A $10 billion hole on a balance sheet. Untenable risk exposure fueling yields on customer deposits leading to insolvency. A daisy chain of contagion as retail users are left to pick up the pieces once again.
FTX, Celsius, and Crypto 2022.
Centralized trust breaches are running rampant in crypto lately. The prevailing narrative that the latest string of catastrophes is a native crypto problem is misguided. Recent events illustrate the incursion of familiar centralized models of TradFi enveloping crypto – where trust in a third party is necessary.
Trust that a CEX’s trading, liquidation, and risk engines function properly – without backdoors. Trust that the custodians of customer assets aren’t failing to disclose investment activities and risks with the deposits. Trust that CEXs’ proof of reserves are accurately displaying liabilities. And trust that whatever centralized platform customers use isn’t unduly exposed to excessive risk.
In an industry defined by an ethos of decentralization, the prevailing issues displayed by recent events are painful.
Where do we go from here?
First, let’s examine how we got here.
Evading Transparency – CEX Domination
Mass intrigue in centralized crypto products is nothing new. It’s the status quo. Centralized exchanges (CEXs) have dominated the market share of crypto trading volumes, users, and liquidity for years.
CEX volumes encompassed over 90% of spot and derivatives volume in crypto over the past year. The reasons for their dominance are apparent. Advantages CEXs hold over DEXs include:
- Deeper liquidity
- Feature-rich trading venues (e.g., perps, spot, cross-margining)
- Fiat on/off-ramping
- HFT-friendly infrastructure
- Lower fees
- Sleek & familiar UX
It’s easier for the mainstream user to trade spot BTC on Coinbase or ETH perpetuals on Binance than a DEX. For high-frequency traders (HFTs), the plug-and-play infrastructure on CEXs is even more compelling.
The “Summer of DeFi” in 2020 sparked a new wave of interest in decentralized financial products, including DEXs. But the uptake of DEXs still lagged behind CEX incumbents. CEX dominance, anchored by a blend of convenience and superior products, persisted.
User interest still poured into DeFi, however. The “lazy capital” model of passive LP’ing on Uniswap and trading the long tail of DeFi assets induced a bull market phenomenon.
The intellectual capital dedicated to DeFi didn’t rest either. An excess of giga-brained DeFi builders ushered in a new era of financial engineering. Autonomy and optionality arose as users finally had an alternative to CEXs. It was the good, the bad, and the ugly – a wild west of finance.
AMMs, in particular, captured the attention of everyone – even the mainstream.
Retail users were enamored with earning passive LP fees and discovering the next diamond in the rough before a major CEX listing. Yield hunters scoured freshly forked protocols for lucrative APYs. Traders probed the depths of Uniswap pools, searching for the next diamond in the rough ready to explode up the ranks of Coingecko. And flash loans on money markets enabled users, whether good or bad, to capitalize on fleeting arbitrage opportunities.
DeFi’s ascendance was total pandemonium. Uniswap’s emergence was so spectacular that on-chain inflows/outflows of CEXs were surpassed by on-chain DEX transaction volume for an extended period – even though the metric is a poor proxy for examining trading volumes.
Certifiably transparent, the success of DeFi is enriched by its transparency. Trading engines and risk parameters are verifiable on-chain. DAO treasuries are easily discoverable on-chain, often subjecting themselves to laborious governance processes to allocate capital. And identifying patterns on-chain soon became trivial as analysts scrutinized real-time data for their next public exposition – helping users identify risks beyond their individual capacity.
It seemed like the stranglehold of CEXs, marred by years of misaligned incentives and shady behavior, would finally end. DeFi was coming.
But soon, the effect of aggregated liquidity began to eat away the profits of LPs on AMMs. Gas fees spiked to untenable levels on Ethereum, and as the signs of the endless bull market began to fade, DeFi markets evolved. Passive LPs were unknowingly facing off against unseen bots and professional prop firms chipping away at their dwindling portfolios behind the veil of MEV and toxic flows.
