Kapil Rathi: DeFi’s Good, Bad and Ugly

Kapil Rathi is CEO of CrossTower, a crypto exchange and structured products provider. He has held senior leadership roles at Cboe, Bats, ISE and the New York Stock Exchange.

Everyone has fallen in love with decentralized finance (DeFi). We’re all giddy about it. One subset of DeFi is the ever so popular decentralized exchange (DEX). DEXs, such as 0x, Uniswap and Kyber, have tried to compete with centralized exchanges by offering a peer-to-peer trading model, which theoretically requires no intermediaries and no deposits on a centralized exchange.  

There’s one big problem: liquidity or, more specifically, a lack of liquidity. In the past, there were buyers that couldn’t find sellers and sellers that couldn’t find buyers. With a lack of liquidity, the spreads on these platforms weren’t competitive to centralized exchanges. This is precisely why centralized exchanges played a critical role bringing market makers and traders to a central limit order book.

See also: Redel/Andoni – DeFi Is Just Like the ICO Boom and Regulators Are Circling

The latest breed of DEX have solved this liquidity problem by developing “automated market making” (AMM) models where liquidity providers commit assets into a network (controlled through smart contracts) and the exchange generates bids and offers by using an automated mathematical formula. Partakers at these exchanges are able to generate potentially hefty returns by using techniques like “liquidity mining” and “yield farming.” 

For my non-crypto friends, liquidity mining is analogous to rewarding market makers for providing liquidity with new tokens. Yield farming is an algorithmic way to lend assets into different pools to generate a return. “Farmers” may hop from one protocol to the next to maximize returns. Yield farmers can also be rewarded with incentives, or additional tokens.

One example of a successful decentralized exchange is Uniswap. In fact, according to recent news, Uniswap may be doing more trading volume than the largest U.S. centralized exchange. And many are citing volumes at these decentralized exchanges as the benchmark for success. 

But before we make that comparison, let’s dig a little deeper into an entity like Uniswap and the “volume” on its platform. A large percentage of Uniswap volume is in coins that are spanking new and may not have a real use case. Anyone can create a token on Uniswap. Does high volume in coins like SUSHI, YAM and KIMCHI really mean Uniswap is better than other exchanges? 

We are aware of the allegations that there may be questionable volume on crypto exchanges. Such claims have tarnished the reputation of the crypto industry and may have deterred investors from joining. Have we forgotten the initial coin offering (ICO) craze and how long it took to polish the crypto industry image? Personally, I’m not sure I’m ready to commence celebrating high volumes in these food coins.

It is true the mature coins, such as ETH and USDT, have also seen a lot of volume on Uniswap. Stablecoins are the on and off-ramp of such food coins and these coins are built on the Ethereum network, so naturally they are seeing a spike in volume. That volume does not mean that the DEX is an efficient and effective marketplace.

The returns on some of these food coins have been very lofty. In some cases, one can pocket more than 100% return (or 1,000% in some cases) in a short clip. Sound attractive? 

But there is “rug pulling” now, otherwise known as pump and dump. A lot of suspect coins are being introduced solely for the purpose of generating fast returns for token issuers. For example, a new token, HOTDOG, keeping with the food theme, was launched on Uniswap on Sept. 2. It surged to $6,000 in a few hours. Early adopters of that token started selling it, creating a free fall. Within five minutes, HOTDOG went to less than a dollar. 

A rug pulling scenario is less likely on a centralized exchange because centralized exchanges have strict listing criteria and trading rules, and work to ensure traders are treated equally. 

There may be high volumes on a DEX for other reasons. Could it be possible a group of individuals that have not (or cannot) participate on centralized exchanges are rushing forward to benefit from the decentralized exchange opportunity? Some industry participants highlight the lack of know-your-customer (KYC) obligations on decentralized exchanges. Again, do we really want an industry where lack of KYC is seen as a feature instead of a bug?

There are also issues with “gas guzzling.” Due to these non-tested coins that Uniswap is facilitating, gas prices on ETH are at an all time high. If this choking effect on the network is not stopped soon, it could have a detrimental effect on the value of the network as a whole. 

See also: What Is Yield Farming? The Rocket Fuel of DeFi, Explained

We must give credit to Uniswap and other decentralized exchanges for breaking the walls between exchange order matching and market making. Traditional exchanges like CME, CBOE and Nasdaq have tried for years to provide automated market-making tools to their customers. Exchange order types such as pegging orders, discretionary orders, post-only orders and others provide automated pricing and repricing of customers’ interest. 

Due to the regulatory roles traditional exchanges play, they are not allowed to provide market-making services for customers on their behalf. Traditional market makers also do not feel confident ceding control to exchanges and empowering them to decide the market makers’ price and size of their quotes. It is a great advancement, or at least a new development, that market makers are comfortable ceding this control to decentralized exchanges. 

But market makers may still prefer centralized exchanges over decentralized exchanges because the former are not forced to use the exchange algorithm. Market makers craft their own algorithms, advanced pricing and risk management strategies to determine their quotes, streaming them to a centralized exchange. 

Sophisticated market makers may ultimately be reluctant to rely upon a third party to determine their quote quality. A centralized exchange provides market makers a platform on which to compete effectively while a decentralized exchange is a socialized way of treating all market-makers equally without giving any market maker a benefit or edge. Retail customers benefit from a strong marketplace with multiple market makers because this competition provides tight bid and ask spread, i.e. better pricing for the customer.  

While we should celebrate innovation and creativity, it is important we as an industry ensure a safe trading environment where there is no front-running, spoofing and other market manipulation practices. 

See also: William Mougayar – For DeFi to Grow, CeFi Must Embrace It

People responsible for the design and development of an algorithmic trading system should assume responsibility for an equal and fair market. In the traditional marketplace, the Securities and Exchange Commission introduced the Series 57 license requirement for algorithmic designers and developers. 

I share the vision of DeFi to promote interoperability, open source, accessibility and financial inclusion. CeFi can use DeFi principles without jeopardizing the integrity of a safe marketplace. DeFi allows for some incredible benefits to mitigating credit and settlement risk where parties can freely trade without physically moving assets. 

There is a lot of potential for innovative products and services. DeFi should be able to innovate within a CeFi framework to facilitate more peer-to-peer transactions among traders that are fully vetted to ensure market participants are protected. We need to make sure bad actors do not weaponize DeFi for illicit activities, which could inhibit the potential of this industry.