Opinion: Despite investors’ re-turn to Bitcoin, DEXs are still the future of crypto

KYC (Know Your Customer) and AML (Anti-Money Laundering) laws have forced most cryptocurrency exchanges to be more transparent about the identities of their users, and for those that refuse, have had to limit the scope of services they can provide.

In order to operate legally in many countries, many exchanges have no choice but to comply with strict Anti-Money Laundering procedures. With the exception of Monero (XMR), most major exchanges have delisted a large number of privacy coins.

Recently, regulators have begun to tighten oversight, with jurisdictions around the world continuing to tout further measures to ensure that investors disclose their cryptocurrency holdings and pay taxes on their profits.

This is all happening as the U.S. Department of Justice arrested the co-founder of BitMEX and the CFTC charged its owner with operating an illegal crypto derivatives exchange.

About a week later, the Financial Conduct Authority, the UK’s largest regulator, even banned investors from trading derivatives on all cryptocurrency exchanges.

All of these measures are designed to force crypto service providers to play by the rules, and while they may ultimately help further mass adoption, many crypto thinkers are looking for alternative ways to strive for financial autonomy.

Decentralized exchanges may be the solution

In response to a growing number of investors’ belief that centralized cryptocurrency exchanges operate in essentially the same way as traditional banks, decentralized exchanges like Uniswap, 1inch, Curve Finance, and Balancer have become increasingly popular throughout 2020.

For more sophisticated investors, decentralized exchanges that offer derivatives trading are also already available. Similar to traditional derivatives, crypto exchanges that offer this service essentially act as brokers, but in decentralized exchanges, the process is slightly different. This is because they use smart contracts instead of brokers, and derivatives contracts are not settled until the terms of the contract are met.

Currently, Synthetix is ​​one of the most popular decentralized derivatives exchanges, with its total value locked (TVL) rising to $1 billion in 2020 before a major correction across the industry led to a decrease in TVL as well as daily active users for most decentralized exchanges.

Total value locked in Synthetix Source: DeFi Pulse

The Synthetix exchange allows users to create instruments called synthetic assets, or “Synths,” that track gold, fiat currencies, and cryptocurrencies. It also allows the creation of assets that track the price of an asset inversely.

Platform users can also stake native SNX tokens as collateral to mint new synthetic assets. Similar to Uniswap, those who provide liquidity will be rewarded by earning a portion of the exchange’s trading fees.

Those familiar with decentralized exchanges like Uniswap will know that, literally, anyone can list a new asset, which in the case of derivatives means that any underlying asset can be transformed into a derivative instrument.

These platforms allow users to trade derivatives without depositing funds in any centralized platform and do not require them to complete any KYC process.

While some investors shy away from KYC and tax compliance, this is a serious problem for crypto service providers. According to Molly Wintermute, the anonymous developer who created Hegic DEX, compliance issues are more of a problem for centralized crypto service providers than DEXs.

When asked how DEXs can remain compliant with financial regulators, Wintermute explained in a uniquely blunt way:

“They can’t. This is a new financial infrastructure layer, not an addition to the existing financial system. It’s similar to TCP/IP or FTP, not just decentralized crypto exchanges. You can’t ban code or the internet. It’s almost impossible to ban decentralized derivatives protocols unless public blockchains are open and permissionless.”

Wintermute further explained that decentralized derivatives attract a specific group of investors because:

“Non-custodial trading (protocols/people don’t hold funds as they are allocated into smart contracts). Proven on-chain settlement (no ability to cheaply manipulate derivatives, no closed-source trading algorithms that only exchange owners know how to manipulate). Higher liquidity (new peer-to-pool/peer-to-peer contract models may offer lower spreads and better terms to users).”

According to Wintermute, the number of investors who actually use DEXs is very small compared to the total number of cryptocurrency investors. For Wintermute, this means that the FCA derivatives ban and the recent legal action against BitMEX are completely irrelevant and do not apply to decentralized finance protocols.

Wintermute said: “Decentralized derivatives are part of the crypto world. There are more than 100 million crypto holders worldwide. Of these, there are probably about 5-10 companies actively trading crypto derivatives (globally). I don’t think the FCA ban will bring any new interesting opportunities. Nothing has changed.”

