What does it take for DeFi to go from casino to Wall Street?

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Photo by Roberto Júnior on Unsplash

With Uniswap’s daily trading volume hitting almost a billion dollars, Automated Market Making has become the dominant force of decentralized exchanges today. The reason behind this is simple — with the underlying technical infrastructure and cost structure of blockchains, it is no longer feasible for market makers to quickly place and withdraw orders as they used to do on order book-based exchanges.

Platforms like Uniswap, which uses a constant product AMM algorithm, have a clear product-market fit for long-tail assets that do not need much pricing and liquidity support elsewhere, and projects themselves usually need to provide liquidity for retail traders. However, as I laid out in a previous article — Uniswap is not a one size fits all market-making solution and cannot be used as the sole oracle for the DeFi space.

There are also other attempts trying to optimize the experience for market makers and traders, including Curve for stablecoins and Balancer for multiple asset liquidity pools. However, none of them can work as a generalized model for all market making use cases.

The number one principle of financial product design is that financial transactions need to be priced at market prices.

If this doesn’t hold, the product can be continuously arbitraged by outsiders. Without proper risk management measures in place, no rational market participants would enter such a market.

The real market makers may hesitate to enter Uniswap because they could lose money when the market is volatile. This problem is even more pronounced for liquid assets on the platform, as their prices could constantly diverge from the external market prices. It is also difficult to convince professional traders to come to Uniswap because any sizable trade could cause a high slippage.

CoFiX will be the game changer for AMM.

The CoFiX protocol introduces a market-making model that is based on market price, with a completely computable risk control mechanism.

It uses a decentralized price oracle, NEST, which provides a set of mathematical proofs for price risks. With this toolkit, CoFiX designs a fully computable on-chain market-making protocol that accounts for all systematic risks.

Here is how CoFiX works at a high level:

  1. CoFiX protocol receives a market price P from NEST
  2. CoFiX factor a risk co-efficient K into P to account for time delay and volatility, which are the two major price risks
  3. With K, CoFiX produces a new reference price P’, and P’ is the price that traders and market makers refer to when making transactions

When comparing with other existing AMM protocols, CoFiX’s advantage is obvious. It leverages real market prices to eliminate system-level arbitrage opportunities, while also quantify risks to preserve “automation,” a unique characteristic offered by DeFi.

One of the biggest flaws of existing AMM protocols is that market makers do not have complete certainty of how much risk they are taking when providing liquidity. Since these AMM protocols do not execute on actual market price, market makers also cannot accurately hedge their positions on other platforms. They continue to subsidize arbitrageurs since these AMMs rely upon the latter to approximate true market price.

By directly using external market price, CoFiX allows market makers to accurately assess their risks and hedge positions accordingly. The protocol also provides additional risk control mechanisms to account for network congestion or oracle attack. CoFiX revolutionizes the AMM game and makes DeFi an attractive options for all traders, all market makers, and all assets.

We used to trust Goldman Sachs of the world for its capabilities to operate the business on a sustainable basis. However, in such trusting, we also forfeit visibility into their operations and take upon opaque default risks. As finance moves from off-chain to on-chain, this information asymmetry between Goldman Sachs and us is broken — we now have access to all the information as the on-chain “bankers.”

Along with information symmetry also comes comprehensive calculability. In traditional finance, we can never calculate when “Lehman” would collapse or a P2P lending company would run away with users’ money. Even geniuses at Long Term Capital, who could build perfect financial models, couldn’t accurately calculate the probability of Russian bond default.

DeFi completely changes this game by allowing us, for the first time ever, to create a financial system running without human interventions, and calculate the risk-reward structure behind all assets and financial transactions with precision.

Ultimately, the big money will only come to DeFi for protocols with solid fundamentals. When financial institutions need to place multi-millions or even billions of dollars into trading or lending protocols, they will not take pricing risks from any individuals or a small group of people. They will not put capitals into a DeFi protocol without proper risk management measures.

Projects such as Uniswap have already laid a solid foundation for DeFi and attracted the first 100k users. However, for DeFi to go from casino to Wall Street, where it is all about pricing risk and risk management, the entire space needs to take full advantage of this new era of finance that features mathematical certainty and computability.

Thus we see DeFi gradually evolve into CoFi (computable finance), where every financial parameter can be qualified and computed. Having accurate prices on-chain and providing financial products with sound risk management will set the foundation for DeFi 2.0. And CoFiX is an important step towards this direction.

Thank Victor Zhang and Celia Wan for their contributions to this article.

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