Understand the historical evolution of the crypto market structure and understand the future of CeFi and DeFi integration (www.blockcast.cc)

From the two major evolutions of the encryption market in the past decade, we can see the profound impact of DeFi on the encryption industry.

Written by: Arjun Balaji, investment partner of Paradigm, a crypto venture capital firm. Compiled by: Zhan Juan

In the early 2010s, the crypto market consisted of a small number of small brokers focusing on retail investors. In the past ten years, this market has grown to a daily trading volume of more than 15 billion U.S. dollars across the spot, derivatives, and chain markets. Today, BTC has become one of the most liquid assets in the world .

The weirdness of crypto assets creates a novel market: the crypto market is open around the clock . Users all over the world can access fully interchangeable assets. The public blockchain allows users to transfer cryptocurrency and fiat currency without friction within minutes. Individuals can keep their assets as safe as a bank. Unlike the New York Stock Exchange or Nasdaq, retail investors can trade directly on the largest crypto exchanges without the need for intermediaries .

Due to the global fragmentation and rapid changes, coupled with the diversity of participants in the crypto market, even with the above advantages, the structure of the crypto market is still opaque , and little is known about it.

This article outlines two major evolutions in the crypto market in the past decade and sets out a possible vision for the future.

Market structure 1.0: 2010 to 2017

The history of the crypto market began with P2P transactions through Bitcointalk and IRC . In July 2010, with the launch of Mt.Gox , the first real market structure began to emerge. In the next five years, many early exchanges have launched fiat currency platforms serving individuals.

With the birth of Bitcoin, obtaining stable banking channels has become a challenge, which has led to the rise of stable coins such as Tether .

As adoption rates continue to grow, over-the-counter (OTC) transactions have begun to provide services to a few early institutional companies. At this time, there is no mature market maker and liquidity is very poor. Cross-border and cross-regional spreads are usually measured in single-digit percentages.

By December 2017, the influx of new market participants made the exchanges overwhelmed every day, which marked the end of an era.

There is no need to further reflect on this past era; but we have to thank the early builders, who led us into today.

Market structure 2.0: 2018 to present

Since December 2017, the crypto market has developed to a 2.0 iteration , from a market designed for individuals to a market that institutions can enter . During this period, the trading volume of derivatives increased by more than 25 times , while the bid-ask spread dropped by 10 times . The market has matured from a manual, expensive, BTC-denominated market to a fully electronic, cheap, and stable currency-denominated market.

The main drivers of this transition are:

Derivatives liquidity eclipses the spot market

Since 2017, the center of cryptocurrency liquidity has shifted from the spot market to derivatives. The trading volume of crypto derivatives lags behind the spot in 2017, but the current trading volume is 3-5 times that of the spot, exceeding $10 billion per day. With the increase in bilateral liquidity, the volatility of Bitcoin has dropped significantly . The current 60d volatility is 2-4%; in comparison, it was 4-8% in 2017-18 and more than 7-10% in 2013-14. Today’s derivatives landscape is also diversified, including products provided by US regulated markets (CME, Bakkt), global participants (FTX, Deribit), and international spot exchanges (Binance, Huobi, OKEx).

Electronic execution of OTC transactions

Since 2017, the over-the-counter transaction spread has been compressed by an order of magnitude, from 50-200 basis points to 5-10 basis points for 8-digit BTC transactions. In 2017, OTC transactions were mainly conducted through voice and chat. It is now fully electronic, led by quantitative trading companies such as Jump , B2C2 , Amber and Alameda Research . Customers do not need to start Skype, but can directly connect to the platform hosted by the market maker to stream quotations and execute transactions via API.

The emergence of borrowing

In 2017, the credit of cryptocurrencies was almost zero. Today, trading companies can obtain more than $2 billion in BTC and stablecoin loans, and the service desk can provide intermediary services for both retail (BlockFi, Celsius, Blockchain.com) and institutional (Genesis) lenders. The lending market reduces the capital cost of market makers , which is beneficial to institutional clients with small spreads and retail investors with high single-digit yields.

