Why Crypto Wallets Are Broken | Armani Ferrante

The State of Crypto Exchanges: CEX vs DEX

The cryptocurrency industry is constantly evolving, and one of the most hotly debated topics is the battle between centralized exchanges (CEXs) and decentralized exchanges (DEXs). Armani Ferrante, founder and CEO of Backpack, a wallet and crypto exchange, offers a unique perspective on this ongoing debate.

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Ferrante argues that the conversation around centralization versus decentralization is often misframed. He suggests that the real issue is not about the technical aspects of centralization, but rather about compliance versus censorship resistance. This distinction is crucial in understanding the current landscape of crypto exchanges and their future trajectories.

The Technical Similarities Between CEXs and DEXs

Interestingly, Ferrante points out that from a technical standpoint, well-designed centralized and decentralized exchanges share many similarities. He explains:

"If you look at, go check out the GitHub, go look at Backpack or whatever, what does the exchange look like? And what you'll see is, you'll see a global linear log of authenticated transactions. You'll see multiple different versions of the matching engine, all replaying the exact same transactions, all signed with an ED2-5519 signature by some client that has some key pair somewhere in the world."

This description highlights that the underlying architecture of both types of exchanges can be remarkably similar, focusing on secure transaction processing and state management.

The Real Difference: Censorship Resistance

According to Ferrante, the key differentiator between CEXs and DEXs is not their technical implementation, but their level of censorship resistance. He argues that truly decentralized exchanges are geographically distributed to such an extent that they become impossible to censor or shut down. On the other hand, centralized exchanges, despite potentially using similar technical architectures, have clear points of control that make them subject to regulation and potential censorship.

The Importance of Compliance for CEXs

Ferrante emphasizes that for centralized exchanges, compliance with local laws and regulations is not just a choice, but a necessity. He points out recent examples in Europe and Japan where major exchanges have had to shut down or limit their services due to regulatory issues. This highlights the critical role that compliance plays in the operation and sustainability of centralized exchanges.

The Strength of DEXs in Spot Trading

While discussing the merits of decentralized exchanges, Ferrante acknowledges their strengths, particularly in spot trading. He cites the example of Jupiter, a decentralized exchange on Solana, which has excelled in listing a wide array of tokens, including meme coins, much faster and more efficiently than centralized counterparts.

The Challenges of Margin Trading on DEXs

However, Ferrante identifies significant challenges for decentralized exchanges when it comes to margin trading and more complex financial products. He explains that in margin systems, users don't truly own their assets, as the system needs to have control to manage liquidations and risk. This introduces complexities in terms of risk management and liquidation processes that are more challenging to implement in a fully decentralized manner.

The Role of Liquidators in Exchanges

Ferrante delves into the critical role of liquidators in both centralized and decentralized exchanges, especially for margin trading and perpetual futures. He explains:

"Who is running the liquidator? Who is running that piece of software that is monitoring prices, monitoring portfolio values and saying, oh, you know, Mert's becoming too leveraged. I need to send a transaction on chain to go and liquidate Mert because otherwise he's going to get bankrupt and we're not and he's not going to be able to cover the loss."

This highlights the complexity of implementing truly decentralized margin trading systems, as the liquidator component needs to be censorship-resistant for the entire system to be considered decentralized.

The Importance of Risk Modeling

Another crucial aspect Ferrante emphasizes is the importance of risk modeling in exchanges. He explains that every margin system requires careful modeling of price impact functions and asset volatility. This modeling is typically done by humans making judgment calls and assumptions, which introduces a potential point of centralization in otherwise decentralized systems.

The Broken State of Crypto Wallets

Shifting gears, Ferrante makes a bold statement about the current state of crypto wallets: "I think fundamentally all wallets are broken." He backs this claim with a startling statistic:

"$4.2 billion has lost every year to people that lose access to their wallets. It's roughly what they tell you $4.2 billion. So this is more than every centralized exchange every single year."