Private market maker models (PMM), common with leading DeFi aggregators on liquid venues, allowed market makers to avoid toxic flow by not taking the other side of large market-moving orders. AMMs became hotbeds of toxic flow for retail users as arbitrage and MEV eroded LP’s profits.
Zero-sum games on permissionless networks reared their dark side. Immensely popular with retail users, AMMs were losing their luster as the premier speculative market venues in crypto.
Conversely, the speculative allure of leverage motivated users to eschew DeFi and capture larger gains on CEXs. High-frequency traders (HFTs) also felt the drag of AMMs. The fixation on robust APIs and SDKs required for executing automated trading strategies remained superior on CEXs. Cross-margining for capital efficiency and various reasons, such as liquid derivatives markets, for holding more capital on CEXs overcame DeFi’s advantages.
More familiar and efficient TradFi-style DEXs like sequential, central-limit order book (CLOB) exchanges arose to fill the insatiable need for more efficient markets in DeFi. But they were still hampered by various drawbacks relative to CEXs, including:
- Exposure to MEV
- On-chain latency boundaries
- Subpar liquidity
- Isolated product features
- Complex UXs
- Lack of fiat on/off ramps
The transition to off-chain order books became prevalent to minimize MEV and improve trading execution latency. API and SDK infrastructure, indispensable for HFTs to provide better liquidity, manifested. Wielding dynamically-adjusting bonding curves, AMMs even progressed towards better market efficiency. Batched market order CLOBs (i.e., Sei) also emerged as low-latency, on-chain alternatives to previous CLOB models.
DEXs appeared to be on the fast track toward stealing the CEX crown. The power of CEXs, however, endured.
Smart contract hacks and oracle exploits eroded confidence in using DeFi apps, and a waning bull market deflated DeFi’s TVL. Impermanent loss for passive LPs on Uniswap V3 continually outweighed accrued LP fees. Retail users ended up being better off by simply holding spot assets. Subpar liquidity, lack of resting orders, and other shortcomings of incumbent CLOB DEXs were insufficient to pilfer long-term CEX users.
The emergence of DEXs with a chance of defying CEX dominance materialized a moment too late. The bull market’s dramatic ending crushed beleaguered speculators, and DeFi contracted as users sought refuge in familiar venues with fiat on/off ramps.
Brimming with plush treasuries and armed with vibrant features, on/off ramps, and better liquidity, CEXs proved too formidable. The incursion of DEXs into the CEX market share was adamantly defended. CEXs continued hoarding the vast majority of crypto users for themselves.
Users were relegated to the convenience of a handful of CEXs as DeFi’s clunky shortcomings overpowered its advantages.
Mercurial exchanges like FTX eventually climbed to the industry's summit – leaving any contenders outside of Binance behind. With fast listings and high leverage, they scaled the ranks of fame using trust as their ladder. Sports partnerships, media darlings, and VC golden boys, they were industry paragons – everything appeared above board. Even with seemingly endless profits, it wasn’t all sunshine and rainbows behind the curtain.
Accounting backdoors, raiding customer deposits, and insolvency simmered beneath the surface. The breaches of trust are almost too surreal to believe.
A major CEX, positioning itself as altruistic placaters to user interests, was covertly abusing the faith afforded to them over the years. The advantages of DeFi in transparency, accessibility, self-custody, and composability were bludgeoned by the inauspicious mastery of CEXs over crypto.
Recent events illuminate a centralization problem in crypto. Blindsided by the scale of deception, users were again victimized by the same opacity that crypto sought to wrest from TradFi in the first place.
So, where do we go from here? Or, more specifically:
How can DeFi better emulate the allure of CEXs while still delivering the advantages of crypto that brought us all together in the first place?
Well, we keep moving forward. Armed with the most brazen example of just how far down the rabbit hole CEX behavior skews perverse, it’s time to abandon the shackles of centralization and harness DeFi’s power to rid the industry of centralized opacity.
