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Centralized exchanges must form symbiotic relationships with DeFi platforms and products

DeFi offers a fast-growing ecosystem of continuous innovation as distributed project teams interact ... [+] with open source protocols and create novel use cases previously unimaginable. In order to be competitive and retain market share, centralized exchanges must form symbiotic relationships with DeFi platforms and products.

SOPA Images/LightRocket via Getty Images

Coinbase’s direct listing on Nasdaq NDAQ is a watershed moment for the crypto industry. It will be the first public crypto company with pure and dependable cash flows that is on par with some of the largest and most established exchanges in the world. Coinbase generated 2020 revenue of $1.3 billion, compared to CBOE’s $1.2 billion, Nasdaq’s $2.9 billion, and CME’s $4.9 billion. Despite launching a myriad of products such as Commerce SPSC , Earn, Custody, staking, and others, trading fees make up the lion’s share of Coinbase’s $3.4 billion LTD revenue, at approximately 96%.

Coinbase, Kraken, Gemini, and other exchanges are thriving, but what will happen if decentralized exchanges (“DEXs”) continue their spectacular growth, fundamentally threatening to disrupt their centralized counterparts?

DEXs are a type of crypto exchange within the decentralized finance (“DeFi”) ecosystem that allow for direct peer-to-peer transactions to take place without intermediaries. By utilizing decentralized smart contracts encoded on public blockchains, users always retain their private keys which removes counterparty risk inherent to centralized exchanges.

DEXs such as Uniswap, Sushiswap, 0x, Curve, Serum, Balancer, and others combined monthly volume surpassed $61 billion in January of this year. Six months prior in July 2020, the combined DEX monthly volume was just $4.9 billion, an astounding increase of over 1,100%. Although the combined volume of centralized exchanges in January was considerably higher at $906 billion, DEX volume is catching up with a current volume ratio of 7%, up from 4.6% in July of last year.

The Robinhood and GameStop GME fiasco injected rocket fuel as investors experienced firsthand the pain of punitive trading restrictions exercised by Robinhood’s unilateral control as the exchange faced a potential liquidity crisis. This was a systemic issue caused by the inefficiencies of the encumbered and capital-intensive T+2 settlement system inherent to traditional finance, inefficiencies foreign to the near-instant settlement of public blockchains and the crypto market structure.

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DeFi “Money Legos” Unleash Innovation

DEXs excel in providing access to the long tail of DeFi products and crypto assets that may have too little liquidity or too much regulatory uncertainty for centralized exchanges to consider adding them. DEXs and other DeFi platforms also allow for greater composability and interoperability between the different DeFi “money legos”, unlocking entirely new use cases.

DEXs enable rapid product iteration and experimentation. This has led to the development of novel DeFi primitives such as flash loans, automated market makers, algorithmic stablecoins, synthetic assets, liquidity mining, decentralized price oracles, and more.

Popularized by Aave, a flash loan is a DeFi primitive in which a user can borrow a repay for a loan in a single transaction, which is built into the smart contract logic. This concept can be used to refinance a loan, if the user wants to take advantage of the best interest rate offered in the DeFi market. Let’s say a user opens a DAI loan from Compound at a 9.5% interest rate and there is another protocol that offers debt at 7% interest. The user can refinance the loan at the lower rate by taking the following steps:

1) User takes out a flash loan using the Aave protocol, 2) pays the original debt on the Compound protocol, 3) borrows from the 7% debt offer, and finally 4) pays back the flash loan on the Aave protocol.

This entire process can happen instantaneously in a single transaction without the need for a lengthy application/appraisal process, and the only cost is the associated gas fee to execute the transaction. Furthermore, anyone with an internet connection can execute this transaction regardless of their income level, race, accreditation status, jurisdiction, or any other potentially disqualifying factor in the traditional debt markets.

Flash loans are a DeFi primitive, a user can open and close a loan in the same transaction

Flash loans are a DeFi primitive in which a user can open and close a loan in the same transaction.

Finematics

Centralized Exchanges and DeFi Protocols Can Both Benefit from a Mutualistic Relationship

Ultimately, exchanges may serve as a primary front-end interface for users to interact with DeFi products and will confer greater convenience and a superior user experience.

By integrating DeFi protocols, centralized exchanges can retain market share by offering their users cutting edge products and proactively shaping how users interact with them. Exchanges have the resources to build top notch UI/UX and educate users about specific DeFi assets.