Stable coins as encrypted financial reserve assets

In 2017, almost all mainstream trading pairs of encrypted assets were priced in BTC, which led to serious price dislocation and liquidity evaporation during periods of high volatility. Today, among the top 30 crypto assets, the most liquid trading pairs are basically denominated in stable currencies. Stablecoins have replaced BTC as the reserve asset of the crypto market . This can be seen from the 10-fold increase in the total amount of Bitcoin issued in January 2018 (US$2 billion to US$20 billion).

Institutional services and products

In 2017, institutions can only enter the market through retail channels. Today, in addition to existing institutions such as Coinbase and Genesis/BitGo , institutions can also cooperate with dozens of qualified custodians, electronic executive agencies, and new entrants in the lending market (such as Tagomi, Fireblocks, and Anchorage). Electronic communication networks like Paradigm.co have improved the block trading workflow, and professional venues like LMAX Digital are now leading the global liquidity of BTC/USD trading pairs.

Market Structure 3.0: ~ 2020 to?

We are in the next structural evolution, the early stage from 2.0 to 3.0. At maturity, the 3.0 iteration will:

• Fundamentally improve capital efficiency;
• Connect the centralized market and the emerging Decentralized Finance (DeFi) market.

Capital efficiency

Due to the fragmented market and the lack of industry-wide credit evaluation, the capital efficiency of encrypted transactions is still very low.

Nowadays, exchanges have very high requirements for margin, and companies cannot fully hold margin, that is, use the margin paid by a broker or place to collateralize positions in other places. This forces the company to provide all funds for almost all of its trading activities, and the settlement of transactions is subject to many large confirmations. In a highly unstable environment, full financing is particularly burdensome if the congestion on the chain is the most serious.

Due to the low efficiency of this type of transaction, perpetual contracts have become the main source of short-term funds. Encrypted perpetual “comes for incremental capital efficiency and stays for 20 times leverage.”

Relying on the perpetual contract market as the pillar of market financing is very undesirable : in March 2020, layered liquidation resulted in more than $1.6 billion in nominal liquidation in BitMEX alone, most of which were in a more efficient market It should be avoided.

Credit creation and shortening the transaction life cycle can drive capital efficiency. Credit creation allows companies to obtain purchasing power of more than one dollar per dollar. Shortening the transaction life cycle means that the same dollar can be turned over more times, increasing the liquidity per dollar.

We can see some specific ways to create credit and shorten the transaction life cycle:

• Dedicated prime broker : Large exchanges have the most robust balance sheets in the crypto sector, allowing them to directly provide large amounts of credit. Prime brokers like Coinbase enable customers to pay deposits across markets, while cold storage accelerates the transaction life cycle by moving transfers off-chain.
• Crypto-native derivatives clearing : In traditional markets, exchange-traded derivatives are cleared by the central clearing house, which is responsible for maintaining the ledger for margin calculations. In the past few years, companies like Zero Hash and ErisX have tried to port this model directly to the encryption field. In addition, methods like X-Margin can also achieve this encryption by generating encrypted collateral proofs on the chain.
• Formal repo market : The $2-4T/day repo market allows institutions to borrow cash on a guaranteed short-term basis. Through perpetual contract financing and two-way settlement over-the-counter repurchase (50 million US dollars/day), cryptocurrency has an informal repurchase market. A formal institutional repurchase market can achieve considerable short-term borrowing without going through a perpetual contract venue.
• Lower on-chain confirmation threshold : A better understanding of public blockchain settlement guarantees can make the deposit time between known parties faster. Fireblocks’ digital asset transfer network settles more than $25 billion per month and allows members to choose instant deposits. All transfers initiated by Fireblocks are signed by SGX and ensure that each (unconfirmed) transaction is the only signed transaction for a given UTXO. These guarantees enable exchanges like FTX to accept deposits from other Fireblocks users immediately after the transaction enters the memory pool.

CeFi ↔ DeFi tends to merge

Decentralized finance (DeFi) first appeared at the end of 2017 and developed in parallel with market structure 2.0. As the structural importance of DeFi continues to increase, CeFi and DeFi will tend to converge because they overlap in market participants, liquidity pools, and product user experience.