Refuge in DeFi – All Eyes on DEXs
Despite the decentralized ethos of crypto, it appears that the industry has introduced more intermediaries than it has removed, as third-parties capture value from the underlying protocols. Even JP Morgan, the TradFi behemoth, was nuanced enough to express the issue of centralized risk in crypto, detailing:
“...while the news of the collapse of FTX is empowering crypto skeptics, we would point out that all of the recent collapses in the crypto ecosystem have been from centralized players and not from decentralized protocols.”
DeFi needed a galvanizing force to prompt a resurgent exploration of crypto’s roots, and FTX supplied ample ammunition. Namely, DeFi needs to encase its benefits of transparency, optionality, and autonomy with prevalent CEX features.
Recent events may serve as the inflection point for an exodus of disaffected CEX users to self-custody and, eventually, DeFi. On-chain indications of such a trend’s beginning come from recent BTC outflows from exchanges. Week-over-week Bitcoin outflows from CEXs hit an all-time high of 115,200 BTC departing exchanges. Formerly comfortable third-party custody was upended by the most recent example of shadowy CEX behavior.
Are users withdrawing assets from CEXs to immediately pivot to DeFi instead?
Unlikely, as ongoing anxiety and faith in crypto, even amongst its most devoted followers, is wavering. And DEXs leave much to be desired. But that doesn’t mean self-custodial assets recently withdrawn from CEXs will necessarily return en masse to centralized venues once the dust settles.
Attention now shifts to DEXs – it’s time for them to prove they can become viable alternatives to CEXs. DeFi has an opportunity to appeal to the CEX dissidents besieged by yet another scandal. Open-source protocols must become the haven for disaffected users continually betrayed by CEXs.
But CEX dominance is a formidable moat to overcome. How can DEXs evolve to confront the overwhelming strength of CEXs? It’s a long list, but it’s a list worth pursuing nonetheless.
DEXs need better fiat on and off-ramping. Mainstream users need familiar Web2-style authentication. DeFi users want layer two applications shielded from Ethereum’s dark forest of MEV bots. DEXs must offer competitive features with CEXs – like spot, perpetuals, options, money markets, structured products, indices, and gamified social trading rolled into one application. Resting orders, deep liquidity, tight spreads, and minimal slippage are all part of the required ensemble.
Sophisticated market participants, attracted to the universal cross-margin of exchanges like FTX, require somewhere to manage multiple positions in DeFi efficiently. Traders desire the blazing-fast execution speed of CEXs. Trading firms need better clearing infrastructure that leapfrogs CEXs. And users want deep liquidity and passive yield on the long tail of assets without prohibitively hazardous toxic flow.
All of these requirements are unfolding piecemeal in DeFi. Put together; they have the potential to exceed the experience of popular CEXs.
User complexity, the glaring barrier of DeFi adoption, must be extinguished while the feature set of its applications expands. The stage is set for the next wave of DeFi’s intellectual capital to remove the broken promises of CEXs by outperforming the incumbents.
The opportunity is prescient. And the possible outcomes for users are meaningful.
Interest in self-custody has likely never been higher. The demand for passive LP’ing remains strong. Financial engineering of popular trading instruments chugs along, and lessons learned from previous risk management flaws mature into more robust iterations. DEX design innovation is flourishing with various CLOB models, lower latency, more features, and the exclusion of MEV on layer two networks.
A return to the days of centralized opacity cannot be an option. DeFi must deliver.
Self-custody, no MEV, vertically integrated products, universal cross-margining, deep liquidity, HFT-friendly APIs, and lightning-fast order execution. Fusing the benefits of CEXs with the virtues of DeFi, Vertex is solving for the right DEX. One where the magnetism of CEX features and speed don’t overshadow the benefits afforded by DeFi.
Trade, earn and borrow all in one DEX. Vertex is built on Arbitrum and optimized for everyone.
TradFi models oozing into crypto recently victimized users once again. DEXs, now with a spotlight on them as a potential refuge for CEX dissidents, have an opportunity to change the narrative.
Take back control from CEXs. Welcome to Vertex.