Why is DeFi unstoppable?
Crisis of Trust in CeFi
FTX suffered a bank run in a short period of time, it is a sudden thunderstorm which shocked the entire crypto world. The risks of CEX now should be reconsidered. Reflecting on the meaning of crypto, each participant should seriously consider this question: will crypto has any fundamental problems if supported by centralized exchanges?
FTX’s insolvency is by no means a failure of Crypto, it reflects the vulnerability of the centralized financial system. It shows that how bizarre operations CEX and how speculative institutions have in an environment that lacks enough supervision. FTX once regards itself as a bank. It used part of the exchange reserves to meet customers’ normal withdrawal needs, it mismatched funds with credit loans for any strongly related parties. It leads to an uncontrollable and unimaginable lack of risk control, especially for traditional finance institutions.
The the second largest exchange in the cryptocurrency world, FTX has The well-known brand reputation with image of compliance, security, reputation, yet it collapsed within a week. Its collapse reveals the fundamental problem of centralization — one has to believe it without verifying the true state of the centralized entity.
Crypto provides a decentralized, free, open, and censorship-resistant environment and infrastructure, yet many crypto centralized entities choose to do evil. The decentralized system empowers everyone to participate, interact and supervise freely. Everyone is important, people should work hard to prevent similar incidents again. The bankruptcy of a large CEX is a severe damage to the entire Crypto world.
Cost of Trust and Optimism Bias
💡 FTX is not the first, nor will be the last. In the short course of Crypto’s development, We've seen the collapse of Mt.Gox, Flexcoin, and Bitstamp. We’ve also witnessed the bankrupt of Celsius and BlockFi, so #FTX won’t be the last to surprise us. Why do users still choose to believe CEX after so many insolvencies.
The cost of trust and the optimistic bias drive the market continually look for the next worth believable CEX. In this paper, the cost of trust includes the cost people pay for trust and loss people have due to dishonesty.
Blockchain was designed to solve a trust problem: how to reach a consensus without the endorsement of a centralized entity. Achieving trust under the existing framework has certain costs. Running a decentralized public chain requires participants to continually provide resources needed for trusts, such as machine and network resources. Such expenses have to be paid by public chain users. People spent to maintaining a sufficiently decentralized, anonymous, and secure system.
The most significant contribution of The public chain economy on trust is to make the cost of trust explicit. Every participant now knows that trust has cost and users paid to support the entire system's operation. Under this mechanism, people know that it is challenging to produce untrustworthy behaviors technically (such as changing contracts on the chain, attacking the public chain, etc.), and the system is robust.
However, when it comes to CEX, the distribution of costs of trust is extremely uneven. Users bear the cost of trust only when the CEX goes bankrupt. In fact, every centralized exchange has costs of trust because of opacity and unverifiability. The costs of trust will not reveal while a CEX is stable running. As long as users choose to believe, centralized exchanges do not need to pay the costs of trust in advance. The cost of maintaining trust is minimal, yet, the loss caused by dishonesty is enormous. The loss usually comes after the fact; users will not have an immediate response to the costs of trust they are bearing.
Optimism bias generally refers to the phenomenon that individuals tend to believe they are more likely to experience the good while others are on the contrary. People generally think they are the luckier and are unwilling to consider the risks behind the exchange they choose
Coupling the costs of trust in CEX with customers’ optimism bias, the public keeps making subjective judgments and chooses to use the next CEX they believe in even after experiencing the collapse of the CEX.
DeFi, the Only Solution to Trust Problem
Centralized finance guarantees the rights and interests of users by introducing strict supervision, but it is the transfer of power, not a solution. It is a well-known fact that the SEC and the Federal Reserve have unimaginable controls on financial regulation.
Suppose not introducing more influential centralized entities such as governments and global regulatory organizations into the blockchain, DeFi will be the only solution for the trust problem. We need to use public chains for financial activities and cryptography for the security and transparency of the ledger. The right of choice is back to users; private keys are for securing assets. Decentralized financial activities, thus, will be a new paradigm for the financial system.
In the last few bull and bear market rounds, centralized exchanges occupied a dominant position. People have to transfer funds to cold wallets while panicking, and they can only use centralized exchanges again when transactions rise again. DeFi is here to break this behavior pattern.
During the last bull market, DAPPs have unprecedentedly improved user experience. The trading experience of decentralized exchanges is not much different from that of centralized exchanges. In terms of the transaction depth of mainstream currencies, Uniswap exceeded centralized exchanges on WETH/USDC pool’s trading depth.
Most importantly, DeFi has a lower cost of trust. Although the existence of network fees raises the cost of friction, the public chain solves the trust problems. As the whole system’s trust cost is explicit, the noncustodial service reduces the possibility of short-term bank runs. The uncertainty of the entire system will decrease accordingly.
