Novel Trading Opportunities in DeFi for TradFi

Crypto is a $900 billion global market that institutional investors are sizing up.

Despite the inherent risks involved in participating in any nascent sphere, institutional financial players are going out of their way to discover how they can get involved in crypto. This includes telecom giants staking their coins and venture capital funds providing liquidity to decentralized finance (DeFi) protocols.

Tongtong Gong is the co-founder and COO at data infrastructure and analytics platform Amberdata. You can follow her on Twitter: @Gongt2. This piece is part of CoinDesk's Trading Week.

This is to say nothing of the new forms of programmatic trading, including crypto derivatives and arbitrage opportunities, used by retail and institutional traders alike.

There are novel opportunities for generating value in DeFi that are not feasible in TradFi. Research estimates that institutional DeFi could reach $1 trillion by 2025. By that point, we might not be separating TradFi and DeFi. It will all simply be Finance.

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The novel opportunities in DeFi

The hardest barrier for traditional financial institutions to overcome to get involved in DeFi is understanding that the coded economics of each protocol rely on the laws of supply and demand, and so DeFi assets have a market price. And anywhere there’s trading, there’s a way to make money.

The current crop of crypto and DeFi platforms offer a few ways – familiar and unfamiliar to TradFi brokers – of making money.

Now that Ethereum has officially transitioned from the proof-of-work (PoW) consensus standard to proof-of-stake (PoS), ETH staking has become one of the easiest ways for institutional capital to come into the market. A JPMorgan report from this summer estimated the crypto staking industry could reach $40 billion by 2025.

Staking is the process by which a user locks up a portion of their assets for a length of time to help support the functions of the network. For doing so, they receive rewards in the form of additional assets.

Right now, however, the majority of validator rewards are going to people, firms and projects that have mastered the art of maximal extractable value (MEV). This is the process of using behind-the-scenes strategies to earn the greatest possible amount in fees from all the transactions that a validator will group into a block to be added to the chain.

Anyone or anything can be a so-called “block builder,” and practice MEV. In fact, deploying software created by Flashbots called MEV Boost makes it trivially easy to earn returns and is used by a majority of Ethereum validators. According to data provider Pintail, validators are generating a median return of 6.1% APR using Flashbot’s software.

Institutional financial players can also become liquidity providers (LPs) to decentralized exchanges (DEXs) and lending protocols. Most DEXs use the automated market maker (AMM) model of pricing tokens, so buyers and sellers always have a platform to transact.

LPs are incentivized to add tokens to AMM pools of each side of a token pair, and receive a percentage of transaction fees as a reward. This same system can also be applied to lending pools where LPs earn a percentage of interest by locking up liquidity for borrowers. Given the key role of liquidity in markets, protocols often incentivize network use by providing substantial yields.

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While many of these trading strategies might seem strange to institutions not fully familiar with DeFi, there are still more familiar methods of making money: like traditional trading and arbitrager.

DEXs also enable many new forms of programmatic trading, including crypto derivatives and arbitrage opportunities. Just as in TradFi, crypto derivatives can take the form of futures, options and perpetual contracts but the value is derived from digital assets rather than stocks.

Arbitrage opportunities arise when the price of a token on one DEX is less than the price on other DEXs or centralized exchanges (CEXs). By relying on high-quality real-time data, institutional traders can quickly identify those opportunities to buy the asset where it is listed low and sell it on DEXs with higher listings.

Risks and challenges

Providing liquidity is simple, but it isn’t risk free. For example, it’s important to understand the concept of impermanent loss, which describes the "unrealized opportunity" on a DEX or DeFi platform when the token price changes relative to when it was deposited or withdrawn.

For example, let's say an LP deposits liquidity into an ETH-BTC pool at a time when 1 BTC equals 10 ETH. A month later, the value of ETH doubled while BTC hasn't changed. When this disparity occurs, arbitrage traders will jump at the opportunity to buy ETH from that pool and sell it on a DEX at a higher price thereby bringing the pool ratio and token prices back to market rate. This could hurt a depositor or benefit them, depending on which side of the trade they’re on.

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(That said, during this period of high demand for ETH, transaction fees increase and so LPs may make up the impermanent loss through fees with enough exposure.)

Institutional traders are likely to know already that there’s no such thing as a free lunch. Despite the inherent risks involved with participating in any nascent sphere, institutional financial players are going out of their way to discover how they can get involved in crypto due to the novel opportunities for generating value in DeFi that are not feasible in TradFi.