This staggering figure underscores the urgent need for innovation in wallet technology to improve security and user experience.

Backpack's Vision for Improved Wallets

Ferrante shares Backpack's approach to solving the wallet problem, which involves rethinking the concept of asset ownership and custody. He introduces the idea of using account abstraction and multi-signature wallets to create a more secure and user-friendly experience.

The Backpack Wallet Construction

Ferrante outlines a novel wallet construction that Backpack is experimenting with:

"So one of the products that we've been iterating on just in private in the company has been this kind of new kind of account attracted wallet where the UX is very, very simple. I signed in with my exchange email, email password, 2FA, no problem. I'm in. It's just like using Coinbase or whatever. But then when I go to my portfolio, I have this wallet that I can use. And it has my NFTs, I have my tokens, I could stake soul, I could connect to dapps, I could swap a Jupiter. But when I go to do any action that moves money, not only does it ask me for maybe my exchange 2FA if we want, but also it'll ask me for my ledger, my wallet, my pass key, your favorite wallet of choice."

This approach combines the ease of use of a centralized exchange account with the security of self-custody, potentially offering a best-of-both-worlds solution.

The Technical Details of Backpack's Wallet Solution

Ferrante goes into the technical details of how this wallet construction works:

"What you can do is you can build a two or four squads multi-sick squads. If you for totally vanilla, you can see it on chain. It's immutable, formerly verified, built by the Chads over at the squad seem where you can have two tiers of members on the multi-sick. The first tier are instant signers. So one instant signer is my wallet. So let's just say my ledger just for simplicity. And then the second tier is the exchange infrastructure."

This multi-tiered approach allows for both instant transactions and time-locked recovery options, providing a balance between security and usability.

The Importance of Recovery Options

One of the key features of Backpack's wallet solution is the ability to recover funds even if the user loses their primary key. Ferrante explains:

"If you lose your key pair, say you throw your ledger into the ocean, you're, you know, God forbid your house burns on fire as you know, happened to a lot of folks recently in California, these, these things are very real scenario. But if that happens, no problem. Log into your exchange account, you know, maybe call customer support, talk to our compliance team and recover your wallet in the exact same way that you would recover your bank account or you centralized exchange account."

This recovery option addresses one of the major pain points of traditional crypto wallets while maintaining the principles of self-custody.

The Role of Compliance in Wallet Security

Interestingly, Ferrante argues that compliance and KYC (Know Your Customer) procedures can actually enhance wallet security:

"I don't know about you, but I feel a lot safer when somebody can actually verify who I am. And it's not like somebody trying to scam me. I like to show them a government document or whatever. I understand that's a contentious point and different people have different feelings."

This perspective challenges the common crypto narrative that anonymity is always preferable, suggesting that there might be a middle ground that combines privacy with enhanced security through identity verification.

The FTX Connection and Its Impact on Backpack

Ferrante's background with FTX and the collapse of the exchange has significantly influenced Backpack's development. He shares that Backpack initially raised $20 million, including funds from FTX Ventures, which were caught up in the FTX collapse. This setback forced the company to reevaluate its strategy and focus on building a more robust and compliant exchange.

The Decision to Sell FTX Claims

In the aftermath of the FTX collapse, Backpack made the decision to sell its claims on the bankrupt estate. Ferrante explains the reasoning behind this decision:

"The decision for us was really simple. It's like as a company, we need the money now this year, otherwise we have no company. And so we didn't have the luxury of waiting, however long it was."

This decision highlights the difficult choices startups often face in navigating financial uncertainties and prioritizing immediate survival over potential future gains.

The Vision for Mad Lads NFTs

Ferrante also touches on Backpack's NFT project, Mad Lads, offering insight into his philosophy on NFTs:

"I think the way I think about NFTs is that they're not tokens. They're not utility vehicles. In those genuine sense, they are just art. And then the question becomes, well, how do you build art? And to me, art is ultimately about cultural relevance. It's about distribution."

