Introduction - The Problem
The events that constituted the first half of 2022 demonstrate the fragility and risk of centralized systems in crypto.
CeFi entities have been exposed for opaquely shuffling assets and playing around with client money. Moral hazard has historically been a recurring problem in all financial markets but the causes of these recent fiascos can be summarized as:
- Clandestine centralized entities
- Exorbitant fees
- Divergent incentives between owners and customers
- Abuse of asset custody
- Dubious risk management
Finance without the necessary safeguards is plagued by principal-agent problems whereby principals (users) become victims of their agents’ (centralized third parties) self-interest. Improvements in technology can change this dynamic by creating open-source protocols that are:
Permissionless and inclusive - allowing anyone with a wallet and internet connection to participate.
Transparent and real-time - transactions are recorded on a public blockchain for all to see in real-time.
Self-custodied and trustless - all users retain control of their assets with no need for trusted third parties.
Tamper-proof and immutable - transactions are irreversible, preventing changes or fraud.
Decentralized -there is no longer a single point of failure.
Given the undeniable benefits of decentralization, it may be surprising that DEXs do not dominate the crypto trading flow. At present, we believe this is because of 3 main reasons:
Existing DeFi protocols cannot compete with the wide range of utility and products offered by CEXs.
Different protocols serve users a variety of products. However, because the protocols are unrelated, cross-margining is altogether lacking or completely inefficient. In contrast, major CEXs offer capital-efficient trading and a wide range of products. CEXs also encapsulate on-and-off ramping and cross-chain transactions: most DeFi protocols offer none of these.
The limitations of the blockchain, most notably the blockchain trilemma, have led to innovative— but ultimately suboptimal and fragmented— solutions.
AMMs serve as an interesting lesson. Initially designed for liquidity provision of low liquidity assets on low-throughput platforms, they helped solve some of the limitations of blockchain-based trading and helped spur a growth in diversity of assets. However, the removal of limit orders introduces price inefficiencies which are absent in an order book. Variations of AMMs seeking to address some of these issues further compound the problems by fragmenting liquidity across ecosystems. In a broader sense, attempts to address the blockchain trilemma have typically further compounded issues and led to a confusing diversity of blockchains and economic models with different constraints. This has fragmented activity, TVL, and talent across many networks. DEXs have been constrained by this fragmentation and limited to a given ecosystem. In contrast, CEXs remain flexible, simultaneously accessing multiple liquidity sources and blockchains.
The average DeFi user experience and interface (UX and UI), is intimidating and unfamiliar to most people from a Web2 background.
At this moment, “people from a Web2 background” includes most people on Earth. If DeFi builders continue to ignore this reality, then DeFi’s potential will be squandered and it will remain a niche industry within finance.
To put it simply:
Frictionless UX drives technological adoption. CEXs still hold the keys to crypto (pun intended) because they provide a more frictionless UX. Many users are choosing risky, opaque, expensive centralized solutions, because ultimately “easier” trumps decentralized solutions with “more hassle.” DeFi needs an answer to remain competitive.