After being asked to elaborate on why the SEC, FCA, or other regulators might not seek to shut down platforms like Uniswap and arrest their founders, Wintermute said: “They might arrest 1 or 2 CEOs like the BitMex founder who have some shady practices internally, but only arresting 2 will scare the others. They can’t arrest everyone. They also compared decentralized derivatives to cryptocurrencies used for drug trading. If decentralized derivatives are toys, drug dealers using cryptocurrencies for drug trading are guns. Decentralized derivatives are not a crime.”

Wintermute also seemed to shake off the recent BitMEX scandal, sharply replying: “I don’t think anyone cares about DeFi or DEX. The people at BitMEX have a lot of shady things going on, and it could be a good target, and the DeFi/DEX protocols have 100% transparency, you can’t send someone to jail for building a website with numbers that are transparent to everyone in the world.”

Ultimately, Wintermute believes that “Bakkt/CME and other blockers are mad that no one is using their crap product and they are now trying to send crypto entrepreneurs to jail.”

The anonymous developer then explained that in her opinion, “the general response is to ban all the cool crypto products and try to gain their user base with compliant products.”

While some of Wintermute’s bold assertions may have merit, it takes time for the law to work, and as we saw in the now-defunct ICO era, it takes time to bring those who violate securities laws to justice.

The total value locked in DeFi platforms has risen to $12.6 billion in 2020, and data from Dune Analytics shows that Uniswap had a trading volume of $11.2 billion in October. These huge numbers are sure to attract the attention of U.S. and international regulators, so it is only a matter of time before legal action is taken against DEXs.

Decentralized exchanges are a testing ground for second-layer solutions

In addition to solving privacy issues and restoring decentralization in the cryptocurrency space, DEXs also provide a sandbox for second-layer developers. As Cointelegraph reported, scaling in the Ethereum network has been a persistent challenge.

When the network becomes congested during periods of high demand, gas fees will increase exponentially and transaction speeds will grind to a halt.With the development of Ethereum 2.0, many DEXs have begun to try to integrate second-layer solutions to provide cheaper and faster options for users willing to abandon the Ethereum network.

For non-Ethereum based DEXs, Project Serum is probably one of the most notable success stories.

The decentralized derivatives-based project is built on the Solana blockchain rather than the Ethereum network that most DEXs default to, but it’s also fully interoperable with ERC-20-based assets and Bitcoin.

FTX CEO Sam Bankman-Fried and his team are the brains behind Project Serum, which, according to Bankman-Fried, aims to circumvent the privacy and security issues of centralized exchanges by providing users with a permissionless way to invest in leveraged and swap assets.

The project also offers a cheaper alternative to the high gas fees and slow transaction speeds that often plague the Ethereum network during periods of high traffic.

“In order to build a product that can provide fast, cheap order matching, you need a high-throughput chain,” Bankman-Fried said. “This need to trade in non-standard markets and handle risk or liquidation increases further. Serum chose to build on Solana because Solana is focused on a unique and powerful scaling vision.”

Bankman-Fried believes that technical issues such as congestion and high fees could make or break an investor. Regarding high fees, he said: “They are fatal: you basically can’t use derivatives on Ethereum because of scaling issues. If there are growth opportunities for decentralized derivatives, they will either be on the new L1 or L2.”

Bankman-Fried agreed with Wintermute that “the vast majority of derivatives are on centralized exchanges, so almost no one uses DEXs.” But he suggested that in theory, “composability and self-custody” should be the motivation for more users to use DEXs.

A user-friendly DEX will dominate

Total value locked in DeFi Source: Digital Assets Data

Currently, as the price of Bitcoin, a digital asset, pursues a record high, investors' attention has turned back to Bitcoin. Data from Cointelegraph and Digital Assets Data show that DEX trading volume and daily active users continue to decline.

DEX daily active users Source: Digital Assets Data

While this may disappoint investors, it at least provides some quiet time for developers to focus on how to properly integrate second-layer solutions into DeFi protocols.

The trend of major cryptocurrency exchanges becoming more centralized is unlikely to change anytime soon. This means that once investors choose to invest in decentralized finance and decentralized derivatives again, the first decentralized exchange that successfully offers a platform with low prices, privacy protection, and a fast, user-friendly interface will dominate.

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