Decentralized finance is a term used to describe the shift from using traditional financial systems to using decentralized networks. Decentralized finance is likely to have a significant impact on how banks operate in the future. The potential to shift the structure of the whole financial system at a macroeconomic level is huge.
DeFi is an umbrella term encompassing the vision of a financial system that functions without any intermediaries, such as banks, insurances or clearinghouses, and is operated just by the power of smart contracts. DeFi applications strive to fulfill the services of traditional finance (also coined as Centralized Finance, or just CeFi) – but in a completely permissionless, global and transparent manner.
DeFi applications could be at the verge of challenging traditional finance actors on various fronts .
The blockchain space has been accompanied by the vision of a new financial system since its inception. However, while this has been an aspirational dream for the blockchain community in the past, it has now come some steps closer to becoming a reality.
Since 2020, the DeFi ecosystem has been growing at an astonishing pace, with billions of USD being put into it. The growth is mainly led by applications (also denominated as protocols) that are built on the Ethereum blockchain. In the following paragraphs, we will give an overview of the actors in the DeFi ecosystem from an economic point of view, introduce the maturity stages of DeFi and explain the potential of DeFi to outperform the traditional finance system in the years to come.
Commercial banks
The banking system also plays an important role in channeling funds from savers to borrowers in an economy. The main way that commercial banks make money is by taking in deposits and then lending that money out to their customers. This lending and borrowing is a vital part of a well-functioning financial system, because it gives people who have money a reason to invest it in the markets, and in exchange they earn a return on their otherwise unproductive assets. The banking system is also important in funneling funds from savers to borrowers in an economy.
Protocols that enables borrowing or lending of money on a large scale between unknown participants without any intermediaries first became available with DeFi applications. These applications connect borrowers and lenders, as well as setting interest rates automatically in accordance with supply and demand. In addition, these protocols are inclusive and allow anyone to interact with them at any time, from any location, and with any amount.
The recent increase in interest for DeFi applications is largely due to the advancement of borrowing and lending protocols, such as Compound. In traditional finance, loans are typically secured by over-collateralization. However, companies such as Aave are working on enabling uncollateralized loans, which would be more similar to loans in traditional finance.
Investment banks and issuers of financial instruments
The business model of most investment banks typically includes providing advice on financial transactions and managing assets, as well as creating or trading complex financial products. DeFi protocols are already offering similar products.
For example, Synthetix is a decentralised protocol for issuance and trading of derivatives on assets such as stocks, currencies and commodities. Similarly, decentralised asset management for cryptocurrencies is also evolving. Yearn Finance, for instance, is an autonomous protocol that searches for the best yields in the DeFi space and invests automatically on behalf of its users.
Exchanges
An exchange is an organization that allows market participants to trade different assets, such as stocks or foreign currencies. Even the exchange of cryptocurrencies against fiat money (e.g. US Dollar) can be attributed to CeFi, as the regular holder of cryptocurrencies needs to use exchanges like Coinbase or Binance (which are centralized organizations) to swap a unit of a cryptocurrency against another.
Decentralized exchanges (DEX) are a recent development that allow users to swap cryptocurrencies without leaving the crypto space. A prominent example of a DEX is Uniswap. DEXs are composed of smart contracts that hold liquidity reserves and function according to defined pricing mechanisms. Such automated liquidity protocols play a key role in the development of an independent decentralized ecosystem without any centralized intermediaries.
Insurances
Decentralized insurance can help reduce or stabilize risk for market participants by acting as a safety net of sorts. An example of a decentralized insurance platform is Nexus Mutual, which offers protection against smart contract-related bugs. Since everything in the DeFi space is built on smart contracts, vulnerabilities in smart contract code pose a major risk for users. Decentralized insurance is still in its early stages, but more platforms offering a wider variety of insurance products are likely to emerge as the space matures.
Central banks
According to the text, there are three ways a cryptocurrency can become stable. Stablecoins are based on blockchain protocols that have the principle of price stability encoded into them, meaning that they can be used as a reserve currency. The introduction of stablecoins has set the foundation for a functioning decentralized financial system, as they reduce the risk of price volatility when used in transactions between participants.
This price-pegging relationship protects against large swings in theCoins price. Second, another way in which stablecoins can achieve price stability is by using automated mechanisms, such as algorithms, to buy and redeem the coins for other assets when the price is too high or low. First, stablecoins can achieve price stability by pegging the coin to another asset, such as the US dollar. For example, for each issued unit of USD Coin, a real US Dollar is held in reserve. This price-pegging relationship protects against large swings in the price of the coin. Second, another way in which stablecoins can achieve price stability is by using automated mechanisms, such as algorithms, to buy and sell the coins for other assets when the price is too high or low.
From a decentralized finance perspective, another interesting approach is the issuance of stablecoins by using other cryptocurrencies as collateral. A central protocol for the Defi ecosystem is Maker DAO, which issues the cryptocurrency DAI that is backed by other cryptocurrencies and ensures with its algorithm that the value of 1 DAI is always close to the value of 1 US Dollar.
This, in theory, should result in less violent price swings Thirdly, there are more experimental approaches that aim to reach price stability without the use of collaterals. For instance, the protocol Ampleforth automatically adjusts the supply of token in accordance with demand. This, in theory, should result in less violent price swings.
Why use a DEX?
