DeFi & Trading: Potential and Challenges

DeFi is called the golden child of 2020, and indeed, it was the year when plenty of projects were created and the industry saw a huge inflow of funds. It all changed in 2022, with many projects collapsing, and many major players being kicked out of the market.

Source: DeFi Llama, TradingView

But still, DeFi is a developing industry, and with its main goal - to enrich its users, it has perspectives. Now, you may be wondering what is going on with CEX and where their share in the market is.

Users Lose Trust in Centralized Solutions: Is DeFi Better?

The truth is that people are losing confidence in CEX. The consequences of the FTX collapse alone are still felt after months have passed. But in the case of DeFi, it doesn’t come with the risks that led to the demise of FTX. Founders of Uniswap or Curve, for example, cannot just take users’ funds from a pool to buy the elite property or for the next VIP trip. That’s why many crypto users now move from centralized exchanges to decentralized services, and we will continue observing this process in years to come.

Source: CoinGecko, Dune Analytics

It means that DeFi is the future of crypto trading. And we can already see the trend.

From 2020, spot DEX started growing to the extent that it is even difficult to calculate the volumes the exchanges did at the start of 2020. But in 2021, and even in 2022, during the crypto winter, trading volumes grew immensely. 

Source: Dune Analytics

Not Easier but More Transparent

But still, when lenders give their funds to automatic market makers and hedge funds, are they sure that those loans are secured? If an AMM or a fund isn’t able to repay a loan, it means a loss of reputation in the world of crypto. And for a fund, it is unlikely to risk its reputation for some millions of dollars. 

However, no company or fund is protected from the risk of default. In such a case, a loan that is not repaid could be disastrous to a platform-lender if the sum is big indeed. And it may happen if the lending platform is overexposed to one borrower. Basically, it means that decentralized platforms are not protected from problems that have drawn Celcius and some other centralized lenders. So, what is the benefit of using DeFi then?

The main reason for this is that DeFi is transparent. While you cannot see what is happening behind the doors of centralized organizations such as FTX, Celsius, BlockFi, and others, in decentralized finance, everything is seen on a blockchain.

Of course, lenders cannot prevent a platform from issuing a huge loan to a single organization. But at least they can see everything in real-time mode, not after things have gone wrong for long like it was the case with centralized lenders such as Celcius and BlockFi, and pressurize the platform to close credit lines for a company or fund that is borrowing too many funds.

Borrowing Opens New Trading Opportunities but not Without Risks

It seems that borrowing funds for big traders is a perfect solution to capitalize on the opportunities that spot leveraging offers. 

However, this solution is not perfect. The funds borrowed on one platform are used to borrow even larger sums on another platform, and so on. So, traders create a large exposure for the initial collateral amount and thus, they exacerbate the market procyclicality. It puts a lot of pressure on tokens and causes high volatility levels in the DeFi sector.

And unlike the case with the centralized market, in DeFi, there are no organizations that can amortize that volatility. It, in turn, boosts the risks of default for those who borrow funds. 

The solution? 

Overcollateralized loans are one of the possible solutions, those that give Aave and Compound. Considering their overcollateralized nature, lenders are more protected than in the case when they provide their funds for platforms that issue undercollateralized loans such as Maple Finance. However, not all have access to overcollateralized borrowing options - a fact that limits access to leveraging for many traders. 

What to do then? 

The reply is not new, and it is in the approach to choosing the right lenders and borrowers.

In undercollateralized markets, lenders are normally those retail investors who aim at higher profits and are ready to take higher risks or institutions who want to benefit maximally from the lending opportunities. 

The funds are normally lent to reputable entities with a large balance sheet, AMMs, and hedge funds - those entities that won’t risk their reputation for some millions of dollars.

Overcollateralized markets are more flexible. Lenders in such markets can be anybody who wants to get a safe yield protected from risks. Borrowers can be those who want to optimize their portfolios by parking there assets as collateral to benefit from margin trading and those who get profit from arbitrage trades using Flash Loans. 

Can DeFi Become the Future of Trading?

DeFi definitely offers opportunities not seen before. But with the opportunities, challenges come, especially those connected with the imperfections in DeFi technology. I believe that DeFi is going to become the foundation for the future of trading, so we continue working on the products that are going to change the world of finance and trading in the future.