One of the central debates in crypto trading revolves around the choice between centralized exchanges (CeFi) and decentralized finance platforms (DeFi). This post is intended for readers who are new to Web3 and crypto. Knowledge of basic market microstructure will be a useful primer to skim through before reading this. Each market structure has its own set of pros and cons and caters to different user sets depending on their technical prowess and needs.
Centralized exchanges are the dominant platforms for trading crypto, accounting for 96% of the total volume (source: CoinGecko). All CeFi exchanges use central limit order books (CLOBs) for liquidity, similar to traditional financial exchanges like NYSE and Nasdaq. In addition to CLOBs, exchanges typically offer over-the-counter (OTC) white-glove services for institutional and high net worth (HNW) clients who seek to trade in sizes that would otherwise significantly move market prices. Lastly, large centralized exchanges have become conglomerates with businesses such as derivatives (futures, perpetuals, options), earn products, NFT marketplaces, and their own non-custodial wallets.
These platforms, such as Coinbase and Binance, not only execute orders but also play a crucial role as custodians of users' funds. Security and trust become paramount as the centralized exchanges are playing the role of exchange, clearing house, and custodian.
The history of centralized exchanges is marred by instances of hacks and misappropriation of user funds, such as FTX and Mt. Gox. However, tighter regulation means that exchanges face more reporting and compliance requirements to protect users. The latest wave of exchanges that launched post-FTX, such as Cube Exchange, attempt to separate asset custody from order matching so that user funds remain within the users’ control.
True to the ethos of blockchain and decentralization, DeFi platforms operate without a central intermediary, allowing users to trade token assets directly through smart contract code. Unlike CeFi, where users entrust their funds to a central entity, DeFi empowers users to custody their own funds using their wallets and security measures, eliminating the need for identity verification or trust in a central custodian.
DeFi brings enhanced transparency and accessibility that CeFi cannot match. Transactions are executed and matched through code, providing users with a detailed view of how and why an order was executed at a specific price.
However, DeFi introduces an additional layer of complexity due to the proliferation of various blockchains hosting decentralized exchanges. The market is fragmented across blockchains like Ethereum, Solana, Avalanche, and layer 2 solutions. Asset movement across these diverse blockchains requires the use of bridge applications, adding complexity and security vulnerability.
Unlike limit order books on CeFi, another market structure called Automated Market Makers (AMMs) splits market share with CLOBs. Within DeFi, AMM liquidity pools (LPs) are a key concept. LPs consist of at least two asset pairs such as ETH/BTC and offer participants the opportunity to generate APY yield. Evaluating these pools as investment opportunities requires a careful consideration of factors such as duration of lockup, asset variance, and the credibility of the pool.
A rule of thumb in evaluating liquidity pools is to understand what participants gain, what the pool gains, and the associated risks. Pools with riskier assets may offer higher yields to cover potential impermanent loss. However, excessive yields (> 100%) should raise questions about protocol and rug risks, especially for less-known or trusted pools. Participants should weigh the potential rewards against the risks involved.
One of the topics of interest in the latest crypto cycle, largely led by Solana, has been a serious growth in both TVL in these protocols combined with a surge in volumes on DEXes. A major catalyst for this has been the increase of airdrops from various DeFi protocols and investor interest in altcoins that aren’t readily available on CEXes. To understand the mechanisms behind the recent activity, break it down into these facets:
1) retail crosses the spread of a DEX to buy altcoin, say crossing 10 bps on their transaction. The DEX market maker (MM) here does not pay fees for providing liquidity
2) DEX MM looks to lock something in by crossing/working orders 5 bps from his trade price on another DEX or CEX
3) DEX MM2 who provides the 5 bps wide market repeats the same process against another tighter participant in the combined CEX/DEX space
Nothing fancy, but there is some nuance to what happens here and I wanted to use it as a simple case study. It all starts with some unsophisticated actor who wants to or perhaps even needs to execute a trade on a platform in hopes of future financial returns or airdrop rewards. The first MM, which is backed/supported by the protocol, has the easiest job in the game. His bot merely has to arb this anywhere in the crypto universe because actual liquidity on the token is likely an order of magnitude higher and tighter. What’s amusing is that currently several DeFi protocols have started offering some kind of yield in the form of MM profit sharing. No doubt, the current APY trajectory on these has been quite attractive given the latest bull run, but putting together everything here leads you to two possible paths forward: either interest in DeFi grows and the supercycle continues, or…perhaps these returns won’t stick around. Speaking from experience, if someone’s MM behavior is nearly always a pure arb, they a) are leaving money on the table b) would not perform as well in an environment with less ‘free money’. Always ask yourself why someone would offer you some kind of yield and what all the risks your investment will entail.
As the crypto market continues to evolve, the choice between centralized and decentralized exchanges remains a critical decision for traders and investors. Understanding the strengths and weaknesses of each approach is essential for navigating the crypto space successfully. Whether opting for the security and trust of centralized exchanges or embracing the transparency and accessibility of decentralized finance, users must be diligent in their choices to ensure a smooth and secure trading experience.
