Can the Current Centralized Exchanges Compete With DeFi Derivative Protocols?

Analysis
Reading Time: 3 minutes

So far, the growth of decentralized finance has been driven by lending, borrowing, and yield farming. More recently, derivatives trading has emerged as one of the fastest areas of growth in the crypto industry. Derivatives are financial instruments that traders use to speculate on the price of assets or to hedge their positions.

In the crypto industry, derivatives are traded through decentralized protocols like SynFutures and Uniswap or centralized exchanges like Binance, Coinbase, FTX, and Kraken. The centralized exchanges (CEXes) have dominated crypto derivatives trading for quite a while on the back of liquidity, an intuitive user experience, and low fees. Many decentralized exchanges are still expensive to use and not as efficient as CEXes. 

As DEXes continue to close the gap with centralized exchanges in terms of user experience, the long-term prospects of decentralized exchanges look promising. In fact, the current centralized exchanges might not be able to compete with the DeFi derivative protocols because they can’t match the decentralization assurances of the DEXes.

Even Binance CEO Changpeng Zhao has admitted that in the long run, centralized exchanges will act as “a transient product that will provide users with a bridge to the world of DeFi.” It means the CEXes will lower the barriers to entry for DeFi. New users enter the crypto ecosystem using CEXes, learn how things work, and start dipping into DeFi while retaining the user experience, liquidity, and stability of CeFi offerings. Then they will move to DeFi protocols. 

It shouldn’t come as a surprise because most of the DeFi users, especially derivatives traders, are well established crypto traders and investors. 

The Challenges Before DeFi Derivative Protocols

Centralized exchanges like Coinbase, FTX or Binance can prevent you from trading or shut your account anytime they want. Traders on DeFi derivative protocols don’t have to worry about that because these platforms are decentralized with power distributed among the community members.

Before DeFi derivative protocols can overtake their centralized rivals, they have to overcome numerous challenges. The fees are prohibitively expensive, though derivative protocols have been able to address it by transitioning to Layer-2 scaling solutions or building a multi-chain presence. Besides Ethereum, SynFutures is available on Binance Smart Chain (BSC), Polygon, and Arbitrum that have dramatically lower gas fees.

Other issues that the DeFi protocols have to overcome include liquidity, ambiguous accountability and an intuitive user experience. It’s encouraging to see them come up with innovative solutions to attract users.

To ensure accountability while it fully transitions to a Decentralized Autonomous Organization (DAO), SynFutures has formed a pre-DAO committee called the FutureX. Members of the committee interact with the community via meetups, collect proposals, and discuss the future path for the project. 

Among other things, SynFutures is offering user generated markets, enabling anyone to list any trading pair. It also uses unique financial logics in perpetual futures trading to reduce the risk for users and avoid excessive price volatility. 

The Future Belongs to DEXes

Though centralized exchanges will remain the most efficient in the short to medium term, DEXes that run on smart contracts have a number of advantages, according to a recent report by IOSG Ventures:

  • They are decentralized and censorship resistant, preventing a centralized authority from censoring dissent or abusing their power. 
  • They are permissionless. Anyone could launch new derivative markets and access the products irrespective of their geography, demography, or background. Permissionless protocols could facilitate trading of any security or commodity, not just crypto.
  • Composability of smart contracts, which opens up opportunities impossible outside of DeFi. It will facilitate a frictionless flow of digital assets across the blockchain world, enabling traders to use LP tokens from lending protocols, AMMs, and yield aggregators as a margin to trade derivatives. For instance, SynFutures allows projects to create their own futures market margined in project tokens.

Majority of the DeFi derivative protocols are still evolving. One of the reasons their progress has been relatively slow is that they are complex instruments requiring reliable price feeds, margin trading, adequate risk management, liquidation engines, etc. However, the infrastructure development combined with the breakneck pace of innovation signals that the DEXes will start capturing the market share from the centralized exchanges. 

Closing Thoughts

The future belongs to decentralized derivatives exchanges. We wouldn’t be surprised to see even the centralized exchanges transitioning to provide services that rely on DeFi products in the backend. It’s encouraging to see the DeFi derivatives exchanges address the issues of capital inefficiencies, gas prices, and user experience. 

Of course, CEXes are not going to disappear from the crypto landscape. They have their own set of advantages. But as DeFi continues to mature and innovate, it will become increasingly difficult for centralized exchanges to compete with DEXes.

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