Diving into DeFi Volume 2: An evolution of exchange from the Venetians to the Ethereans
In parallel to remittances, Telcoin is actively working to deliver a full-stack, compliant financial platform — powered by decentralized exchanges (DEXes).
By: Parker Spann
Telcoin’s mission to provide the under-banked with low cost, high quality financial services begins with affordable and fully digital remittances — but does not end there. Affordable money transfers are a key building block to global financial inclusion; equally important are lending, savings, and investment solutions. This series explores the various technologies that will propel consumer finance in the developing world and the target markets which need it most.
Cryptocurrency has always been decentralized finance
Bitcoin introduced the first non-sovereign, hard-capped supply, global, decentralized, immutable store of value — enabling anyone with an internet connection to transact freely and custody their own wealth without relying on third parties. On May 22, 2010, when Lazslo Hanyecz paid 10,000 BTC (worth a paltry US$110,000,000 today) for two Papa John’s pizzas, colloquially celebrated as Bitcoin Pizza Day among crypto sommeliers, he effectively bootstrapped what started as a libertarian computer science experiment into a full-blown unstoppable monetary organism.
However, while Bitcoin has inarguably excelled as a store of value or gold substitute, finishing out the decade as the best performing asset in the world at a 9 million percent return, an entirely new financial system, DeFi, is flourishing on ethereum.
At the time of my first article on April 24th, there was roughly US$773 million worth of collateral locked in DeFi. By June 23rd, that number stood at about US$1.35 billion, a 100 percent increase. Today, the total value locked on ethereum sits at over US$3.75 billion, up 285 percent in just the past month! If software is eating the world, then DeFi is devouring finance.
Telcoin & DeFi
Permissionless, peer-to-peer, value transfer, and secure self custody are the core building blocks necessary for this new system to work, and Telcoin will bring the first compliant crypto x fiat, cross-border transfer money service to terminate in mobile money across multiple continents to the mass market.
This is the bedrock foundation to building a full-stack decentralized financial application. At a high level, core financial services include money transfer, investments, savings, and loans. Telcoin aims to bring high-quality, low-cost products across this whole spectrum to the people who need them most in developing countries.
My last piece focused on consumer lending on the blockchain, and today, we dive into the decentralized exchange market (DEX), which along with money transfer, powers virtually every financial use case.
The History of Exchanges
Though currency exchange dates back at least to the money changers in Biblical times, the first modern financial exchanges formed in 14th century Venice. Eventually converging on Bruges at the intersection of two major trading empires, the Venetians and German Hanseatic merchants of the Baltic Sea would meet at the square in front of the Ter Beurse Inn, often using the local innkeepers as brokers. Carrying around slates of information on the various issues for sale and meeting with clients, much like today’s brokers. The Venetians, however, traded high interest loans and government securities.
Though finance has evolved over the past 700 years since the merchants of Venice professionalized the broker model in the first organized markets, or exchanges, in some ways they’ve stayed quite the same. Legacy financial markets are fraught with layers of gatekeepers and intermediaries, which cause inefficiencies in execution, clearing, and settlement; limit the world of investable assets; and, importantly, are exclusive — a construct antithetical to the open financial system flourishing on ethereum.
Intermediaries & Gatekeepers
Let’s take Robinhood, a popular brokerage service in the USA, as an example.
Execution
When you execute a trade on Robinhood, they route that trade to a market maker, which then executes the trade on an exchange of which they are an exclusive member firm.
Oftentimes, in the payment-for-order-flow model Robinhood uses to enable “commission free trading” (originally pioneered by Bernie Madoff, the operator of the largest ponzi scheme in history), these market makers front run orders and directly trade against brokerage customers.
Clearing
That information is relayed to the National Securities Clearing Corporation (NSCC) or an equivalent clearing company. At the end of the transaction, NSCC provides a report to the broker and the other intermediaries involved in the trade. The contents of the report include the amount due and the positions of the net securities after the trade.
The NSCC gives the Depository Trust and Clearing Corporation (DTCC) the settlement guidelines. The DTCC ensures the transfer of funds from the buyer to the seller. During the transaction, the broker is responsible for adjusting the client’s account.
Settlement
In securities, the official transfer of the asset to the buyer’s account and cash to the seller’s account, or settlement, typically takes two business days, or T+2. In foreign exchange markets (forex, FX, or currency markets), settlement of transactions involving North American currencies can happen T+1, whereas other currencies typically settle T+2. However, due to government restrictions, most emerging markets currencies — such as the Brazilian real or Argentinian Peso — are non-convertible and can’t be freely traded or leave the country, and thus never settle physically outside of their country.