This perspective frames NFTs not as mere digital assets or utility tokens, but as cultural artifacts whose value is derived from their visibility and relevance.

Advice for Crypto Founders

Drawing from his experiences, Ferrante offers advice for aspiring crypto founders. He emphasizes the importance of solving real problems and not getting caught up in the hype of crypto-specific trends:

"The biggest mistake that crypto founders make specifically is thinking that crypto is like some special thing. And all of the wisdom of traditional startups applies to crypto as it applies to any other startup."

He encourages founders to focus on creating value and solving problems for users, rather than getting caught up in building communities or tokens for their own sake.

The Importance of Boring Problems

Ferrante also highlights the value of working on "obvious boring problems" in the crypto space:

"I think there's a lot of value and just working on obvious boring problems over a long period of time. The simplest kind of example of this is just like Fiat, like Fiat, just like such a simple product problem, right? But if you, but it turns out it's really hard to get like Fiat in any country all around the world and get on and off ramps to, you know, whether you're in Europe, using SEPA or you're in the US doing ACH or you're in Brazil and PICS or you're at some random, I don't know, 7/11 and Hong Kong or whatever."

This advice underscores the importance of addressing fundamental infrastructure challenges in the crypto ecosystem, even if they may not seem as exciting as cutting-edge DeFi protocols or new token models.

The Future of Crypto Exchanges and Wallets

As the crypto industry continues to evolve, the insights shared by Armani Ferrante paint a picture of a future where the lines between centralized and decentralized services become increasingly blurred. The focus is shifting towards creating user-centric solutions that balance security, compliance, and usability.

Backpack's approach to combining the best aspects of centralized and decentralized systems could represent a new paradigm in crypto wallet and exchange design. By addressing the critical issues of fund recovery and user experience while maintaining the principles of self-custody, they are working towards solving some of the most pressing problems in the industry.

The emphasis on compliance and risk management also suggests a maturing of the crypto industry, moving away from the "wild west" mentality of its early days towards a more regulated and sustainable ecosystem. This transition, while challenging, may be necessary for crypto to achieve mainstream adoption and integration with traditional financial systems.

As the battle between CEXs and DEXs continues, it's clear that both models have their strengths and weaknesses. The future may not be a clear-cut victory for one side, but rather a nuanced landscape where different solutions cater to different user needs and regulatory environments.

Ultimately, the success of projects like Backpack and the broader crypto industry will depend on their ability to solve real-world problems and create value for users. As Ferrante suggests, focusing on fundamental issues and "boring problems" may be the key to building the infrastructure necessary for crypto's long-term success.

The crypto wallet and exchange space is ripe for innovation, and the ideas presented by Ferrante and Backpack represent just one possible direction. As the industry continues to evolve, we can expect to see more novel solutions emerge, each attempting to strike the right balance between security, usability, and regulatory compliance.

The challenges are significant, but so too is the potential for transformative change in how we interact with digital assets and financial systems. As projects like Backpack continue to push the boundaries of what's possible, the crypto industry moves closer to realizing its promise of a more open, accessible, and efficient financial ecosystem for all.

Facts + Figures

• $4.2 billion is lost every year due to people losing access to their crypto wallets

• Backpack initially raised $20 million, including funds from FTX Ventures

• Backpack had $14.5 million stuck on FTX when it collapsed

• FTX creditors are receiving approximately 118% of their holdings in payouts

• Major exchanges like Binance, Bybit, and OKX have had to shut down or limit derivatives trading in Europe due to regulatory issues

• Backpack is experimenting with a new wallet construction using a 2-of-4 multi-signature setup

• The new Backpack wallet design incorporates both instant signers and time-locked recovery options

• Armani Ferrante previously worked at FTX before founding Backpack

• Backpack sold its claim on the FTX bankruptcy estate to secure immediate funding

• Ferrante argues that decentralized exchanges excel particularly in spot trading for long-tail assets

