-to-peer ways to trade bitcoin, the need for centralized exchanges is disappearing with each new innovation. Centralized exchanges were a big reason for bitcoin’s initial success: after all, price action drove interest and turned what had been a hobby interest into a mainstream financial option. But what took bitcoin to its initial stages of growth may not be what is needed to sustain the network in the future.

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