🏦Introduction - The Problem

The occurrences that comprised the initial portion of 2022 highlight the vulnerability and potential risks associated with centralized systems within the cryptocurrency space.

Centralized Finance (CeFi) entities have come under scrutiny for their opaque practices involving asset shuffling and manipulation of client funds. Historically, moral hazard has been a persistent issue across various financial markets. However, the underlying causes of these recent scandals can be summarized as follows:

1. Clandestine Centralized Entities: These entities have operated in secrecy, lacking transparency in their actions and decisions.

2. Exorbitant Fees: Users have faced excessively high fees when engaging with these centralized platforms, leading to financial burdens.

3. Divergent Incentives Between Owners and Customers: The interests of platform owners and users have not aligned, potentially leading to decisions that benefit owners at the expense of customers.

4. Abuse of Asset Custody: There have been instances where these entities have mishandled or misused customer assets, eroding trust and security.

5. Dubious Risk Management: Questionable risk management practices have been observed, potentially putting customer investments and funds at risk.

In the absence of essential safeguards, the realm of finance often grapples with principal-agent problems, where the principals (the users) find themselves vulnerable to the self-serving interests of their agents (centralized third parties). Technological advancements can alter this dynamic by ushering in open-source protocols that are:

✔️ Open to all and embracing inclusivity - enabling participation for anyone possessing a wallet and an internet connection.

✔️ Providing transparency and immediate visibility - transactions are documented on a public blockchain, accessible to all in real-time.

✔️ Empowering users to maintain control of their assets independently and without the need for trusted third parties, ensuring trustlessness and self-custody.

✔️ Secured against tampering and unchangeable - transactions are permanent, safeguarding against alterations or fraudulent activity.

✔️ Eliminating the presence of a single point of failure - decentralization ensures a distributed and resilient system.

Despite the undeniable advantages of decentralization, it might come as a surprise that Decentralized Exchanges (DEXs) have not yet become the predominant choice for cryptocurrency trading. Currently, we attribute this phenomenon to three primary factors:

1️⃣ DeFi protocols that are currently in existence face challenges in competing with Centralized Exchanges (CEXs) due to their limited range of utility and product offerings.

Various protocols cater to users with a diverse array of products. However, due to their lack of interconnectedness, cross-margining is either entirely absent or highly inefficient within these protocols. In contrast, major Centralized Exchanges (CEXs) provide capital-efficient trading options and a comprehensive selection of products. Additionally, CEXs encompass features such as seamless on-and-off ramping and support for cross-chain transactions, which are notably absent in the majority of DeFi protocols.

2️⃣ The limitations of the blockchain, most notably the blockchain trilemma, have led to innovative— but ultimately suboptimal and fragmented— solutions.

Automated Market Makers (AMMs) offer an intriguing case study. Initially conceived to provide liquidity for assets with low trading volumes on platforms with limited throughput, they effectively tackled some of the challenges of blockchain-based trading and facilitated the expansion of asset diversity. However, the absence of traditional limit orders introduced price inefficiencies not seen in order book systems. Various iterations of AMMs, attempting to address these issues, have only exacerbated the problem by scattering liquidity across different ecosystems. In a broader context, efforts to confront the blockchain trilemma have often inadvertently created additional complications, resulting in a perplexing array of blockchains and economic models, each with its distinct constraints. This fragmentation has led to a dispersion of activity, total value locked (TVL), and talent across numerous networks. Decentralized Exchanges (DEXs) have been hampered by this fragmentation, constrained within specific ecosystems. In contrast, Centralized Exchanges (CEXs) maintain flexibility by simultaneously accessing multiple liquidity sources and blockchains.

3️⃣ The average DeFi user experience and interface (UX and UI), is intimidating and unfamiliar to most people from a Web2 background.

Currently, the term "people from a Web2 background" encompasses the majority of the world's population. If DeFi developers persist in neglecting this fact, the potential of DeFi will go unrealized, and it will continue to exist as a niche sector within the broader financial industry.

To put it simply:

The ease of user experience (UX) without hurdles is a significant driver of technological adoption. Centralized Exchanges (CEXs) maintain their dominance in the crypto landscape because they offer a smoother and more frictionless UX. Despite the associated risks, lack of transparency, and higher costs, many users opt for centralized solutions simply because they find them "easier" compared to the relatively more cumbersome decentralized alternatives. To stay competitive, DeFi must find a solution to address this challenge.