Is the future of margin trading decentralized?

U.S. regulators are focusing on making crypto margin trading less accessible to U.S. citizens. There are alternatives like Deribit who offer an identical perpetual swap contract but the exchange has less liquidity. On top of being illiquid, it is too similar in nature and therefore just as easy to regulate. If easy access comes to centrally provided leveraged trading in crypto, there’s only one clear alternative.

The state of crypto margin trading

Trading itself is risky, but adding 100x leverage to the equation lowers chances of success to an even greater extent. Nonetheless, blockchain is all about freedom and the ability to margin trade with a small investment is something unique to the crypto space.

Leveraged trading has reached somewhat of a pinnacle with the rise of BitMex. The platform has been able to get away with letting U.S. citizens leverage their bitcoin by implementing geo-restrictions rather than KYC (know your consumer) policies. It worked for a while, but they are now being investigated by the CFTC for allowing U.S. traders to use their platform. Similar circumstances have resulted in Binance making a separate trading platform for U.S. customers when they released margin trading on their own site.

The slow regulation of freedoms provided by the internet is reminiscent of how torrenting evolved. Bittorrent provided a new peer-to-peer protocol that was was different from Napster because people were exchanging links rather than actual files.  New torrenting technology allowed people to continue downloading free music through Limewire and thepiratebay. By the time thepiratebay was hard to access, streaming unlimited music was affordable. Eventually there wasn’t as much of a demand to torrent.

Blurry lines of decentralization

Binance DEX blocking U.S. IP address from exchange

In this situation, Napster to LimeWire is analogous with online exchanges to a decentralized exchange (DEX). Unfortunately, there are various aspects of an exchange that can be decentralized and filling a few of those criteria is enough for companies to market themselves as a DEX.

The founder of Binance himself, Changpeng Zhao, affirmed that his “DEX” platform is not fully decentralized in a tweet,

“A few guys seem to be bent out of shape, take it easy. Don’t call it a DEX. Call it an exchange where users control their own funds, runs on a fast blockchain maintained by a number of nodes, plus a fast and easy UI. That’s it.”

BNB to BTCB swaps are an example of how Binance DEX is not fully decentralized. BNB is Binance’s self minted coin and BTCB is their version of a BTC stable coin. Binance made their own version of Bitcoin since it is incompatible with their network and it is backed by your trust that they own as much BTC as they sell. In this exchange, Binance controls the order book and order matching in this exchange.

The decentralized margin trading solution

At its core, a DEX needs to have five characteristics:

  1. Allow deposits

  2. Exchange assets

  3. Have an order book

  4. Match orders

  5. Store zero data in a centralized location

Many decentralized exchanges have the first and second traits down. The most standard thing that a DEX will allow users to do is trade directly from their wallets. As we’ve learned, Binance fails in the rest of the criteria.

Where Binance fails, the 0x protocol steps in. 0x or ZRX is one of the few tradeable projects on Coinbase. The excitement of this project isn’t as much about the performance of the asset as it is it’s role in decentralized trading.

0x is a protocol built off of smart contracts on the Ethereum network that a DEX can build their exchange off of. Basically, it allows creators of a DEX to focus on the features they want to offer to the customers and takes the need for liquidity away.

This is how 0x works:

  1. Trader market buys on dYdX

  2. dYdX uses 0x protocol to find a seller from any exchange using 0x

  3. Shared liquidity pool has potential to be more liquid compared to an independent DEX

  4. Increased liquidity allows for higher leverage than independent DEX

Here, you can see how 0x has successfully provided liquidity in the past:

24 hour DEX volume rankings where 0x beat all competition

As a disclaimer, 0x is not always topping the DEX volume charts and has not been doing very well since August. Regardless, the idea of a shared order book allows for more variation in governance. Most DEX’s that use the 0x protocol do not list the ZRX token, which takes away the Binance network conflict of interest. 0x does not require or encourage users of their network to exchange via ZRX.

Immunity of decentralized transactions

According to the Financial Crimes Enforcement Network (FinCEN),

“If a CVC trading platform only provides a forum where buyers and sellers of CVC post their bids and offers (with or without automatic matching of counterparties), and the parties themselves settle any matched transactions through an outside venue (either through individual wallets or other wallets not hosted by the trading platform), the trading platform does not qualify as a money transmitter under FinCEN regulations.”

In essence, regulations do not effect sites assisting peer to peer transactions of currency. Exchange dYdX allows deposits of crypto onto the exchange, but that function of the exchange is vulnerable. If margin trading becomes accessible only via DEX, the cost of paying a gas fee for each transaction will be necessary.

Decentralized exchange costs more

There is no way of getting around the fact that on-chain transaction are slower and more costly than processing off-chain.

Let’s say you would like to long ethereum with makerdao’s dai coin on dYdX with 4x leverage. Compared to BitMex ETH to USD contract, there would be a .075% fee for the market order, and every 8 hours, there is a funding around .01%. Bitmex pays long contracts when funding favors buyers. Funding happens every 8 hours, but if you are in a long term position, funding can be in your favor and help balance the cost.

On dYdX, a DAI to ETH long with any kind of leverage can hit you with 14% APR depending on the time of the year. The interest is compounded continuously, so you will see it start piling up as soon as you enter your trade. On top of that, each time you deposit from your wallet to the exchange, there is a gas fee.

Ethereum is the easiest asset to deposit to dYdX because of wallet and centralized exchange compatibility, so I will use their gas cost as an example. The two main things that determine the cost of gas are the difficulty of the transaction and the market price of Ethereum.

How Ethereum gas cost is calculated

The Ethereum network charged me an $0.42 fee to move $11.49. While 3% is a high fee, the cost is relative to the amount you move. A thousand dollar transaction would have also had the same fee.

Centralized exchanges require gas fees to deposit and withdraw, but there are no gas fees for movement within. One of the main draws to using a DEX is that they do not hold any of your money.

Will it be worth it?

Much like trading itself, we can only analyze the trends. Currently, Google Trends displays a stagnant interest in the term “decentralized exchange.”

The success of decentralized trading depends on technology improving to compete with the speed and cost effectiveness of centralized exchanges. On the flip side, exchanges won’t have to be as complete as what traditional institutional traders are used to. Trading firms don’t occupy the crypto space because it is more difficult to make quick transactions on exchanges. Most of the volume on margin trading sites like BitMex come from independent traders. This means that a good DEX will only need to meet the needs of independent traders.

b0x claim their protocol is capable of supporting 100x leverage

The most leverage any DEX will offer right now is 4x, which is likely due to the lack of liquidity in the space. A protocol similar to 0x called b0x, says on their website that with their protocol, you could trade with 100x leverage on Ethereum. Even so, the exchange that they advertise to use their protocol only offers 4x. Traders used to using 100x leverage on BitMex will want the same set of options to migrate organically.

Whenever speed, cost and feature sets of a DEX can compete with centralized exchanges is when adoption will speed up. The only alternative is if leveraged trading becomes even harder to access from the U.S. In that case, a number of traders will use the best alternative rather than quitting entirely. The most unregulated alternative to centralized margin trading at this time seems to lie within decentralized exchanges.