Custody
A custodian, generally large, well-known firms, such as banks, hold onto your financial assets and process transactions on customer’s behalf..
Additional middlemen include the exchanges themselves, like the New York Stock Exchange (NYSE), who, until the early 2000’s virtually operated a monopoly and today host about 80% of public market American securities for trading. They have broad discretion in deciding whether or not companies can be listed, require expensive listing and annual fees, and oftentimes reject applicants.
The Exclusivity of Legacy Financial Markets
These gatekeepers, along with an explosion in venture capital investment, which generally requires deep social connections or financial capital, has led to a shrinking world of high quality investable assets. According to Federal Reserve Economic Data, FRED, the number of listed companies per million people in the United States decreased from 30 in 1996 to 13.33 in 2017. And this is the United States, the largest and most sophisticated capital market in the world!
How Exchanges Work
Without going too much further into dealer and broker markets, let’s dive into exchanges at a high level and how they work. Exchanges connect buyers and sellers directly via an auction based market. Buyers enter bids while sellers submit offers(asks). The exchange keeps track of the bids and asks in an “orderbook” and matches them when possible. Market makers create bids and asks while market takers cross the “bid-ask spread”, or the difference in price between the most competitive prices on both sides, taking the best available price.
These systems work well when there are enough buyers and sellers in the market, but rely heavily on market makers to constantly “make the market” for a certain asset. In the absence of high interest and volume, assets become difficult to buy and sell, resulting in high volatility and illiquidity.
Cryptoasset Exchanges: The Centralized Approach
Though cryptoassets enable decentralized, permissionless, censorship resistant finance, free from trusted third parties, the majority of trading volume over the years has taken place on centralized exchanges.
At a high level centralized exchanges perform three key functions:
1. Custody user funds - Users deposit and withdraw their assets to and from addresses the exchange controls. Exchanges have full custody over customer funds and must be trusted to secure them from hackers, rogue employees and other attackers. In 2019 alone, nearly $300 million USD worth of cryptocurrency was stolen from exchanges.
2. Host & distribute orders - Exchanges host order books and match orders similar to legacy financial exchanges.
3. Settle trades - Exchanges settle trades in user accounts.
This presents a number of problems.
Exclusivity: The number of investable assets is limited to what exchanges deem worthy, often picking favorites and choosing winners, where the most well capitalized teams pay to play and get exposure. This is the antithesis of what cryptocurrency is meant to offer, which is permissionless access to anyone with an internet connection.
A Paradox of Trust: While cryptocurrencies were created to reduce trust in a centralized third party, the construct where users primarily trade and custody their assets on centralized platforms, is paradoxical.
These exchanges operate largely the same as legacy financial exchanges: fraught with exclusivity in the form of expensive, discretionary listing processes & fees.
An Exchange Renaissance
Historically considered slow, illiquid, and costly compared to centralized exchanges, decentralized exchanges (DEXes), or exchanges where users trade cryptoassets with one another, all on-chain, and retain control over their assets, are finally finding product-market fit and are rapidly taking market share.
This makes sense for a number of reasons: for years, the cryptoasset market’s only tangible use case was price speculation; centralized exchanges with fiat on-ramps, sub-second latency, deep order books, and margin trading capability were a far superior product.
Now, with the introduction of liquid on-chain financial primitives such as lending markets, self balancing index funds, synthetic asset markets, institutional grade wallet infrastructure, and most importantly, Automated Market Makers (AMMs) or Liquidity Pool Exchanges (LPEs), we are seeing a renaissance of DeFi applications.
The composable nature of DeFi, where developers can combine different protocols to create new financial products and services, has shifted the crypto market from rampant speculation to outright disruption of the legacy financial system via superior product offerings.
All of this is made possible by & built on the core foundation DEXes provide.
Market Statistics
After a couple of years of mediocre volume trading volume, ethereum based DEXs have exploded onto the scene in 2020. By May of this year, users had generated US$2 billion in volume on ethereum DEXes, nearly surpassing all of 2019’s roughly US$2.4 billion.
Fast forward to today, nearly US$2 billion in volume has traded on DEXes in the past week alone, with US$265 million in the past 24 hours. For context, aggregated DEX volume has surpassed Bithumb (Korea’s largest trading venue) and Kucoin in trading volume in the past 24 hours, coming in at number five on the global cryptocurrency exchange leaderboards. Furthermore, DEX volume is cryptographically verifiable, whereas fake centralized exchange volume is a well known reality in the cryptocurrency space.