Even in its 1.0 iteration, DeFi has begun to subvert CeFi . To give a few examples:

• Liquidity is first established on automatic market makers : In 2017-18, establishing liquidity in new assets requires cooperation with exchanges and market makers. With the implementation of permission-free listing of AMM, passive retail liquidity providers can create market depth before professional liquidity providers have token inventory. For many long-tail assets, large global cryptocurrency exchanges have become late entrants in terms of providing liquidity.
• Best execution requires on-chain interaction : AMMs like Curve now have a stablecoin pool of nearly $1 billion. The direct implication is that, compared with those brokers that can obtain on-chain liquidity, brokers that cannot obtain on-chain liquidity will have a direct disadvantage . This transformation happened very quickly; the impact of AMM on centralized exchanges only began to become apparent in March 2020. For many market makers, this is already a forced feature that forces them to join DeFi.
• Encrypted native full warehouse margin : DeFi’s margin position has been tokenized from the beginning, in the form of Uniswap LP shares, Compound cTokens and Synthetix synths. The DeFi margin tokens are fully mortgaged and can be redeemed on the chain. When used in combination, transparent remortgage can be realized (for example, using Uniswap LP shares as Maker CDP collateral). Although FTX has taken the lead in introducing tokenized margin on centralized exchanges, the design interface has just opened.
• DeFi’s frictionless user experience : DeFi’s user experience is better than CeFi in many aspects. Although critics tend to focus on high gas costs, DeFi provides users with a superior security experience (non-custodial) and frictionless access. Scan the QR code and sign the MetaMask transaction to access. Compared to dealing with traditional brokerage companies, this experience is closer to using Snapchat.

Although DeFi already has a spot trading and lending market with a high transaction depth, DeFi has not eaten away CeFi . Throughput and high gas fees are still important structural obstacles. With the launch of the L2 solution , DeFi poses a real threat to centralized exchanges. For example, DeFi applications like Synthetix can copy BTC margin synthetic assets, and the user experience is equivalent to using FTX.

What does this mean for CeFi players? It has the following influences:

• Better DeFi interface : The exchange will rely on its economies of scale to provide users with intermediate DeFi services just like providing mortgage services. Centralized exchanges can provide an interface to access DeFi, which can prevent the escape of funds on the chain. The exchange can incentivize users to access DeFi products through its interface, thereby providing liquidity of locked assets, lower fees (through pooling), and additional off-chain margin. For many users, an exchange account may be the most convenient way to access on-chain protocols as a default wallet .
• Standardization of non-custodial transactions: Non-custodial trading products are another natural line of defense against capital flight. Binance and FTX have already begun to meet the challenge, establishing non-custodial DEX Binance Chain (in the Cosmos zone) and Serum (in Solana) respectively. Agreements like Arwen can enable non-custodial transactions for exchanges that use a hybrid approach. Newer projects such as dYdX and DeversiFi (originally via Bitfinex) are scaling up to compete with the centralized UX supported by StarkWare’s ZK-based L2.
• “CeDeFi” is real : In addition to non-custodial window decorations, every major CeFi participant will try to use “CeDeFi” . The effort-saving solution can be a structured product that tries to imitate on-chain revenue. A more comprehensive solution can include a fully EVM compatible chain that can be ported to DeFi, such as the Binance Smart Chain attempt.
• Institutional support for DeFi : Compared with large institutions, retail investors have less friction in accessing DeFi, but they are subject to compliance or regulatory obstacles. As large companies begin to treat the DeFi market as first-class citizens, service providers will seek to provide customers with frictionless access without affecting existing workflows. Over time, we may even see some projects gradually launch whitelist (KYC) liquidity pools. Off-chain DeFi insurance can alleviate the mechanism and contract risks without collateral or insufficient collateral, thereby providing more protection.

As scalability improves, on-chain financial infrastructure will begin to compete with centralized infrastructure. However, the diversity of users and the importance of fiat currency entry means that centralized exchanges will not disappear soon . The long-term winners are users , who can explore various options in terms of trust, price, risk, and user experience.

Conclusion

In the first ten years, the structure of the crypto market has undergone two major changes. Despite the rapid pace of innovation, the market is far from mature and has not reached the scale needed to support a market value of tens of trillions of dollars.

The transformation of the crypto market has always been bottom-up , driven by the needs of entrepreneurs and users. The optimistic view is that innovation will lead to victory in the long run-today’s encryption sandbox is the design of every major market in the future.

Historically, the crypto market has been opaque, and little is known about it. We hope that as we build an open and efficient financial system in the next decade, this article provides a useful starting point for future dialogue.

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