DeFi protocols can gain value by tapping into a wider distribution and getting their tokens into the hands of users much faster. Listing the top DeFi assets will generate revenue for exchanges in the form of trading fees, listing fees, net interest margin (for DeFi lending products), staking rev-share, and other new product lines. Exchanges have already built out substantial infrastructure and market liquidity, which DeFi products are seeking to replicate.   

The growth of DeFi isn’t without challenges. Ethereum is currently experiencing usability issues as users flock to the platform, driving transaction fees up. The average transaction fee has skyrocketed 2,100% from around $1 in October to $22 now. Rising transaction fees are double-edge sword. They indicate rising demand for block space but also limit certain use cases and price out smaller users from the network. If users are discouraged from using the network because of high fees, DeFi protocols would suffer and adoption could screech to a halt.

The average transaction fee on Ethereum has skyrocketed 2,100%.

In recent months, the average transaction fee has skyrocketed 2,100% indicating rising demand for ... [+] block space but also limiting certain use cases and pricing out smaller users.

FSInsight, CoinMetrics

Exchanges are positioned to help alleviate this issue by acting as a scalable second layer on top of Ethereum. Coinbase, Kraken, Gemini and others could integrate DeFi lending protocols such as Maker, Aave, Compound, and dYdX and offer their lending products and associated tokens to users. Exchanges could batch transactions and settle with the Ethereum mainchain less frequently, effectively acting as a load balancer and reducing congestion on the network. Exchanges already serve this purpose when a user transacts a layer-one token on the exchange. When users trade Bitcoin, exchanges have internal ledgers that automatically update account balances, but they may only need to interact with the public network when users withdraw the Bitcoin.

Taking this a step further, exchanges can proactively integrate layer-two solutions to enhance scalability. In December, Kraken announced their initiative to integrate the Bitcoin Lightning network this year. As part of the initiative, Kraken will allow users to deposit and withdraw Bitcoin on Lightning instantly and with low fees. Exchanges can integrate layer-two solutions native to Ethereum and DeFi such as Optimistic Rollup and ZK-Rollup. Project teams working on scalability solutions include Optimism, Fuel Labs, Arbitrum, Matic, and Celer, amongst others. This will improve the overall user experience and allow developers to explore the full range of possible DeFi use cases.  

Layer-two solutions like Optimistic Rollup and ZK-Rollup can enhance scalability for DeFi.

Layer-two solutions like Optimistic Rollup and ZK-Rollup can enhance scalability for DeFi products ... [+] built on Ethereum.

Interdax

Coinbase has already taken steps to form closer relationships with leading DeFi protocols. In late 2019, the exchange provided $2 million worth of USDC for lending protocols Compound and dYdX to inject more liquidity into the system. The goal was to bootstrap supply side liquidity, allowing the protocols to grow.  

By supplying liquidity directly, or serving as an interface for users to supply liquidity and earn the associated yield, exchanges would be the among the largest stakeholders. By holding a large percentage of the DeFi protocol token supply, exchanges would be entitled to voting rights necessary to shape the development of the protocol.

DeFi offers a fast-growing ecosystem of continuous innovation as distributed project teams interact with open source protocols and create novel use cases previously unimaginable. In order to be competitive and retain market share, centralized exchanges must form mutually beneficial symbiotic relationships with DeFi platforms and products.

There Is No Free Lunch

Of course, most DeFi protocols are in their infancy and carry a considerable amount of risk. Many DeFi products are novel financial instruments that can be gamed and allow savvy attackers to siphon funds from other users, even while remaining compliant with the rules of the protocol. There have already been numerous DeFi rug pulls and exploits, resulting in the loss of over $154 million in 2020 alone.  

Regulatory issues around securities and tax laws are another element that need to be addressed. New regulation like the proposed FinCEN KYC crypto wallet legislation will place extra burden on exchanges interacting with smart contracts in the form of additional reporting and disclosure requirements. Many DeFi protocols exist in a regulatory gray area as they facilitate the exchange of potentially unregistered securities and movement of funds under the guise of decentralization. Exchanges will need to perform their own diligence and risk analysis to determine which projects are sufficiently decentralized and do not violate securities or money transmission laws.

Furthermore, DeFi projects possess the risk that the underlying smart contract is insecure, the risk that borrowers may default and investors will not be able to recover their investment, the risk that the underlying collateral may experience significant volatility, and the risk of certain core developers with administration rights making unauthorized or harmful changes to the underlying smart contract. If any of these risks materialize, user funds would be vulnerable to loss and the exchanges would be on the hook.

Although these challenges exist, the biggest risk to centralized exchanges would be to not integrate DeFi, sticking to their current business model while new protocols progressively innovate and upend the market.