【ChainNews Featured】Trading, leverage, and synthetic assets are becoming more mature, where is the invisible ceiling of DeFi?

Managing Partner Kyle Samani of Multicoin Capital analyzes the limitations of DeFi protocols compared to CeFi in applications such as trading and leverage.

Original Title: "The Invisible Ceiling of DeFi"
By: Kyle Samani, Managing Partner at Multicoin Capital

The decentralized finance (DeFi) ecosystem has made significant progress over the past two years, and I have been considering the competitiveness and market size at the protocol level. While I conducted an analysis on the former in April, this article will focus on researching the latter.

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My biggest concern regarding the current state of DeFi on Ethereum is that it is constrained by one or several invisible asymptotes (which I will explain below). According to Eugene Wei's definition, an invisible asymptote is an unseen ceiling—it cannot be directly measured and only manifests in analyses that defy reality—but it effectively limits growth.

While it is still early to make definitive statements, the DeFi ecosystem has likely touched upon these limits. For instance, the highest value of ETH staked in DeFi protocols represents approximately 2-3% of the total ETH supply.

In this article, I will evaluate the relative strengths and weaknesses of the current DeFi system compared to CeFi (centralized finance). Subsequently, I will attempt to explore some invisible ceilings that restrict the growth of DeFi and propose solutions.

While the applications of DeFi are diverse (including fee-less lotteries, prediction markets, staking, identity, etc.), its primary use cases currently revolve around the following three:

• Leverage (such as collateralized borrowing in Maker, Compound, or margin trading on dYdX)
• Trading (e.g., 0x, Uniswap, Kyber, IDEX, dYdX)
• Synthetic asset exposure (e.g., Synthetix, UMA)

These three applications dominate the majority of DeFi activities.

Each of the decentralized financial protocols mentioned above competes directly with centralized alternatives. In the following, we will analyze the dynamics of these application scenarios one by one to understand the hidden ceiling of DeFi.

For most traders, leverage is crucial in two main aspects: leverage ratio and cost. However, in these two aspects, DeFi falls short compared to CeFi.

1. DeFi offers lower leverage ratios. Limited by system latency (Ethereum's block time is 15 seconds), the leverage ratios cannot be too high. So why does higher latency reduce the maximum leverage? Considering the volatility of digital assets and the risk of cascading liquidations within a 15-second block time, DeFi struggles to provide high leverage products. dYdX launched 10x leverage BTC perpetual contracts in April, but compared to BitMEX where users' average leverage ratio is 25-30x.

2. CeFi has lower borrowing costs. CeFi firms achieve this by expanding credit (like banks such as Silvergate), reducing collateral requirements based on trust (e.g., loan departments that work with trusted clients), or by offering a large amount of customer deposits (like the loan departments of Binance and Coinbase). While in some cases, the lending rates of current DeFi protocols may be lower, they have structural flaws. Although theoretically possible: traders slowly start trading Compound's cToken - the protocol effectively replicates the advantages of Binance and Coinbase centralized ledgers - but this would dilute liquidity between cToken and the underlying assets.

So can DeFi protocols offer more leverage? Given the volatility of cryptocurrencies and Ethereum's current limitations (15-second block time), it is hard to imagine a platform offering leverage exceeding 10x, especially after the events of Black Thursday on March 12.

However, there are Layer 2 solutions (such as Skale) with block times as low as 1 second, reducing network latency. Yet, it is still unclear if decentralized exchanges (DEXs) and traders like dYdX will shift settlements to Layer 2 solutions like Skale.

Looking ahead, can DeFi protocols offer more competitive loan rates? The answer is likely no. I expect more banks to enter the crypto space in the next few years (they can offer loans through fractional reserve lending), reducing the capital costs provided by centralized financial institutions. Additionally, as DeFi protocols cannot underwrite trust relationships, they require higher collateral ratios, further increasing capital (opportunity) costs.

In the foreseeable future, I believe DeFi protocols will not beat traditional leverage providers. While DeFi protocols can offer marginal profits for some clients that traditional providers cannot, the market share is very small. The vast majority of market participants seek optimization in cost and availability of leverage, areas where DeFi protocols struggle to compete with CeFi.

Current market data also clearly illustrates this point: the vast majority of leverage in the crypto ecosystem is provided by traditional exchanges.

Sources: DeFi Pulse, Skew

It is worth noting that if all trading activities were to move to a single, public, trusted, neutral DeFi standard protocol (like the one I mentioned a few weeks ago, a single Layer 1), DeFi could eliminate fundamental risks, thus enhancing capital efficiency for all market participants. However, the likelihood of this happening in the foreseeable future is very low.

DeFi protocols significantly lag behind centralized alternatives in several key areas. Overall, the following factors hinder DEXs from overtaking CEXs' market share.

