The decentralized finance (DeFi) ecosystem has made great strides in the past two years. I have also been considering the competitiveness at the agreement level and the market size. I analyzed the former in April, and this article will focus on the latter.

My biggest concern about the current DeFi status of Ethereum is that it is subject to one or more invisible ceilings (I will explain below). According to Eugene Wei’s definition, an invisible ceiling is an invisible upper limit—it cannot be measured directly, and it will only appear in an analysis that violates the facts—but it really limits growth.

Although it is still too early to make assertions, the DeFi ecosystem is likely to have touched these limits. For example, the maximum value of ETH pledged in the DeFi protocol is about 2-3% of the total amount of ETH.

In this article, I will evaluate the advantages and disadvantages of the current DeFi system relative to CeFi (centralized finance). Then, I will try to explore some invisible ceilings that limit the growth of DeFi, and propose solutions.

DeFi application scenarios

Although DeFi’s application scenarios are very rich (including non-sweeping lottery tickets, prediction market, pledge, identity, etc.), currently its main uses are as follows:

Leverage (for example, pledge borrowing in Maker, Compound, or margin trading on dYdX)
Transactions (e.g. 0x, Uniswap, Kyber, IDEX, dYdX)
Obtain synthetic asset exposure (eg Synthetix, UMA)
These three major applications account for the vast majority of DeFi activities.
Each of the above decentralized financial agreements directly competes with centralized alternatives. Next, we analyze the dynamics of these application scenarios one by one to understand DeFi’s invisible ceiling.

Add leverage

For most traders, the two most important characteristics of leverage are leverage multiple and cost. But in these two aspects, DeFi is not as good as CeFi.

1. DeFi’s leverage ratio is lower. Subject to system delay (Ethereum block time is 15 seconds), the leverage multiple cannot be too high. So why does higher latency reduce the maximum leverage? Considering the volatility of crypto assets and the risk of serial liquidation within a 15-second block time, it is difficult for DeFi to provide products with high leverage. dYdX launched a BTC perpetual contract with a leverage of 10x in April, but the average leverage multiple of BitMEX users is 25-30x. 2. CeFi’s borrowing costs are lower. CeFi companies expand credit (banks like Silvergate), reduce trust-based mortgage requirements (such as the size of the loan department that works with trusted customers), or provide large amounts of customer deposits (such as the loan departments of Binance and Coinbase) To achieve this. Although in some cases, the current DeFi agreement loan interest rate is lower, but they have structural flaws. Although in theory there is such a possibility: traders slowly start trading Compound’s cToken-this protocol effectively replicates the advantages of Binance and Coinbase’s centralized ledger-but this will disperse the liquidity between cToken and the underlying assets.

Can the DeFi protocol provide more leverage? Considering the volatility of cryptocurrencies and the current shortcomings of Ethereum (15-second block time), it is difficult to imagine that a platform will provide more than 10 times the leverage. The tragedy of Black Thursday on March 12 is still vivid.

However, there are certain Layer 2 solutions (such as Skale) that can achieve a block time of 1 second, reducing network latency (please note that the vanilla optimistic rollup architecture cannot reduce block time, so it cannot solve this defect). However, it is unclear whether decentralized exchanges (DEX) like dYdX and traders will transfer settlement to Layer 2 solutions such as Skale.

So in the long run, can the DeFi agreement provide a more competitive loan interest rate? The answer is: probably not. I expect that in the next few years, more and more banks (which can provide credit through partial reserve loans) will enter the crypto space, and the capital cost provided by centralized financial institutions will gradually decrease. In addition, since DeFi agreements cannot underwrite trust relationships, they require a higher mortgage ratio, which will further increase the cost of capital (opportunity).

In the foreseeable future, I think the DeFi agreement cannot defeat traditional leveraged suppliers. Although the DeFi agreement can provide certain customers with marginal profits that traditional suppliers cannot, the market share is very small. The vast majority of market participants want to optimize the cost and availability of leverage, and the DeFi protocol is difficult to match CeFi in these two aspects.

Today’s market data also clearly shows this: the vast majority of leverage in the crypto ecosystem today is provided by traditional exchanges.

It is worth noting that if all trading activities are transferred to a certain, open and credible neutral DeFi standard agreement (such as a single Layer 1 I mentioned a few weeks ago), then DeFi can eliminate basic risks, Thereby improving the capital efficiency of all market participants. However, this possibility is very low in the foreseeable future.

transaction

The DeFi protocol is far inferior to centralized alternatives in several major ways. Overall, the following factors have prevented DEX from grabbing CEX’s market share.

Delay and probabilistic determination. Because Ethereum adopts the Satoshi Consensus—which is accompanied by a high-latency probabilistic determination—the buyer and seller cannot accurately know their exact location in real time. Due to lack of accuracy, their transactions must be more conservative (for example, using a larger spread). For this, any solution with a shorter block time can alleviate the situation.
Miners are pursuing profits (front-running). As the crypto ecosystem matures and traders transfer more transactions directly to the chain for settlement, the block-producing nodes will begin to maximize the benefits available to miners themselves (MEV). When this happens, miners will start preemptive transactions, which is very unfavorable to liquidity providers.
Full position leverage and offset positions. Currently, Binance and FTX provide users with full positions of different types of products (for example, a bullish perpetual position to guarantee call options). In the next year, I expect them to gradually provide offset positions (for example, through ETH short positions, users extend BTC long positions), and then other centralized exchanges will follow up. Although the decentralized environment can theoretically provide full position leverage, the actual operation is more difficult because the decentralized trading market is not yet mature.
Lack of fiat currency. The decentralized approach is difficult to transfer users from the fiat world to the encryption field on a large scale. There are indeed several teams working on this problem, but none of them have yet found a solution. Prior to this, for users who already held cryptocurrencies, stablecoins were a good stopgap measure.
Throughput and gas costs. Traders want to settle transactions quickly, readjust the mortgage ratio, and then quickly open new orders. These operations require a lot of gas costs.
So, can the DeFi protocol reduce latency and provide faster certainty? On low-latency Layer 2 (eg Skale) or Layer 1 (eg Solana), the answer is yes.
Can the DeFi agreement mitigate the threat of miners’ profit-seeking? Some Layer 1 does have theoretical solutions, but they cause higher latency, complexity, and gas costs. For Layer 2 of certain license verification nodes, the answer is yes.

Can the DeFi agreement make up for the lack of fiat currency support? With stablecoins, the answer is yes.

In the foreseeable future, it is difficult to see decentralized exchanges surpassing centralized exchanges. Although there is a relatively clear solution to solve the problem of delay and finality, experienced traders 1) do not want the block node to preempt the transaction, 2) hope to be able to trade margin positions and offset positions to increase their capital efficiency.

This situation is also very obvious in the data: traditional exchanges account for the vast majority of trading volume, and almost all prices are found to depend on CeFi.