written by JP Smith, Head of R&D
As of April 18th, 2023, the cryptocurrency market has grown to a $1.3tn market. DeFi and on-chain finance remains a small portion of this market, but a growing number of protocols are providing ways to trade derivatives/spot and lend/stake digital assets using the blockchain. Events in 2022 served as a stark reminder of the centralized counterparty risks in an environment where regulatory and economic headwinds in crypto remained strong. Despite these headwinds that still exist today, an increasing number of market participants are exploring ways to access DeFi and on-chain finance.
Right now, the cryptocurrency market is dominated by derivatives trading. Since January 2022, derivatives account for more than 60% of the total overall trading volumes, including spot, across crypto exchanges. The following table considers select derivatives venues by open interest, as of April 18, 2023.
Cryptocurrency exchange metrics have historically not been the cleanest dataset, but we’re starting to see a clear DeFi segment outside of the top centralized crypto exchanges. Binance is clearly the absolutely dominant venue, but even a couple years ago it would be surprising to see on-chain protocols mingling with Huobi and Kraken. Structurally, we believe there are two primary causes.
First, DeFi exchange tokens have outperformed CeFi exchange tokens significantly as of late, which means venues can issue tokens to fund CAC while enduring comparatively less dilution. This particularly incentivizes “passive liquidity,” and longer-duration strategies.
The second is that DeFi markets offer a new and potentially radically improved set of tools for evaluating counterparty risk. Derivatives trading will, as best we know, always include the possibility of counterparty default. However, live balance sheet transparency, market availability depending only on chain availability, and EVM simulation/verification tooling allow the most sophisticated users risk management tools more powerful than anything we’ve seen before.
Crypto history is written out of bad counterparty risk decisions, from Mt. Gox, to the original DAO, to FTX most recently. DeFi cannot prevent these decisions from being made, and has even historically enabled some of them. That being said, there’s only one venue in the list above where users can empirically model every possible interaction and reason with that model about what failure modes are possible. DeFi has a structurally higher “risk management ceiling” which will only continue to benefit as the market grows.
DeFi spot markets are unusually hard to transfer CeFi intuition to, as the no-order book exchange is among the more radical market structures ever successfully adopted. For this reason, it may be easier to consider DeFi as analogous to trading with or onboarding an OTC desk, rather than an exchange with a central limit order book.
Liquidity aggregators present a simple RFQ API that will offer liquidity on almost any digital assets, with the largest difference from more conventional systems being the settlement protocol. DeFi trade settlement is in real-time, so pre-funding is required. With this also comes a reduction in counterparty risk, since all transfers associated with a given trade settle simultaneously and immediately, rolling back if any component transfers fail.
This settlement strategy is incredibly capital-efficient for DeFi markets. You can buy a new asset and fund a trade with it on another market effectively instantaneously. However, this means DeFi margin requirements can be quite staunch, and the pre-funding requirement is absolute. Margin is certainly available on-chain, but margin calls in DeFi are instantaneous, automatic, and may be more swift and violent than human-administered venues.
DeFi liquidity has several additional beneficial qualities. Almost every digital asset has at least some liquidity and is available to trade 24/7/365. Smart contracts will make the markets they’ve been programmed to make and perform as per their programming, whether it’s in the best interest of their creator or not. The tens of billions of dollars of passive liquidity farming rewards on these markets mean that trades that could shake up a market anywhere else in the world barely make a ripple here. We typically see activity concentrated in long-tail assets where DeFi dominates available liquidity, but pricing for large BTC/ETH trades can be highly competitive and DeFi stablecoin liquidity is unmatched. For example, a recent $647,000 market sell of BUSD on Binance moved the price to $0.20 and set off a tiny news cycle, whereas 1inch quotes $646,839 USDC as of this article being written.
Lending, Staking, and More
Many of the points made in the Derivatives section apply directly to lending as well such as counterparty risks. We believe that the combination of better tooling to evaluate counterparty risk and token-based CAC subsidization presents compelling opportunities in the space, and as such the space will continue to gain secular share.
Perhaps the more salient point is that as digital assets grow more sophisticated and functional, they increasingly gain financially valuable on-chain functions. Consider ETH staking, token governance, or hybrid NFT/ERC-20 systems. Actors with large quantities of these assets on their balance sheet will either learn to leverage these capabilities, or be outcompeted by those who do. Spot ETH vs. staked is about the same difference in yield as cash vs. treasuries.
Building strong DeFi capabilities now will only pay dividends as more token issuers mature and build real crypto-native functionality. From the ability to acquire in-demand assets at low cost basis (consider yield-farming COMP right after the Coinbase listing), to balance sheet optimization, to participating in governance, good DeFi interfacing is key.
In our estimation, a majority of the top 20 cryptocurrencies by market capitalization have yield enhancement opportunities available on Ethereum DeFi. We expect this proportion to approach 100% as time goes on. While the immediate path forward on exposing this to clients may be the least clear, it is the richest in possibility long-term.
Skolem continues to build for a long-term DeFi future. If you or your team need support and tooling for accessing on-chain finance, please do not hesitate to reach out to firstname.lastname@example.org or request a demo at skolem.com.