• Centralized exchanges are facing increasing regulatory pressure, especially in Europe and Japan

• Ferrante suggests that truly decentralized margin trading systems are challenging to implement due to liquidation and risk modeling requirements

• Backpack is developing a wallet solution that combines elements of centralized exchange accounts with self-custody principles

• Ferrante proposes that compliance and KYC procedures can enhance wallet security, challenging the common narrative in crypto

• The Mad Lads NFT project by Backpack focuses on cultural relevance and distribution as key metrics for success

Questions Answered

What is the main difference between centralized and decentralized exchanges according to Armani Ferrante?

According to Ferrante, the main difference between centralized and decentralized exchanges is not their technical implementation, but their level of censorship resistance. He argues that truly decentralized exchanges are geographically distributed to such an extent that they become impossible to censor or shut down, while centralized exchanges have clear points of control that make them subject to regulation and potential censorship.

Why does Armani Ferrante believe that crypto wallets are currently broken?

Ferrante believes crypto wallets are broken because of the massive annual losses due to users losing access to their wallets. He cites a statistic that $4.2 billion is lost every year due to people losing access to their crypto wallets, which he argues is more than the losses from centralized exchanges. This highlights a critical usability and security issue in current wallet designs that needs to be addressed.

What is Backpack's approach to improving crypto wallets?

Backpack's approach to improving crypto wallets involves rethinking the concept of asset ownership and custody. They are experimenting with a new wallet construction that combines elements of centralized exchange accounts with self-custody principles. This includes using account abstraction and multi-signature setups to create a more secure and user-friendly experience, with features like easy account recovery and enhanced security through compliance measures.

How does Armani Ferrante view the role of compliance in crypto exchanges and wallets?

Ferrante views compliance as a necessary and potentially beneficial aspect of centralized crypto services. He argues that for centralized exchanges, compliance with local laws and regulations is crucial for long-term sustainability. Furthermore, he suggests that compliance and KYC procedures can actually enhance wallet security by providing verified ways to recover access and prevent scams, challenging the common crypto narrative that anonymity is always preferable.

What advice does Armani Ferrante offer to crypto founders?

Ferrante advises crypto founders to focus on solving real problems and not get caught up in the hype of crypto-specific trends. He emphasizes that the wisdom of traditional startups applies equally to crypto startups. He encourages founders to create value for users and solve actual problems, rather than focusing solely on building communities or tokens. Additionally, he highlights the value of working on "obvious boring problems" in the crypto space, such as improving fiat on-ramps and off-ramps.

How does Backpack's wallet solution address the issue of fund recovery?

Backpack's wallet solution addresses the issue of fund recovery through a multi-tiered approach using multi-signature wallets. It includes both instant signers (like the user's hardware wallet) and time-locked recovery options tied to the exchange infrastructure. If a user loses their primary key, they can recover their funds by logging into their exchange account, potentially going through customer support and compliance checks. This provides a balance between security and the ability to recover funds in case of lost access.

What is Armani Ferrante's perspective on NFTs, particularly in relation to the Mad Lads project?

Ferrante views NFTs not as mere digital assets or utility tokens, but as cultural artifacts. He believes that the value of NFTs, including projects like Mad Lads, is derived from their cultural relevance and distribution. His focus is on maximizing "eyeballs on the images or on the logo per second" as a key metric for NFT success, emphasizing the importance of visibility and cultural impact in the NFT space.

How does Armani Ferrante view the challenge of implementing margin trading on decentralized exchanges?

Ferrante identifies significant challenges for decentralized exchanges when it comes to margin trading and complex financial products. He explains that in margin systems, users don't truly own their assets, as the system needs control to manage liquidations and risk. This introduces complexities in terms of risk management and liquidation processes that are more challenging to implement in a fully decentralized manner. He particularly highlights the difficulty of creating a censorship-resistant liquidator system, which is crucial for truly decentralized margin trading.