1. Latency and probabilistic finality. Due to Ethereum's adoption of Nakamoto consensus - which comes with high latency and probabilistic finality - trading parties cannot know their exact positions in real-time accurately. Due to this lack of precision, their trades must be more conservative (e.g., with wider spreads). Any solution with shorter block times can alleviate this situation.
2. Miners' front-running. As the crypto ecosystem matures and more traders settle transactions directly on-chain, block producers will begin maximizing their own profit potential through miner-extractable value (MEV). When this occurs, miners start front-running trades, which is detrimental to liquidity providers.
3. Full-margin leverage and offsetting positions. Currently, Binance and FTX offer users different types of full-margin products (e.g., a long perpetual position to secure a long call option). In the future, I expect them to gradually provide offsetting positions (e.g., through short ETH positions, users extending long BTC positions), followed by other centralized exchanges. While a decentralized environment theoretically can offer full-margin leverage, the practicality is more challenging due to the immaturity of decentralized trading venues.
4. Lack of fiat channels. It is difficult to onboard users at scale from the fiat world to the crypto realm in a decentralized manner. While there are teams working on solving this issue, they have not found a breakthrough yet. Until then, stablecoins serve as a decent workaround for users who already hold cryptocurrencies.
5. Throughput and gas fees. Traders desire quick settlement of trades, adjustment of collateral ratios, and swift opening of new positions, all of which require substantial gas fees.

So, can DeFi protocols reduce latency and offer faster finality? The answer is yes on low-latency Layer 2 (such as Skale) or Layer 1 (like Solana).

Can DeFi protocols mitigate miner front-running threats? Some Layer 1 solutions do have theoretical solutions, but they lead to higher latency, complexity, and gas fees. For certain permissioned verification node Layer 2 solutions, the answer is yes.

Can DeFi protocols address the lack of fiat support? Through stablecoins, the answer is yes.

In the foreseeable future, it is challenging to see decentralized exchanges surpassing centralized exchanges. Although there are relatively clear solutions to address latency and finality issues, experienced traders 1) do not want block producers front-running trades, 2) want to trade with full-margin guarantees and offset positions to enhance their capital efficiency.

This situation is very evident in the data: traditional exchanges dominate the vast majority of trading volume, and almost all price discovery relies on CeFi.

Sources: CoinAPI, Bloxy

For trading synthetic assets, exchanges must provide

1) a mechanism to manage collateral and pay winners/losers, and

2) a reliable price oracle.

Currently, traditional exchanges excel in both these functions: they manage collateral and operate centralized price oracle systems for perpetual contracts. Additionally, FTX launched innovative synthetic assets for the 2020 U.S. presidential election, such as TRUMP and BIDEN contracts.

While theoretically DeFi protocols can offer arbitrary synthetic contracts (e.g., through Augur), besides inheriting all the intrinsic features of DeFi protocols - self-custody and permissionless oracles - they seem to lack any execution advantages (though this may be a vulnerability rather than an advantage, depending on the context).

Centralized exchanges hold an advantageous position in the synthetic market competition, as they have demonstrated through perpetual contracts.

Among the mentioned shortcomings, the most common is latency. Given the extremely volatile nature of crypto asset prices, latency is crucial. Prices can fluctuate by hundreds of points within seconds, and the 15-second block time and Nakamoto consensus exacerbate systemic risks.

The operation time of centralized finance is measured in nanoseconds, while decentralized finance operates in seconds. Currently, almost no DeFi operates on a nanosecond time scale, but with solutions like Solana - the only blockchain that separates global state updates from time changes - the operating time of DeFi could potentially drop to microseconds.

Regarding Ethereum 2.0, it will produce a new block every 12 seconds. DeFi is currently Ethereum's main focus, but Ethereum 2.0 has not been optimized for DeFi.

Likewise, throughput is a glaring issue. While Ethereum's network operates smoothly most of the time, its issues were exposed on Black Thursday, March 12 - Ethereum simply could not handle such a large transaction volume. Although DeFi transaction volume is only 1% of CeFi, on the other hand, crypto CeFi trading only accounts for 0.1-1% of traditional asset classes (excluding forex). DeFi has a long way to go.

While DeFi protocols face structural disadvantages for most users and traders, they still offer services that are better than CeFi in certain niche markets, which may hold opportunities worth billions of dollars. For example, I believe that there is a significant market for non-custodial perpetual contract trading. Given the reasons mentioned above, DeFi perpetuals cannot replace CeFi in the short term, but I think a platform offering non-custodial perpetual contract trading could capture a substantial market share. Considering the total market value of mainstream CeFi exchanges is around $20 billion, and this market is still rapidly growing, a platform offering non-custodial perpetual contracts could be a good investment opportunity.

As the underlying technical infrastructure of DeFi continues to improve, it will gradually capture market share from CeFi. At some point in the next two years, as all necessary infrastructure becomes more mature, I expect a step-function change in the growth rate of DeFi.

So, how will the public determine when DeFi has succeeded? The answer lies in the shift of price discovery from centralized exchanges to decentralized venues.

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