In this series, we will look at the practical implications that Ethereum Layer 2 solutions can bring to the financial services industry, from how it can be used for fast access to liquidity by brokers and exchanges, to reducing trading fees for decentralised finance (DeFi) for Hedge Funds and Institutional Investors.
Part 1 - Brokers, Exchanges & Liquidity Providers
Making Ethereum Cheaper and Faster
Transactions on Ethereum are slow and expensive. It's not a controversial statement to make when the network can only manage 14-15 transactions per second and it can cost well over $30 to swap tokens. There are faster Layer-1 blockchains out there. The catch is that Ethereum has a vast amount of utility thanks to its smart contracts and unlike others it has a huge network effect — over 8000 nodes, which makes it incredibly decentralised and trustworthy in terms of network security. This, along with the sheer number of deployed protocols keeps it well ahead of other Layer-1 offerings for now.
The developers behind Ethereum have always understood that scalability was an essential part of their roadmap. Sharding was the solution to that with the ETH 2.0 Beacon Chain launch now in place where load would be spread across 64 separate shard chains. Layer 2 Solutions have long been a part of that plan however, ETH 2.0’s slow progress led to external developers creating their own Layer-2(L2) solutions first. These solutions are built on top of the Ethereum network but can scale much more efficiently, resulting in cheap, almost negligible transaction costs and incredibly fast block times. This has largely driven adoption of Layer 2 solutions like Polygon Matic by SushiSwap, Aave, UniSwap and other DeFi projects, but what does this mean for the various stakeholders such as brokers, exchanges and liquidity providers?
Whilst institutional investors and DeFi funds are by and large remaining on Ethereum's main network, the vast majority of retail and institutional traders, however, are moving to Polygon and other L2 solutions. SushiSwap has more than 15,000 unique active wallets on Polygon, while on Ethereum that number was around 4194 according to data provided by crypto data site DappRadar. This is resulting in competition between protocols to be added to the various Layer 2 networks.
Layer 2 DefI is Solving CeFi's Problems
Traditionally, brokers and exchanges have been considered Centralised Finance (CeFi). However, with the advent of Decentralised Exchanges (DEXs) and increased speeds on Ethereum helped by projects like Polygon, Optimism and Binance Smart Chain, brokers and exchanges have an opportunity to embrace the ecosystem for additional sources of liquidity and yield-bearing opportunities for their customers. For the moment, however, even with the increased speed, DEXs can't beat CeFi for trade execution and settlement as the velocity of trading between brokers and their customers far exceeds the transaction throughput on blockchains.
In traditional finance markets, brokers have the ability to achieve high velocity trading for customers. The broker accepts deposits from customers and then executes the trades on a private centralised ledger. Once trades are executed, the broker then clears the balances. The problem with this for their customers is that it traps liquidity inside the broker or exchange. If you want to move funds between exchanges, it takes time and money, you can't quickly move your assets, and it could lead to missed opportunities.
Unlocking capital to make it more efficient is very important to traders. There are protocols and other blockchains that offer ways to attempt this by locking up a token on one blockchain, for example, and recreating a representation of it on another blockchain and allowing trading with it on that blockchain. Brokers have a unique advantage through API integrations to tap these protocols on behalf of clients. This wrapped asset approach can have its problems, though, as it is hard to build the network effect. Additionally, if the chain doesn't have many participants, security will be harder to achieve until it reaches critical mass. This is where Layer 2 solutions which rely on the security of the underlying Ethereum blockchain can work better as they don’t require as many participants to be secure.
We are starting to see multiple decentralised exchanges flocking to the same Layer 2 solutions. We have seen this with DEXs such as 1Inch & Uniswap deploying across multiple solutions like Polygon Matic and Optimism. In principle, if multiple brokers and exchanges deploy to the same Layer 2 solution, then funds can essentially be used across all of them without being trapped on one individual platform. This creates a much larger liquidity pool for brokers and exchanges to access and frees up investors' capital. The DeFi world is solving problems that the CeFi space has been working to achieve for a while now.
Why Brokers and Exchanges will have to embrace DeFi & Layer 2
What does all of this mean for CeFi? While DeFi and its use of L2 solutions could be seen as a threat, it actually opens an opportunity for brokers and exchanges. Even with sharding on Ethereum 2.0 and a Layer 2 solution like Polygon, the transaction speed is still likely to only reach several thousand transactions per second.
If a CeFi broker or exchange was to take a hybrid approach to DeFi they could execute the business logic and order matching on a centralised system as they did before but can clear all trades directly to the Layer 2 itself because it's cheap and fast and lets brokers tap into a single liquidity pool for the customer without trapping liquidity on the exchange.
Not everyone will necessarily turn to DeFi as there is still a vast amount of utility in centralised finance, but what we might see is a shift in perception in terms of finding utility with DeFi and everyone joining a Layer 2 network and clearing transactions on a Layer 2 network to access better liquidity or extend yield-bearing or margin trading opportunities to their customers.
In order to do something like this as a broker or exchange, you will need to partner with the right tech provider and crypto custodian as DeFi is inherently complicated and lacking in fundamental services institutional traders value and need such as customer support, compliance and custody. At Trustology we have been working on adding Layer 2 support to our TrustVault product, including Polygon and Optimism and DYDX, as well as Layer 1 networks including Avalanche and Binance Smart Chain. We are now piloting those solutions and would like to invite users to take part in our beta trial. With our bespoke integrations into MetaMask and WalletConnect combined with our DeFi Firewall rules, flows and notifications brokers can gain a unique vantage point to offer a superior user experience whilst leveraging DeFi liquidity in the backend.
Contact us to talk about this and your requirements.
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