Crypto’s capital efficiency upgrade heralds new era for Decentralized Finance

By 0xTJ

Crypto markets were again in the spotlight as April began, but this time the mood music was not bleak, but upbeat. The reason for all this attention? The demise of the license that for two years has kept others from copying the code of hugely popular decentralized exchange Uniswap V3. 

The April 1st expiry is already fueling a rush to duplicate the features that have made Uniswap one of the world’s most popular decentralized asset marketplaces. Pancake Swap, which joined the fray just two days after the expiry, has already attracted more than $133 million in Total Value Locked (TVL) and rising, according to Defi Llama. 

Arguably, it also heralds a new golden era for decentralized finance.

To understand why this is, it’s necessary to dig into the differences between decentralized crypto exchanges – or DEXes – and their centralized counterparts. 

Like traditional asset markets, centralized exchanges are managed by an intermediary – either an institution or a group of individuals. DEXes, in contrast, are owned by a community, often via a decentralized autonomous organization (DAO) and governed out in the open through smart contracts held on blockchains.  

Centralized exchanges require investors to hand over control of their assets to intermediaries and trust that they will keep them safe from both external threats (hackers) and internal ones (theft and mishandling of funds by insiders). DEXes are non-custodial, which means that investors retain control over their assets and trades are conducted in the open. 

These differences give DEXes two major advantages over centralized marketplaces: they are more secure and more transparent. 

For years, though, they fell short in one key area: capital efficiency. 

Because centralized exchanges are often larger and appear similar to traditional marketplaces, they are a reassuring option for retail investors, particularly those new to crypto. And because they attract more buyers and sellers, transactions can be cemented without either side making a big compromise on price. 

DEXes tend to be smaller and more plentiful, so each has far fewer human dealmakers than centralized marketplaces do. They have solved this issue with code: automated market makers (AMMs) that use liquidity supplied by users, who earn rewards for lending their assets to the cause. 

Although AMMs kept them in the fight, DEXes continued to underperform centralized marketplaces on capital efficiency. 

Then came the May 2021 release of Uniswap V3, the AMM that rewrote the book on liquidity by offering providers a host of new ways to earn more on their assets. 

Chief among these was something called “concentrated liquidity”. Liquidity providers were now able to to allocate their liquidity against the price ranges where they saw the most potential for deals. This made it easier to earn returns and reduce the risk of capital languishing in undifferentiated pools without being put to use. V3 also introduced tiered compensation, which offered larger rewards for taking on more risk. 

The innovations worked. According to research Uniswap published a year after the release, V3 provides significantly more liquidity than major centralized exchanges on major asset pairs – often twice as much. 

It was official: with the arrival of Uniswap V3, centralized exchanges had lost their edge. 

This, coupled with the string of misfortunes that befell centralized marketplaces last year has hammered home the lesson that decentralization truly is the way forward for finance. Secure, nimble, adaptable and insulated against human foibles by the power of code, decentralized finance (DeFi) is more than equipped to fill the vacuum left by the recent failures of centralized bodies.

And with the expiration of Uniswap V3’s Business Source License (BSL) on April 1st, other DEXes are free to copy the code that gave Uniswap V3 such unparalleled liquidity. 

The timing is perfect for DeFi to stage a major resurgence. Technical analysts are pointing to some encouraging signals and investors are showing signs of reinvigorated interest. DeFi’s TVL is now making a comeback running above $50 billion and a big improvement from the start of 2023, when it hit a two-year low of $39 billion. 

Centralized finance is still suffering from the damage to trust inflicted by the high-profile implosions FTX, Three Arrows Capital, and others, and it is drawing unwelcome attention from regulators. In the latest blow, the U.S. Commodity Futures Trading Commission filed a lawsuit against the world’s largest crypto exchange, Binance, for not registering its services with regulators.  

The woes of traditional financial institutions are spilling over into the crypto world too. Last month, Circle’s seemingly invincible stablecoin USDC temporarily lost its peg to the U.S. dollar after markets learned it had a $3.3 billion exposure to the collapsed Silicon Valley Bank. 

All of this puts DeFi in a prime position to take the reins of the world’s financial system from the shaking hands of centralized financial institutions. 

After all, DEXes equipped with AMMs can deliver all that is best about decentralization: privacy, transparency, scalability, user control over assets, removal of human intermediaries. And with the innovation of concentrated liquidity made possible by Uniswap V3 becoming widely available, they can outperform on capital efficiency too. 

0xTJ is the founder of decentralized finance platform Unbound Finance