GM DeFi aficionados ❤️
Enjoy the expert article from our founder that was recently published in CVVC’s Blockchain Report 2023. The original version can be found here: https://www.cvvc.com/insights#germanreport
Decentralized Finance (DeFi) is an ambitious disruption to traditional finance that offers peer-to-peer financial systems without intermediaries. Meanwhile, the continuous regulation process of Centralized Exchanges (CEXs) leads to increased interest and adoption of DeFi, and the increased usage of DeFi unveils specific structural inefficiencies that give CEXs a significant edge.
AMMs: Price impacts and capital efficiency 💹📉
Automated Market Makers (AMMs) represent the core of many DeFi platforms. It substitutes the traditional order book systems and sets prices based on the corresponding reserve ratios in a liquidity pool. While this ensures guaranteed liquidity, it has the following trade-off: low reserves lead to price slippage, whereas high reserves lead to capital inefficiency. For DEX traders, slippage increases with increased trade size. Therefore, AMMs are unsuitable for high-volume traders.
In contrast, most CEXs use traditional order book systems to match buyers and sellers. To attract market makers, CEXs use their flexibility advantage over DEXs. Specifically, that is the case for their fee structure. The higher the monthly/weekly trading volume the lower are trading fees (measured in basis points, i.e., 100 basis points = 1 percent). For CEXs, this is a suitable approach to incentivize market markers, however, its economics of scale factors lead to unfair trading conditions. In terms of basis points, small-volume traders end up paying up to twentyfold more in fees than market makers and high-volume traders.
DeFi is built to treat traders equally 🤝💸
The dynamic fee approach at CEXs allows low or even negative trading fees (meaning that market takers pay market makers) and offers lucrative trading conditions for market makers. Therefore, these lucrative conditions attract a lot of capital resulting in low slippages for traders in the order book system. Another effect of negative trading fees is an efficient market pricing of assets at CEXs. For market makers, negative trading fees lower the threshold to execute arbitrage trades. It follows, that the cross-exchange prices at CEXs are almost identically pegged. (Please, note we neglect all negative effects of negative trading fees such as market manipulations, concentration of power, and more. We focus only on the benefits that DeFi needs to compete with).
The order book system offers accurate real-time pricing that eliminates the need for external data sources. DeFi platforms have tried to use oracles to import external price data. However, these oracles can be manipulated, centralized, and might not always provide up-to-the-minute data, which can result in even bigger problems. DeFi relies heavily on user-provided liquidity. The AMM system is revolutionary in terms of fairness distribution and participation towards small market participants. However, it also has its pitfalls notably due to its static nature. Challenges like comparably high slippage and inaccurate market prices need to be resolved. In most DeFi protocols, funds are static and are largely unresponsive to market demand. This is in sharp contrast to CEXs, where funds are dynamically adjusted and relocated based on market conditions. To rival its centralized counterparts, DeFi protocols must innovate beyond its static liquidity to embrace dynamic liquidity management. Furthermore, the static nature of liquidity in DeFi has direct consequences for yield and capital efficiency. When liquidity is fixed and doesn’t adapt dynamically to changing market, pool, and protocol conditions, it often remains trapped in less productive pools. This results in low returns for liquidity providers, reducing the annual percentage yield (APY) they receive on their staked assets. Centralized competitors, with their adaptive mechanisms, ensure that capital is more likely to be employed more efficiently. The discrepancy in capital utilization between DeFi protocols and CEXs means that DeFi participants might be sacrificing potential gains for the sake of decentralization. Addressing the static liquidity challenge will be key for DeFi protocols to ensure optimal returns for their users.
Arbitrage: The silent drain in DeFi 🚿💸
A particularly troubling inefficiency in DeFi is the rampant arbitrage that siphons value out of decentralized protocols. The decentralized nature of these platforms, coupled with the occasional price discrepancies between DEXs or between DEX and CEX, opens doors for arbitrageurs. These market participants capitalize on cross-exchange price differences, often at the expense of regular users and liquidity providers. A study on Solana’s DEXs revealed that arbitrage actions resulted in a loss of 27.8% of the Total Value Locked (TVL) annually. This exorbitant drain discourages liquidity providers since they suffer divergence losses that reduce returns on their investments. In contrast, CEXs that allow higher trading flexibility can promptly rectify potential arbitrage opportunities. Their integrated systems, real-time data, and centralized liquidity provisions allow them to act quickly, minimizing the window for arbitrage actions and even utilizing mispricing at DEXs that leads to even higher profits for market makers at CEXs by the cost of liquidity providers at the DEX (or trader).
Conclusion 📜✨
DeFi’s promise of decentralization and democratization of finance is undoubtedly compelling. However, juxtaposed against the efficiencies of CEXs, the current DeFi cracks become evident. As pioneers like Stabble, we are aware of the structural advantage of CEXs and have solutions to compete with CEXs. The broader DeFi space must take this note and react together to address these hurdles. It is not just desirable, but imminent. DEXs have to work together and strengthen smart contract interoperability to ensure a more robust capital system. For cross-chain interoperability and capital flows, it is a must to create bridges and reduce the associated cost of capital flow. Only by resolving these inherent challenges, DeFi can move beyond being a mere fascinating experiment. It must evolve, harnessing its unique strengths and innovations, to position itself, not just as an alternative, but a superior alternative to CEXs in the future landscape of finance. The team of Stabble is reaching out to the DeFi world to work together toward a fairer capital system rather than copying the traditional financial system.
Learn more about stabble here: https://linktr.ee/stabbleorg