- Uniswap is clearly leading the market.
- Automated Market Makers (AMMs) account for the majority of trading volume, whereas orderbook exchanges lag behind.
At Telcoin, we see this trend towards DEXes as a major paradigm shift vs a temporary fad. Furthermore, we view this development as evidence that the cryptoasset marketplace is maturing from a trader’s game not too discernible from traditional finance, to a user’s market with revolutionary properties fulfilling and expanding upon the original vision of building an entirely new financial system.
After all, how can one build a useful decentralized application if the user has to constantly deposit and withdraw assets from a centralized exchange? How can closed legacy currencies, like non-convertibles compete with programmable monies that can be freely exchanged & instantly converted across the world?
Revolutionary Properties of DEXes
Permissionless: Anyone with an internet connection can trade & list any asset without relying on gatekeepers to give them access.
Efficient: AMMs explained below, completely automate the execution, clearing, and settlement process on the blockchain via code rather than humans.
Guaranteed Liquidity: AMM’s guarantee liquidity at every price level without relying on market makers to continuously place bids and asks.
Immutable: No third-party can reverse transactions.
Non-custodial: Users custody their own funds which never leave their wallet until a trade or swap is executed.
Composable: Builders can combine on-chain exchange with other DeFi products and services to create novel and even full stack applications for users.
How DEXes work
There are three types of DEXes on Ethereum: order book exchanges, swaps, and aggregators.
Order Book Exchanges (OBEs)
Definition: Similar to traditional exchanges, OBEs maintain an order book and facilitate matches between buyers and sellers.
Overview: OBEs vary in their architecture, but essentially take the orderbook, auction style model explained above and enable users to custody their own assets and settle trades on chain, peer to peer with instant delivery.
Examples: 0x exchanges like Tokenlon, IDEX, and Etherdelta
Pros
Great under the right conditions: When markets have deep orderbooks due to high interest and active market making, OBEs work reasonably well.
Peer to peer: Enabling peer to peer asset exchange without custodians is a major innovation and a core building block for a permissionless financial system.
Cons
Illiquidity: Tokens on OBEs with less interest or volume suffer from illiquidity and large individual orders can cause undesirably high volatility and hinder token adoption.
High touch & costly: Market makers have to constantly update bids and asks to make a liquid market, which can be expensive on ethereum.
Swaps
Definition: Smart contracts hold liquidity reserves of various tokens, and trades are executed directly against these reserves. Prices are set using a conversion formula.
Overview: Also known as Automated Market Makers (AMMs) or Liquidity Pool Exchanges (LPEs), in this type of exchange, users swap assets against token reserves. Instead of using a traditional buy/sell orderbook, trades are pre-funded by investors. Market makers no longer specify price when providing liquidity. Instead, they merely supply the funds and the rest is automated.
Examples: Uniswap, Balancer, Bancor, Curve Finance, Kyber Network
Advantages over OBEs:
Guaranteed Liquidity: Rather than relying on market makers to actively provide liquidity, investors supply an equal amount of two tokens. So long as the pool is sufficiently sized proportional to volume, there is liquidity at every price level.
Permissionless & Simple: Anyone can easily create a token trading pair, or liquidity pool, by providing an equal value of two tokens in one click. In Uniswap, these pool creators earn a 0.3% fee for each trade.
Automated Market Making Providing infinite liquidity, automated market makers price an asset using an exponential rate curve. As the reserve pool of the asset is bought up, it becomes increasingly more expensive, making purchasers less likely to purchase, and vice versa
More Efficient: Code is simple and therefore gas is lower when compared to OBEs. Execution, clearing, and settlement all happen immediately, in one click, on-chain with no third parties involved.
Further Reading:
DEX Aggregators
Definition: Routes trades from all of the DEXes into one transaction.
Example: 1inch exchange
Overview: These types of exchanges source all of the available liquidity from all of the DEXes into one transaction, sourcing the best prices for users.
Telcoin x DeFi
DeFi on Ethereum continues to flourish, but so far, we’ve simply rebanked the banked.
Permissionless, peer-to-peer, value transfer, and secure self custody are the core building blocks necessary for this new system to work, and Telcoin will bring the first compliant crypto x fiat, cross-border transfer money service to terminate in mobile money across multiple continents to the mass market.
In parallel to remittances, Telcoin is actively working to deliver a full stack, compliant financial platform, powered by DEXes, to the financially under-served. We are excited to announce more on this, in stages, over the coming months.
Send Money Smarter. Exchange Money Smarter. Telcoin.
