A Brief Analysis of the Invisible Ceiling of DeFi in Trading, Leverage and Synthetic Assets

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Chain News ChainNews (ID: chainnewscom)

Chain News ChainNews (ID: chainnewscom)

, by Kyle Samani, Managing Partner, Multicoin Capital, published with permission.

The Decentralized Finance (DeFi) ecology has made great progress in the past two years, and I have been considering the competitiveness and market size at the protocol level. I analyzed the former in April, and this article will focus on the latter.

My biggest concern with the current state of DeFi on Ethereum is that it is subject to one or more invisible ceilings (which I explain below). According to Eugene Wei's definition, the invisible ceiling is an invisible ceiling—it cannot be measured directly, but only appears in the analysis that violates the facts—but actually limits growth.

While it’s too early to tell, it’s likely that the DeFi ecosystem has already touched these limits. For example, the highest value of ETH pledged in DeFi protocols accounts for about 2-3% of the total ETH.

• In this article, I will evaluate the advantages and disadvantages of the current DeFi system compared to CeFi (centralized finance). Then, I will try to explore some invisible ceilings that limit the growth of DeFi and propose solutions.

• Application Scenarios of DeFi

• Although the application scenarios of DeFi are very rich (including no-fee lottery, prediction market, pledge, identity, etc.), it currently has the following three main uses:

Leverage (e.g. collateralized lending in Maker, Compound, or margin trading on dYdX)

Exchange (e.g. 0x, Uniswap, Kyber, IDEX, dYdX)

Gain exposure to synthetic assets (e.g. Synthetix, UMA)

These three applications account for the vast majority of DeFi activity.

Each of the aforementioned decentralized finance protocols competes directly with centralized alternatives. Next, we analyze the dynamics of these application scenarios one by one to understand the invisible ceiling of DeFi.
Leverage

For most traders, the two most important characteristics of leverage are leverage and cost. But in these two aspects, DeFi is not as good as CeFi.

1. The leverage ratio of DeFi is lower. Subject to system delay (Ethereum block time is 15 seconds), the multiple of leverage cannot be too high. So why would a higher latency lower the maximum leverage multiple? Considering the volatility of encrypted assets and the risk of serial liquidation within a 15-second block time, it is difficult for DeFi to provide high-leverage products. dYdX launched a BTC perpetual contract with 10 times leverage in April, but compared to the average leverage of BitMEX users is 25-30 times.

2. CeFi has lower borrowing costs. CeFi businesses either by expanding credit (banks like Silvergate), reducing trust-based collateral requirements (e.g. lending arm size with trusted clients), or by offering large customer deposits (e.g. Binance and Coinbase’s lending arm) to achieve this. While DeFi protocols currently offer lower lending rates in some cases, they are structurally flawed. While it’s theoretically possible that traders slowly start trading Compound’s cTokens — a protocol that effectively replicates the advantages of Binance and Coinbase’s centralized ledgers — this would split liquidity between the cTokens and the underlying asset.

So can DeFi protocols provide more leverage? Considering the volatility of cryptocurrencies and the current shortcomings of Ethereum (15 second block time), it is difficult to imagine a platform that will provide more than 10 times leverage, and the tragedy of Black Thursday on March 12th is still vivid.

So in the long run, can the DeFi protocol provide more competitive loan interest rates? The answer is: probably not. I expect more and more banks (which can provide credit through fractional reserve loans) to enter the crypto space in the next few years, and the cost of capital provided by centralized financial institutions will gradually decrease. Additionally, since DeFi protocols cannot underwrite trust relationships, they require higher collateralization ratios, which further increases the capital (opportunity) cost.

In the foreseeable future, I don't think DeFi protocols can beat traditional leverage providers. While DeFi protocols are able to offer certain clients margins that traditional providers cannot, the market is very small. The vast majority of market participants want to optimize for the cost and availability of leverage, and DeFi protocols struggle to match CeFi on both counts.

image description

trade

Source: DeFi Pulse, Skew

• It is worth noting that if all transaction activities are transferred to a certain, open, and credible neutral DeFi standard protocol (such as a single Layer 1 I mentioned a few weeks ago), then DeFi can eliminate basic risks, Thereby improving capital efficiency for all market participants. However, this possibility is very low in the foreseeable future.

• trade

• DeFi protocols are far inferior to centralized alternatives in several major ways. Overall, the following factors prevent DEXs from taking market share from CEXs.

