Problems with Exchanges

Centralized exchanges control access to information and order flow. As we have seen many times, this creates misaligned incentives for privileged parties to abuse this control through internalization and Payment for Order Flow (PFOF). In essence, traders are playing against the house. Additionally, exchanges have violated the custody of traders’ assets, repeatedly losing those assets to hacks or financial mismanagement. DeFi was born largely due to the lack of trust in financial intermediaries. Meanwhile, mass market adoption of DeFi has been obstructed by the inability of DeFi to meet the expectations established by the tools of traditional finance. Slippage and front-running create inefficiencies for large traders, and high gas/platform fees make them less accessible for smaller traders. Platforms lack composability, requiring bridges that are susceptible to hacking. Decentralized exchanges cannot compete with centralized and traditional trading without addressing predation, friction, risk, and fragmentation all together. 

The failures of these systems manifest for different reasons, but affect traders in similar ways.

Table of Contents

    • Price Not Representative of Market Conditions

      Centralized Exchanges

      In traditional finance, many brokerages are required to offer their customers the National Best Bid and Offer (NBBO), the highest bid price and lowest ask price in an asset. This is required, for instance, by the US Securities Exchange Commission's Regulation NMS. In crypto, there is no such regulation. Therefore, centralized crypto exchanges, which act as both exchanges and brokers, are not beholden to giving their customers a market-representative price. As liquidity can vary widely between different exchanges, and market moves across crypto exchanges are not necessarily correlated, especially on lower time frequencies, microeconomic pricing exists on many exchanges at any given point in time. The primary solution to this, as on DEXes, is arbitrage, where certain users extract value which would otherwise belong to less sophisticated traders.

      Decentralized Exchanges

      DEXes offer prices based on local microeconomic conditions which often do not align with the broader market. This places undue financial risk on traders, the only answer for which has been to expend additional effort to research fair market prices or place all their trust in aggregators. This is a ludicrous inefficiency. A trader in TradFi would not consider price shopping between brokers when purchasing a stock.

      Attempts to solve this problem via oracles have introduced additional attack vectors, putting the assets of LPs at risk. We have seen that the first domino in the downfall of numerous tokens has started with relatively easy manipulation of pricing on DEXes.

      OUR SOLUTION

      Deepwaters price discovery is managed by a decentralized oracle which samples prices off-chain from centralized exchanges. This ensures you receive a true mid-market price that is protected against manipulation.

    • Poor Execution

      Centralized Exchanges

      As crypto exchanges act similarly to brokers without a centralized exchange, liquidity is fragmented across order books. This thins the order books, leading to greater price fade (what would be called slippage in DeFi).

      Decentralized Exchanges

      Invariant-based automated market makers rely on their internal liquidity for pricing. Fragmentation of liquidity across pools and chains limits the liquidity available for trading of any particular asset. This leads to high slippage, poor execution, and MEV-based attack vectors.

      OUR SOLUTION

      Deepwaters’ pricing oracle samples CEXes to ensure traders receive a fair market price. Single-sided liquidity is deployed across the entire platform, freeing it to be used wherever it is most needed and thereby increasing liquidity depth for any purpose. Native cross-chain transactions eliminate bridging, unshackling assets from only being useful within a particular chain, thereby eliminating another cause of liquidity fragmentation. Deeper liquidity, fair pricing, and protection from predation means superior execution.

    • Orders Subject to Predation

      Centralized Exchanges

      Most securities regulations do not apply to licensed cryptocurrency exchanges. They therefore have the freedom to do as they please with your orders - including sell the order flow, resulting in more profit for the exchange and their trading partners, but preventing your order from hitting the order book to ensure it receives the best possible price.

      Decentralized Exchanges

      Large transactions are subject to front-running, sandwich attacks, and MEV. Transactions afford no privacy, allowing bots to profit from the actions of traders at those traders’ expense. The industry needs to decide if DeFi is something for bots and insiders to exploit, or something that is fair and equitable to all participants.

