Every significant transformation comes with a new toolset, one that is always surprising at the time and obvious in hindsight. Bitcoin (BTC), climate change and GameStop are all examples of ways in which mass action is pushing for dramatic, not evolutionary, action. We can also see that these are individual vectors of the same movement, highlighting the inefficient parts of the legacy system and the solutions driven by an aggregation of individuals with a collective belief.
What is so striking, but not unexpected, is that some of these events highlighted the opaque nature of centralized systems. They follow the recent trend of companies like Reddit, Robinhood and E-Trade restricting user access to entire platforms or specific features. The GameStop episode demonstrated how centralized systems could steer trading processes and unfairly disadvantage retail investors for the benefit of legacy institutions. Specifically, it brought to light a surprising amount of collateral requirements on brokers — such as Robinhood — by the clearing corporations. The reasoning for this was the maintenance of sufficient levels of margin.
Another thing that came to light is that brokers like Robinhood, Fidelity, E-Trade, Charles Schwab and TD Ameritrade engage in a much-debated practice called “payment-for-order-flow” that could lead to front running. In this process, market-making firms like Citadel Securities pay a broker a fee to access orders placed by retail traders. When bundled, these orders give market makers access to information about potential short-term, future price movements. Is there any benefit for the retail trader? As the brokerage companies state: yes, as this practice allows for commission-free trades.
Although these practices are commonplace in traditional internet and finance within a narrow context, things can get uncertain when we take a broader perspective of similar implications of censorship in other areas of our society.
In response to this broken system, viable decentralized alternatives create the precondition for a mass exodus, marking a historical curtailment of centralized structures. Decentralized finance, or DeFi, and decentralized exchanges, or DEXs, play an important part in this broader transformation, addressing the opacity inherent in legacy financial systems and the resulting disadvantages to common participants.
Can DeFi and DEX be a fair alternative to traditional finance?
The decentralized nature of blockchain technology confers censorship resistance. It thus allows for applications where the ability for centralized actors — such as Robinhood — to restrict traders can simply be designed out. The open-source and auditable nature of a decentralized ecosystem would make such moves obvious and result in the discrediting of such exchanges by its users. Thus, DEXs offer the promise of a censorship-resistant exchange function where users, regardless of retail or institutional status, can conceptually participate on a much more even playing field.
Innovation around DEXs is still in the early and experimental stages. But, it carries the potential to allow disparate participants unfettered access to a limitless world of asset exchange, not just for traditional blockchain tokens but public equities, commodities, derivatives and — yes indeed — even eventually GameStop, should the users demand it.
Many founders in the space say that the inequalities of traditional finance motivated them to build their part of the DeFi ecosystem. Alex Pack, the managing partner of Dragonfly Capital, said:
“The goal of DeFi is to reconstruct the banking system for the whole world in this open, permissionless way. You only get that shot every 50 years.”
In 2014, Bitcoin Foundation’s Harsh Patel published a paper titled “A block chain based decentralized exchange,” outlining how code, not institutions, could manage the trading market. The idea wasn’t new, but it came at a time when crypto markets were facing difficulties. Mt. Gox, along with many other centralized crypto exchanges, met its demise between 2011 and 2014 through hacks and loss of its users’ assets.
To avoid the flaws inherent in centralized exchanges, a number of entrepreneurs sought to launch DEXs, supporting what would come to be the core values of DeFi: transparency, unfettered access to trading opportunities and markets, and the option to participate in decision-making in the platforms they use through ownership of governance tokens.
The future is decentralized
Early DEX protocols functioned by utilizing smart contracts to facilitate cryptocurrency trading in direct peer-to-peer transactions. However, challenges, including lack of liquidity and poor user experience, prevented DEXs from becoming viable platforms for users. Today, iterative and innovative DEX protocols have made considerable strides to overcome those challenges and are shaping up to have trading interfaces familiar to traditional markets. For example, traders today can buy crypto with card and bank account balances directly with fiat on/off ramps that convert fiat to cryptocurrency and vice versa.
In addition, soon-to-launch DEXs will introduce features germane to traditional markets such as market analytics, and trading tools like liquidity charts, trading volume and order book depth. These functionalities provide users with objective real-time data and insights into the trading landscape.
In this new financial system, DEXs that utilize automated market makers — like Uniswap or 1inch — generate an equal playing field for all participants. There are no brokers, clearinghouses or centralized market makers; trades are settled peer-to-peer or peer-to-protocol without arbitrators, except those codified by smart contracts. And critically, there are no different sets of rules for different groups of players.
Access is also improved. Whereas in traditional markets, it can be difficult to gain entry due to the complex requirements for accreditation, a typical DEX requires little to no private information from the user. These standards offer a benefit of pseudonymity and a measure of privacy protection that otherwise isn’t guaranteed when handing over your personal, identifiable information to a centralized broker. However, this may change with more Anti-Money Laundering laws coming to DeFi and the regulatory environment remaining uncertain. But, teams are working on solutions to address both the compliance requirements and an individual’s desire for privacy, which enables users to retain full ownership of their assets and identity rights, and grants specific permissions to businesses to verify their identity.
If the GameStop saga proves to be more than just a momentary anomaly, we might presently be witnessing the emergence of a profound change in the financial system or the creation of an entirely new one. As financial technology companies made it easier for consumers to participate in financial markets, DEXs are tackling the flaws of centralized markets. In some ways, this generation of DEXs may become the new Robinhood’s. Perhaps this is one of those moments where the people, and not institutional legacy, will define the future.
This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.
The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Elvina Kamalova is a director of investments at Aludra Capital, a digital assets investment management firm based in San Francisco. Elvina has a background in digital assets investments, portfolio management and fintech product development. She is the recipient of the President’s Volunteer Service Award, presented by former President Barack Obama. She’s supported underrepresented entrepreneurs and STEM education of girls and believes in the importance of developing solutions for reducing the wealth gap and cultivating human advancement.