• Latency and probabilistic determination. Because Ethereum uses the Nakamoto consensus — which comes with high-latency probabilistic finalization — buyers and sellers do not know exactly where they are in real time. Due to the lack of precision, they must trade more conservatively (for example, with wider spreads). In this regard, any solution with a shorter block time can alleviate the situation.

• Miners are front-running. As the crypto ecosystem matures and traders move more transactions directly to the chain for settlement, block producers will start to maximize the miners' own profit (MEV). When this happens, miners start front-running transactions, which is very bad for liquidity providers.

Cross leverage and offsetting positions. Currently, Binance and FTX provide users with cross positions in different types of products (for example, a bullish perpetual position to cover a call option). Over the next year, I expect them to gradually offer offsetting positions (eg, users extend BTC long positions through ETH short positions), and then other centralized exchanges will follow. Although the decentralized environment can theoretically provide cross-margin leverage, due to the immaturity of the decentralized trading market, it is more difficult to operate in practice.

Lack of fiat currency channel. It is difficult to transfer users from the fiat currency world to the encrypted field on a large scale in a decentralized way. There are indeed several teams working on this problem, but none of them have found a solution yet. Until then, stablecoins are a nice stopgap solution for users who already hold cryptocurrencies.

Throughput and gas costs. Traders want to settle trades quickly, re-collateralize ratios, and open new trades quickly. These operations require a lot of gas fees.

So, can DeFi protocols reduce latency and provide faster finality? On low-latency Layer 2 (such as Skale) or Layer 1 (such as Solana), the answer is yes.

Can DeFi protocols make up for the lack of fiat currency support? With stablecoins, the answer is yes.

This situation is also very evident in the data: traditional exchanges account for the vast majority of trading volume, and almost all price discovery relies on CeFi.

synthetic assets

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Source: CoinAPI, Bloxy

synthetic assets

In order to trade synthetic assets, an exchange must provide 1) a mechanism to manage collateral and pay out winners/losers, and 2) a reliable price oracle.

Currently, traditional exchanges do both functions well: they both manage collateral and run centralized price oracles for perpetual contracts (perps). In addition, FTX has launched ingenious synthetic assets for the 2020 US presidential election, such as TRUMP and BIDEN contracts.

While DeFi protocols could theoretically offer arbitrary synthetic contracts (implemented, for example, via Augur), they don't appear to have any execution advantages other than inheriting the intrinsic properties of all DeFi protocols—self-custodial and permissionless oracles (but this Might be a bug rather than an advantage, depending on the circumstances).

Centralized exchanges are well positioned to compete in the synthetic market, and they have already proven this with perpetual contracts.

Breaking through the invisible ceiling of DeFi

Of the flaws mentioned above, the most common is latency. Latency is critical because crypto asset prices are extremely volatile. Its price may fluctuate by hundreds of points in a few seconds, and the 15-second block time and the consensus of Satoshi Nakamoto make the systemic risk worse.

Centralized finance operates in nanoseconds; decentralized finance operates in seconds. Almost no DeFi currently operates on the nanosecond time dimension, but with a scheme like Solana - the only blockchain that decouples global state updates from temporal changes - DeFi's runtime could be reduced to microseconds. second level.

In terms of Ethereum 2.0, it will produce a new block every 12 seconds. DeFi is the current highlight of Ethereum, but Ethereum 2.0 is not optimized for DeFi.

Again, throughput is an obvious issue. Although the Ethereum network runs smoothly most of the time; but on Black Thursday, March 12, its problems were exposed-Ethereum simply cannot withstand such a large transaction volume. This is despite the fact that DeFi transaction volume is only 1% of CeFi. But on the other hand, encrypted CeFi transactions account for only 0.1-1% of traditional asset classes (excluding foreign exchange). DeFi has a long way to go.

Invest in DeFi

While DeFi protocols face structural disadvantages for most users and traders, they are still better served than CeFi in certain market segments that may represent multi-billion dollar opportunities. For example, I think there is a huge market for non-custodial perpetual contract transactions. In view of the reasons mentioned above, DeFi perpetual contracts cannot replace CeFi in a short period of time, but I think a platform that provides DeFi perpetual contract transactions will have a considerable market share. Considering that the total market capitalization of major CeFi exchanges is about $20 billion, and the market is still growing rapidly, a trading venue that offers non-custodial perpetual contracts may be a good investment opportunity.