During DeFi Summer, also known as DeFi 1.0, a high APY narrative drove the whole market to an outbreak. Yet, we believe that high returns will not evoke DeFi 2.0. A real DeFi 2.0 is based on the fundamental belief of Crypto, which is driven by characteristics of DeFi: being noncustodial, transparent on the chain, and resolving trust.
The crisis of trust in CeFi becomes the real starting point of DeFi 2.0.
The paradigm shift evoked by DeFi, following “the code is the law” belief, has many problems on the user threshold, MEV, and various security problems. Despite continuously optimized solutions, the problems can not be erased. DeFi has a long journey.
Control Your Assets, Don't be an Ostrich
💡 In behavioral finance, the ostrich effect is investors’ attempts to avoid negative financial information.
FTX’s insolvency deeply hurt this market. One should not ignore the risks of centralized entities. Start by controlling your assets to weaken the influence of centralized entities. When transferring the assets to the wallet, you have officially entered the world of Crypto and have complete control of your assets. Learning to use DeFi is hard, But as long as you know how to use DeFi protocols, such as trading tokens and lending assets, you will get rid of the control of centralized exchanges.
We believe that the collapse of this second-largest crypto exchange profoundly affects the market and reminds users that if it is not your private key, it is not your money.
The Status Quo and Trend of DEX
The Status Quo of DEX
I believe that ten or twenty years from now, decentralized exchanges will be bigger than centralized exchanges.
—— Changpeng Zhao, Founder of Binance, the Largest CEX***
Can DEX replace CEX now?
The answer is yes. Numerous DEXs or DeFi protocols provide functions from transactions to staking to fiat currency deposits and withdrawals. In fiat currency deposits and withdrawals, DeFi has Moonpay, Transak, and Wyre. and many DEXs have integrated with their services. A large number of protocols based on DEXs provide staking and other interest-earning services. In product experience, mainstream DEXs such as Uniswap, Pancake, and DODO support the charts, and front-end built-in K-line toosl. 1inch, 0x Protocol, DODO, Tokenlon, and Paraswap, have launched the limit order function, which is similar to the pending order of CEX that users can pre-set the transaction price. The gap between DEX and CEX in terms of product functions is already very small.
There are user education and user habits gaps, such as private key management and wallet interaction, between DEX and CEX. Moreover, DEX has relatively insufficient liquidity compared to CEX, but this will no longer be a problem as time goes by. DEX is undergoing rapid iteration and evolution. Whether it is product experience or liquidity, DEX is maturing.
Data Performance
- Regarding total spot trading volume, DEX accounts for between 10% and 30% and is still catching up with CEX. Compared with 11.79% in October, it increased to 16.84% as of the 15th, which is somewhat related to the FTX event.
- In the past 30 days, the number of users and the number of on-chain transactions of some mainstream DeFi protocols have experienced double-digit growth. The collapse of FTX indirectly stimulates on-chain transactions, and DeFi applications are having significant user growth.
- As of 2 PM UTC+8 on November 16, the 24h trading volume of Uniswap V3 surpassed OKX, ranking third in CEX, second only to Binance and Coinbase.
Trend of DEX
We have been tracking DEX's product and market for a long time. Our work DEX weekly brief presents our observations on a bi-weekly basis. Next, we will analyze these long-term trends and discuss why these trends appear from the first principles to illustrate our finding of new trends in DEX.
Routing Algorithm of Liquidity Aggregation
💡 The routing algorithm will become increasingly efficient as the degree of aggregation of on-chain liquidity is increasing. On-chain liquidity has the potential to far exceed centralized exchanges, improving the overall system transaction efficiency.
The most significant advantage of on-chain liquidity is mutual aggregation, the nature of DeFi. Any contract or individual can directly interact with the liquidity pools, and the liquidity of DeFi is one. The routing algorithm is the bridge that aggregates the on-chain liquidity. The routing algorithm of each DEX or aggregator may be different, but the core principle is the same. When a user sends a transaction request, the routing algorithm will calculate the most optimal trading path and interact with multiple liquidity pools to achieve better trading prices and lower slippage.
Since the on-chain liquidity is scattered, even in a DEX, there may be multiple liquidity pools for one trading pair. Therefore, in pursuing the optimal transaction price and the lowest slippage, DEX needs to aggregate other sources to provide better transaction prices. It is a long-term trend because accessing aggregation functions or self-developed routing algorithms will bring better prices. Users are sensitive to prices. This market competition will force more and more DEXs to use routing for on-chain liquidity aggregation.
In the long-term observation of the DEX market, we found that the aggregation competition is becoming more fierce. An increasing number of DEXs, aggregators, and wallets are aggregating with each other, which makes the degree of integration of liquidity on the chain higher and higher. And there are many ways of aggregation, including aggregators accessing the liquidity of DEX, DEX accessing aggregators, DEXs aggregating other DEXs, wallets and DAPPs integrating DEXs or aggregators, and cross-chain aggregation.
