As the DeFi summer of 2020 approaches its two-year anniversary, the nascent digital asset ecosystem has undergone many transformations. The competition between centralized exchanges (CEXs) and decentralized (DEXs) exchanges, as well as the implementation of creative new "Ethereum-Killer" protocols, have been key drivers in the emergence of a mirror world of unprecedented financial innovation. Tracking this evolution is the Total Value Locked in DeFi, currently approximating $230 billion.
Nevertheless, this growing network of interacting market participants is still governed by the same forces shaping traditional finance. Price efficiency, market liquidity, and the overall market structure, to name a few, also play an essential role in the brave new world of DeFi. Central to the functioning of any financial network is the market maker.
Traditionally, market makers post orders to a centralized limit order book, sourcing nurturing liquidity to markets without which they would become barren deserts. The algorithms behind different liquidity provision strategies can be very intricate, and many such active market makers fiercely compete for market share. With the advent of liquidity pools (LPs) in DeFi, things changed. LPs are crowdsourced collections of tokens locked in smart contracts, enabling decentralized trading by incentivizing liquidity providers with rewards. Automated market makers (AMMs) act on LPs and thus bypass the need for a centralized limit order book. Underlying these passive market-making strategies is a mathematical formula that dictates the change in asset price resulting from the trading activity.
DEXs are smart-contract implementations of AMMs. Uniswap's constant product formula was the first example of an AMM, copied and enhanced by other DEXs. With Version 3 of its protocol, Uniswap introduced yet another innovation; now, liquidity providers can define a price range in which they want to be active. In effect, Uniswap v3 approximates a limit order book.
While traditional market makers need to manage their inventory risk, participants in an LP are exposed to what is known as impermanent losses, which stem from price volatility. A recent study uncovered that nearly 50% of liquidity providers on Uniswap v3 incurred impermanent losses that overshadowed the gains earned from trading fees. However, perhaps the greatest deterrent to providing liquidity to AMMs on the Ethereum blockchain comes from the high gas fees, emblematic of the protocol's scalability issues. Moreover, tokens listed on both CEXs and DEXs are vulnerable to arbitrageurs, indicative of the discrepancy in the maturity of the markets. Overall, price discovery still happens primarily on CEXs, while another study showed that DEXs suffer from lower market quality. Indeed, even listing a token on a DEX comes with novel challenges, as sniper bots roam free, programmed to initially buy as many tokens as possible to then sell at the detriment of all other market participants.
Today, we stand at the threshold of a bright new era of DeFi. New prototypes have been realized within an astonishingly short time. While challenges abound, the creative potential of the ecosystem can hardly be underestimated. As a result, many innovative solutions to Ethereum's ills are being proposed, while evermore disruptive protocols are being launched and multiple cross-chain interoperability options explored.
Nature's age-old blueprint for designing complex networks has always heavily relied on the notion of decentralization, fostering the uncanny process of emergence. This universal design pattern is also why we witness adaptivity, resilience, and sustainability in natural systems. We marvel at Nature's display of collective intelligence and wonder why so many of our centralized and hierarchical man-made systems are lacking the spark of this invisible guiding force.
At flovtec, we fully embrace this new decentralized vision for finance. We offer holistic market-making solutions for token issuers across both the centralized and decentralized worlds of digital assets. With our expertise rooted in market making on CEXs, we are expanding our tech stack to incorporate this brave new world of decentralization. Not only do we offer advisory services, helping our clients successfully navigate this often treacherous terrain, but we also assist in the DEX-listings of tokens. Soon, our active market-making algorithms will also be deployable on DEXs, helping the thriving digital asset ecosystem unveil its full decentralized potential.
* This article was initially published in CV VC Top 50 Report for 2021.
The CV VC Top 50 Report prepared in collaboration with PwC Switzerland and focuses on market valuation developments from Crypto Valley. It shows the growth of the crypto and blockchain space and highlights the best companies in terms of funding, valuation, and employees. The report also highlights the diverse blockchain and cryptocurrency ecosystem in Crypto Valley which consists of startups, corporations, government entities, and more.
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