The ability to trade nearly any crypto asset on a DEX is much easier than using a traditional exchange, because there is less friction. This definitely beats any centralized exchange, which presents the following barriers:
- KYC. While I do understand the necessary KYC procedures concerning AML, I believe that many people are left out the financial system because of this, and, therefore, miss out on wealth creation and management opportunities available to the rest
- Fiat-to-crypto. Exchange some WETH for some ALPHA? That is a hard feat to accomplish on any CEX. Most offer USD/EURO/GBP based trades. It would be a pain to have to convert into those currencies, just to buy another asset when you can pierce straight through all of that on a DEX
- ACH. This is definitely an issue in the U.S. (Coinbase, Kraken, Gemini). Why do you have to wait 7 days to send an asset off to a browser wallet if you want to, say yield farm? I understand why Coinbase has to do it (not really their fault that the financial plumbing is old here), but why should consumers endure it? Uniswap takes seconds…
Before I begin, I want to concede that gas fees are expensive. However, I believe that ETH 2.0 and other scaling solutions will make gas fees much cheaper in the future. Even now, large transactions on decentralized exchanges have lower fees than on centralized exchanges. However, Binance’s 0.1% fee is very low.
While Crypto Exchanges (CEX) are working to address asset availability and hosting ICOs, they still cannot match the vast selection available on a Decentralized Exchange (DEX). For example, users are more likely to find the asset they want on Uniswap or Balancer before checking a CEX. In the future, demand for a variety of assets will increase, making it even more important to have a platform like a DEX that lets users create liquidity around demanded assets.
and thus the outcome. An ICO, or initial coin offering, is a type of funding using cryptocurrencies. Compared to an initial public offering (IPO) in which a company sells shares to the public, in an ICO a company sells digital tokens. Usually, these tokens are offered in exchange for other cryptocurrencies such as Bitcoin or Ethereum.
. The main vulnerability with centralized exchanges is that they have control over your assets and data. This can lead to situations where assets are lost, as was the case with Mt. Gox. However, the bigger exchanges have put in place security measures, like 2FA and vaults, to try to prevent this from happening. For people who know how to properly safeguard their assets, a DEX is a better choice. However, it should be noted that this is a big if—for some people, the security measures that CEXs have in place, like vaults and custody services, are a better solution.
Given those 5 core points, it is also fair to list some of the disadvantages:
- Lack of fiat onramps: this is a tough pill to swallow, and something that the crypto world really needs to figure out. CEXs are the main and nearly sole way to bring on wealth to crypto ecosystems from the non-crypto world
- BTC and non-ETH denominated trades: this can also be a key point for certain crypto users who don’t want to be or are not part of the Ethereum ecosystem, where basically most of the DEX volume lies
- Cold storage: some CEXs offer cold storage solutions as part of your account. This is great for those that wish to have more security and don’t want to go the Ledger route
DEX vs CEX: the transformation so far
The tremendous growth of TVL and volume in DeFi in 2020 is amazing, but the space is still in its infancy, which creates both opportunities and risks.
We’re currently in the midst of a battle between centralized exchanges (CEX) and decentralized exchanges (DEX). Let’s take a look at a few numbers to see where we stand.
Daily Trading Volume (stats from CoinMarketCap)
DEXes:
- Uniswap: $866m
- Sushiswap: $295m
- 1inch: $165m
CEXes:
- Binance: $22,471m
- Huobi: $6,983m
- Coinbase Pro: $3,135m
. The average multiple on volume for centralized exchanges (CEX) is $10,863m / $442m = 24.6x. This figure for decentralized exchanges (DEXs) is much lower at 3–4%. This signifies that there is a massive runway for growth for DEXes, especially if there is no growth at all in crypto volume. The disadvantage of this is that volume can be a driver of efficiency and a builder of moats. Could this volume discrepancy be building a wall around a subset of crypto users? I think not, especially in the long run.
Assets Listed (stats from CoinMarketCap)
DEXes:
- Uniswap: 1,246
- Sushiswap: 139
- 1inch: 718
CEXes:
- Binance: 331
- Huobi: 311
- Coinbase Pro: 46
The average ratio of assets listed on DEX/CEX is 3.1x. If you want to get involved in crypto beyond ETH/BTC, DEXs are the place to go.
Fees (stats from DApps and exchanges themselves)
DEXes:
- Uniswap: 0.3%
- Sushiswap: 0.3%
- 1inch: variable and based on DEXes it aggregates off of (can be considered sub 1%)
CEXes:
- Binance: 0.1%
- Huobi: 0.2%
- Coinbase Pro: 1.49% — 3.99%
Binance is doing better than other exchanges, but I’m not sure if that’s sustainable. Gas costs weren’t considered here, which would make other exchanges more attractive, but I’m assuming that Ethereum will eventually solve its scalability issues.
Conclusion
While some people may see decentralized exchanges (DEXes) as inferior to centralized exchanges (CEXes), I believe that DEXes have many advantages. For one, DEXes offer more availability and lower/constant fees (except against Binance). Additionally, the three key quantitative parameters tell an interesting story: DEXes may only make up a small portion of the market, but they offer more availability and lower/constant fees. I find the space truly fascinating and believe that DEXes will become more popular as people better understand the benefits they offer. Of course, there is always risk involved in using any type of exchange, but that risk was also present when the internet was first created. I look forward to following DEXes closely as I interact with and monitor them.
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