From the perspective of aggregators, 1inch, Matcha, and 0x Protocol are the leading aggregator protocols. Many DEXs have integrated their APIs since the beginning of this year. For example, Woofi, Chainge Finance, Wirex, and Aurora integrated 1inch, Bancor and DODO integrated 0x. Aggregators constantly increase the number of DEXs they access, such as 1inch accessing Babyswap, Elasticswap, Kyberswap, etc.; 0x accessing Balancer, etc.; RoketX accessing Paraswap, etc. Many newer aggregators also perform well, such as Atlas DEX, which focuses on cross-chain aggregation transactions, and RoketX, which aggregates centralized exchanges.
DEXs using aggregation functions are increasing. For example, Sushiswap launched Trident at the beginning of the year, accessing aggregators and aggregating the liquidity of DEXs, and then upgraded the routing algorithm; Jupiter aggregated the liquidity on the entire Solana; Canoe Finance integrated DODO’s routing aggregation algorithm to realize the aggregation function.
Introduce Professional Market Makers and Provide RFQ
💡 Professional market makers provide a large part of CEX's liquidity. At the same time, DEX uses the RFQ function to inquire from market makers, allowing professional market makers to become counterparties and provide greater liquidity.
Why serving market maker service is the trend? Professional market makers provide a large amount of liquidity for the market. It is difficult for professional market makers to reach full potential as of high on-chain transaction costs,. Therefore, if DEX wants to surpass centralized exchanges, how to provide market makers with better solutions to attract more of them is important.
For professional market makers, on-chain market making is a matter of cost. If the order book is the optimal choice in the frictionless situation, AMM is the optimal choice under the high cost of the chain, then the RFQ function is somewhere in between. Most of the RFQ completes the inquiry process off-chain through private key signatures and processes on-chain transactions after both party confirmations, reducing transaction costs and improving transaction efficiency through off-chain signatures and polling. However, the off-chain inquiry process inevitably leads to specific trust issues, the focus of the RFQ design. In addition to making markets through the RFQ, professional market makers also actively adapt to the market-making model of on-chain liquidity pools, such as Wintermute and Wootrade.
For users, RFQ function provides the experience with less gas fee or gasless and MEV attacks resistance. Less gas or gasless means the market maker pays gas for users, which does not reduce the overall transaction cost (because there is an inevitable cost for interacting with the blockchain). Combined with functions such as limit orders, it can provide users with a good trading experience. Since quotations and matching is completely off-chain, it resists MEV attacks and reduces the uncertainty of swap on the chain.
Cowswap, Hashflow, 0x Protocol, Tokenlon, Matcha, and DODO have RFQ functions. Cowswap names its RFQ function as Batch Auction. In the process, users authorize a token transfer and approve an off-chain sign. After confirming signatures, the Solver will calculate the optimal solution based on all received orders, and report to the protocol for selection. The protocol selects the optimal solution for on-chain execution. A competition mechanism ensures Solvers will not do evil. Hashflow is another RFQ-focused exchange, that screens market makers with a review mechanism. 0x, Matcha, Tokenlon, and DODO provide typical RFQ functions and have no unique design for off-chain trust issues. We observed that more and more DEXs are introducing RFQ now. Matcha and DODO both launched RFQ functions this year, and Sushiswap launched gasless transactions, an RFQ function indeed, this year. The DEX with RFQ function has access to more market makers, such as Hashflow, newly accessing GSR, Ledger Prime and Kronos. In short, more and more DEXs have introduced the RFQ function, and more and more market makers have joined.
Pursue Higher Capital Efficiency by Improving Market-Making Algorithm
💡 The liquidity pool is a native on-chain solution, a main battlefield of DEX. Starting from AMM, mainstream DEXs are continuously optimizing their market-making algorithms to improve capital efficiency.
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Capital Efficiency
AMM is a fascinating innovation. Everyone can be a market maker to provide liquidity, which increases the potential upper limit of liquidity on the chain. However, AMM has capital efficiency problems. Capital efficiency measures how to offer higher trading volume with less TVL, which means lower slippage and higher market depth for the trading experience. The core market-making algorithm determines the capital efficiency and user experience of DEX. The iteration of the algorithm will continue. How to cover higher trading volume with less TVL will be an eternal topic for DEX exploration.
We have demonstrated that the aggregation of on-chain liquidity before. The trend of liquidity integration in the market leads to fierce competitions between DEX. Whichever has more efficient market makers, which acquires a larger market share.
