Big trading firms are flirting with DeFi, but liquidity and trust issues hold them back

Some of the biggest names in the crypto trading scene have shown rising interest in Open Finance (DeFi) as of late – but there is still something holding them back. 

Last week, The Block reported that TD Ameritrade, DRW Cumberland, DV Trading and a few other trading firms have come together to form an alliance that mentors DeFi projects, after receiving numerous inquiries from them on how to attract professional traders.

Indeed, even with an asset like bitcoin, traders are still most comfortable with the traditional way of trading. That is, a system supported by centralized service providers: custodians, exchanges, over-the-counter desks, and even sometimes clearing facilities. 

However, professional traders have demonstrated considerable interest in the DeFi, according to Jump Capital head of fintech investing Peter Johnson. Traders he knows have been following the space very closely, he said.

“What one of the traditional trading firms said to me is, I have no idea what DeFi is, but I want to know if this is going to affect my industry,” said Imran Khan, whose firm Volt Capital leads the alliance. 

For DeFi projects looking to onboard trading firms, this means that they have to help these traders leap into a world where all trading rules are codified in smart contracts and executed automatically.

“I would get pinged a lot from the DeFi projects out in San Francisco, in New York, worldwide actually, to understand and learn more about the Chicago trading ecosystem - whether it's connecting with market makers or liquidity providers, or just understanding it, or even just getting feedback about their products and seeing if they can build or tweak their products in a way that could on-board and more traders or users to their platform,” said Khan.

Liquidity catch-22 

As Khan recognized, liquidity is the most acute obstacle that is preventing DeFi projects from bringing trading firms onboard, as it directly determines whether the DeFi market is meaningful enough for these trading firms to spend time and money to participate. 

The 24-hour ETH trading volume on exchanges such as Binance can reach over $200 million, and a crypto market marker like B2C2 can trade out “an order of magnitude” over $20 million to $30 million in a day. By comparison, the DeFi space – with its $700 million total locked value – is just a tiny fraction of the market that trading firms seek to address. 

“We have done an extensive study in market making on Uniswap. Theoretically, the profit margin is high, but the trading volume and trading frequency are so low that… for a company to dedicate one or two researchers per year on this, the revenue does not cover the cost,” said crypto market maker Altonomy co-founder Ricky Li. 

Unfortunately, the catch-22 for DeFi is that trading firms want to see better liquidity in DeFi before jumping in, while these trading firms need to already be in DeFi to boost that liquidity. Hence DeFi projects’ persistent effort to get professional traders involved. 

“I think it's obviously that in the end, it is all about liquidity and market-making opportunities. So as long as they [trading firms] can get an early understanding of that, you know, that's something that they're really interested in,” said Khan. 

New trust model

DeFi essentially introduces a trading environment with no centralized exchanges, custodians, or single counter-parties, which means that traders have to consider security, counter-party risks, and trust models in a whole new light. 

“Trading on a centralized platform with centralized custodians like BitGo, if anything goes wrong I can call BitGo or Coinbase and they are going to help to make it right. With a decentralized platform, there is nobody to call up. You need to be sure there are no flaws in the protocols, that there is no way to be hacked. It’s a different aspect of trust that is very different than the way people used to operate,” said Johnson. 

In centralized trading, asset security can be guaranteed by insurances and security audits while counter-party risks can be reduced through careful background checks. But with DeFi, a new set of measures is needed to cope with a different trust model – one built upon smart contracts. 

DeFi protocols usually go through smart contract audits to make sure that their systems are not vulnerable to hackers. However, such audits do not prevent attacks that exploit loopholes of the protocols themselves. 

For example, some bots were able to win liquidation auctions on the Maker protocol with $0 bids on Black Thursday, when ETH's price flash crashed and triggered a cascade of liquidations. While these bots caused some users to lose all of the collateral – an event that has now led to a lawsuit against the Maker Foundation – the protocol by design did not prohibit such practices. 

“You need to be cognizant of how the risk of the contract defaulting/losing money affects your strategies. In CEX trading, [the risk] has come from only trusting a few exchanges,” said Gauntlet Network CEO Tarun Chitra, whose firm provides consulting and stress testing services for DeFi projects. 

When DeFi protocol bZx suffered a flash loan attack in February, Bloomberg columnist Matt Levine noted the risk of trading on DeFi may be that there is nobody blame when something goes wrong.

As he put it:

“Traditional finance was humans talking things over with brokers, and then traditional finance computerized and automated that process, but the computerization included a little bit of the old overrides and reasonableness checks. And then crypto came along and was like ‘what if we made all of this perfect immutable code that would all happen simultaneously,’ and the answer was very elegant and appealing but also super fun to hack. And so it got hacked.”