      OUR SOLUTION

      By storing and processing orders off-chain, but settling those orders on-chain, we create a system that is immune to predation but still trustworthy and auditable.

      Deepwaters v2, coming in 2023, will utilize a combination of encryption, hardware-based cryptography, and blockchain validation to demonstrably prove that the system is behaving as is prescribed by our audited code. This means that no one, not even the platform itself, could alter the order flow. Orders are executed or reach the order book in the exact order they are received. We couldn’t sell your order flow if we wanted to, and you’ll be able to prove it yourself. 

    • High Fees

      Centralized Exchanges

      Centralized exchanges charge more to smaller traders, making small-volume trading less advantageous for users.

      Decentralized Exchanges

      Gas and trading fees limit the viability of small transactions, discouraging participation from smaller-volume traders.

      OUR SOLUTION

      By storing and processing orders off-chain, but settling those orders on-chain, we create a system that is immune to predation but still trustworthy and auditable.

      Orders in Deepwaters are efficiently processed off-chain, while still being settled on-chain for complete auditability. Whereas most DEXes compensate LPs solely through trading fees, resulting in high fees, Deepwaters compensates liquidity providers with a combination of  internal arbitraging profits and a modest trading fee.

    • Lack of Composability

      Centralized Exchanges

      Centralized exchanges skirt the composability issue by holding custody of all assets, which creates huge risks.

      Decentralized Exchanges

      Cross-chain transfers are difficult, expensive, and unfriendly to the users. Bridges have proven to be points of vulnerability in the DeFi ecosystem, offering large, attractive targets for hackers. Current L0 solutions only address the difficulty; they are still expensive and slow to settle.

      OUR SOLUTION

      Deepwaters uses the fast and inexpensive Avalanche blockchain to maintain state while interoperating with other chains directly for rapid settlement without bridging or custody.

    • Fragmentation of Liquidity

      Centralized Exchanges

      Centralized exchanges trap liquidity in specific trading pairs, limiting the availability and utility of that liquidity. This lack of liquidity depth is the primary driver of price fade (slippage).

      Decentralized Exchanges

      Protocols trap liquidity in specific chains and pools, limiting the availability and utility of that liquidity. This lack of liquidity depth limits DeFi’s scalability and is the primary driver of high slippage.

      OUR SOLUTION

      Liquidity in Deepwaters is truly liquid, free to flow to wherever it is most needed at any point. Pools are single-sided, which maximizes capital efficiency. Native cross-chain composability prevents the need for liquidity of any particular asset to be split across multiple chains. Trading pairs only exist on the order book.

    • Liquidity Treated as Sacrificial

      Centralized Exchanges

      Centralized exchanges do not use passive liquidity providers.

      Decentralized Exchanges

      Most decentralized exchanges treat the liquidity they are given as sacrificial. Liquidity providers assume risk based on the volatility of the market, but are compensated based on volume. The result is impermanent loss which is often greater than the yields generated.

      OUR SOLUTION

      Liquidity providers play a different role in Deepwaters. LP’s liquidity is treated as liquidity of last resort rather than sacrificial liquidity. While taking a risk more akin to underwriting the ecosystem, they still benefit fully from transaction fees, regardless of whether their assets are ever used. This results in capital preservation and improved risk-adjusted compensation.

    • Custodial Violations

      Centralized Exchanges

      Anyone who needed a reminder of the adage “not your keys, not your crypto” received a stark one from the fall of Voyager. While that degree of gross financial mismanagement is a tail-risk event, it is a potentially devastating one to any unfortunate enough to suffer it.

      Decentralized Exchanges

      Custodial violations are a problem largely unique to centralized exchanges, as almost all decentralized exchanges are non-custodial.

      OUR SOLUTION

      Like a DEX, Deepwaters is non-custodial. Assets are held in smart contracts.

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