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Concentrated Liquidity Is the Mainstream Trend
The capital efficiency of AMM is not high because the liquidity of the constant product market-making curve is evenly distributed on the curve. Curve weights the constant product curve and the constant price curve to launch the stableswap curve. Curve V2 provides a market-making curve, adjusts based on the internal oracle's price, and concentrates liquidity around the oracle price. Uniswap V3 proposes the concept of range order, allowing users to provide liquidity within the selected price range to improve capital efficiency. DODO uses the PMM algorithm to introduce external market makers, providing quotations and concentrating liquidity around the market price. DODO significantly improves capital efficiency through the PMM algorithm and is currently the most capital-efficient DEX. These three leading DEXs have adopted the method of centralized liquidity to enhance capital efficiency. We also believe that centralized liquidity and proactive market-making will be the mainstream of future innovation of market-making algorithms.
Some newer exchanges continue to innovate and improve market-making algorithms. Maverick AMM provides lower slippage; 3xcalibur’s Tri-AMM combines lending and trading; Trader Joe introduces a new AMM; Elasticswap's Elastic AMM designs for stablecoins that dynamically adjust token supply. Delphi also proposed the design of SLAMM some time ago to achieve cross-chain liquidity. Some exchanges abandon the order book and pool model. For example, Contango neither uses the AMM mechanism nor the order book model but realizes token exchange through the fixed-rate market.
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Users Provide Funds, Protocols Provide Strategies
Users may not track market information continuously and have low efficient market-making. They may suffer significant losses if they do not keep focusing on the market. Although AMM allows more users to participate in market making, it requires high professionalism. Therefore, based on the market-making mechanism of DEX, many protocols provide auxiliary market-making functions for ordinary users in terms of market demand. The top DEXs have improved their AMM mechanisms. Yet their development in concentrated liquidity and proactive market-making increase users' difficulty in making markets. In our long-term market observation, we found that some protocols have developed liquidity management functions based on DEX. We believe that these protocols or the DEXs that integrate these functions will grow into a decentralized asset management platform, leading to a new development trend of DEX. For example, Aura Finance runs on Balancer, Euler Finance integrates with Uniswap, Visor Finance and Method Finance provide active liquidity management based on Uniswap V3.
Multi-Chain
💡 The competition on the public chain track is intense. Although it is impossible to predict who will be the next Ethereum killer, DEX is being widely deployed and bet on different chains for more influential expansion.
We do not discuss whether the future will be multi-chain, cross-chain, or super public chains. We find that most DEXs have chosen to expand to a multi-chain universe. Although multi-chain deployment has additional development costs, the benefits are apparent: a stable transaction experience and no need to worry about cross-chain security issues. L2 is popular among DEX deployments. The lower transaction fees make the trading experience of DEX very close to that of CEX, and market makers can also provide better quotations and market making.
Is the Real DeFi 2.0 coming?
Since the market entered a bear market, some people have been bad-mouthing DeFi, using declining trading volume and TVL to prove that DeFi is dead. Has decentralized finance failed? No. Contrary to everyone’s perception, DeFi has not died but is running well. The declining transaction volume and TVL of DeFi are just like the falling market price of ETH. This is a macro-market shift that will not hurt its growth.
Since the Luna crisis, several centralized financial entities, such as Celsius, 3AC, Voyager Digital, BlockFi, and FTX have failed one after another. They have no different from traditional financial companies, which are over-leveraged and lack transparency. They collapse in volatility, making their customers suffer heavy losses. And decentralized financial protocols, such as Uniswap, DODO, Curve, AAVE, Compund, MakerDAO, etc., are all working well.
Despite the decline in transaction volume and TVL, the health of these DeFi protocols can be seen compared to the opaque balance sheets of centralized financial entities. The code determines life and death, not market conditions and asset prices that change with the environment. It proves the superiority of DeFi, which provides an open, transparent, and stable financial system for all participants.
FTX will make people realize the actual value of DeFi. Perhaps the DeFi narrative driven by trust and transparency will become the engine that truly drives the development of DeFi, and the real DeFi 2.0 may arrive soon.
Reference
https://messari.io/article/dex-education-uniswap-optimistic-rollups-and-the-layer-2-dex-landscape
https://members.delphidigital.io/reports/uniswap-vs-curve-which-is-the-best-dex
https://www.paradigm.xyz/2021/06/uniswap-v3-the-universal-amm
https://messari.io/article/the-chronicles-of-uniswap-the-token-the-switch-and-the-wardrobe
https://www.nansen.ai/research/the-market-making-landscape-of-uniswap-v3
https://resources.curve.fi/base-features/understanding-curve
https://docs.dodoex.io/chinese/dodo-xue-yuan/pmm-suan-fa-gai-lan/pmm-suan-fa-xi-jie
https://www.nansen.ai/research/the-market-making-landscape-of-uniswap-v3
https://uniswap.org/blog/uniswap-v3-dominance
https://dune.com/msilb7/Uniswap-v3-Pair-Deep-Dive
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