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FTX: DeFi Is Not The Answer (To Price Discovery) In Crypto

DeFi - Decentralized Finance on dark blue abstract polygonal background.  Concept of blockchain, decentralized financial system

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The collapse of FTX (FTT-USD) continues to lead to controversy and commentary. A recent theme in this commentary is that the FTX disaster represents a failure of centralization that decentralized finance – “DeFi” – can correct. Examples include contributions by the very smart and knowledgeable Campbell Harvey of Dukeand An OpEd in WSJ.

I agree that the failure of FTX shows that the crypto business as it is, contrary to how it is often portrayed, is highly centralized. But the FTX implosion does not demonstrate that centralization of crypto trading as per is fundamentally flawed: FTX is an example of centralization done in the worst way, without any of the institutional and regulatory safeguards used by exchanges like CME, Eurex and ICE.

Indeed, for reasons I outlined going back to 2018, the crypto market has been centralized for fundamental economic reasons, and it makes sense that centralization done right will prevail in crypto going forward.

The contender for centralization that Harvey and the WSJ OpEd and many others are DeFi. It uses the nature of blockchain technology and smart contracts to facilitate crypto trading without centralized intermediaries such as exchanges.

One of the examples of the DeFi argument is “automated market making” (“AMM”) of crypto. This article provides details, but the basic contours are easily described. Market participants contribute crypto to pools consisting of pairs of assets. For example, a pool can consist of Ether (ETH-USD) and the stablecoin Tether (USDT-USD). The relative price of the assets in the pool is determined by a formula, e.g. XETH*XUSDT=K, where K is a constant, XETH is the amount of ETH in the pool and XUSDT is the amount of Tether. If I contribute 1 unit of ETH to the pool, I get K units of USDT, so the relative price of ETH (in terms of Tether) is K: the price of Tether (in terms of Ether) is 1/K.

Automatic market maker comparison

Automatic Market Maker Comparison (CoinDesk)

Well. But does this mechanism provide price discovery? Not directly, and not in the same way that a centralized exchange like CME does for something like corn futures. DeFi/AMM essentially relies on an arbitrage mechanism to keep prices aligned across exchanges (like FTX once upon a time and Binance now) and other DeFi AMMs. If the price of Ether on one platform is K, but the price on another is for example .95K, I buy ETH on the latter platform and sell Ether on the former platform. (Just like Sam and Caroline supposedly did on Alameda!) This tends to drive prices across platforms toward parity.

But where does the price discovery take place? At what price do all the platforms converge? This mechanism equalizes prices across platforms, but in traditional financial markets (TradFi, for the cognoscenti!), price discovery tends to be a natural monopoly, or at least has strong natural monopoly tendencies. For example, in the days before Reg NMS, virtually all price discovery in NYSE stocks took place on the NYSE, although it accounted for only about 75-80 percent of the volume. Satellite markets used NYSE prices to set their own prices. (In the Reg NMS market, the interconnected exchanges are the locus of price discovery.)

Why is that? – The centripetal forces of private information trading. Something that Admati-Pfleiderer analyzed 30+ years ago, and I showed in my research. Basically, informed traders earn the most by trading where most uninformed traders trade, and the uninformed mitigate their losses to the informed by trading in the same place. These factors reinforce each other, leading to a consolidation of informed trading in a single market, and the consolidation of uninformed trading on the same market, except to the extent that the uninformed can segment themselves by trading on platforms with mechanisms that make it expensive for the insider to mine their information, such as trade-by-settlement, dark pools and block trading. (What constitutes “informed” in crypto is a whole other topic for another time.)

It is likely that the same mechanism is at work in crypto. Although trade consolidation is not as pronounced as in other asset classes, crypto has become very concentrated, with Binance (BNB-USD) capturing around 75-80 percent of trade even before the FTX bankruptcy.

So theory and some evidence suggests that price discovery occurs on exchanges, and that DeFi platforms are satellite markets that directly or indirectly rely on arbitrage with exchanges to determine price. (This raises the question of whether the AMM mechanism is expensive enough for informed traders to ensure that their users are effectively noise traders.)

The implication of this is that DeFi is not a close substitute for centralized trading of crypto. (I note that DeFi trading of stocks and currencies is essentially parasitic on price discovery performed elsewhere.) So just because SBF centralized crypto trading in the worst way does not mean that decentralization is the answer – or will prevail in equilibrium as anything more than a supplementary trading mechanism suited to a particular clientele, and not the primary locus of price discovery.

So the future of crypto will almost certainly involve a high degree of centralization – performed by adults, operating in a strict legal environment, unlike SBF/FTX. This is where price discovery will take place. In my opinion, DeFi will play an additional role, just as OTCs do in equities today and pre-Reg NMS did.

One last comment. One thing that many in the financial markets lament is the fragmentation of stock trading. It is said to be highly ineffective. Dark pools, etc., have been heavily criticized.

Fragmentation and decentralization is also a criticism leveled against OTC derivatives markets – here it has been seen as a source of systemic risk, and this criticism has led to things like OTC clearing mandates and swap execution facility mandates.

So it’s fair to say that in financial market conventional wisdom, decentralization = bad.

But now, a failure of a particular centralized entity leads people to extol the virtues of decentralization. Talk about strange new respect!

All these criticisms are largely misleading. As I’ve written extensively in the past, fragmentation in TradFi is a way to accommodate the diverse needs of diverse market participants.

If crypto-trading is to survive, well-managed centralized platforms will play a major role, complemented by decentralized platforms. Crypto is not so unique that the economic forces that shaped market structure in stocks and derivatives won’t work there.

So don’t overgeneralize from a likely (and hopefully!) extreme case driven by the frenzy of vigilante mobs.

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Editor’s note: The summary bullets for this article were selected by Seeking Alpha editors.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these shares.

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