Krypton – DeFi solution for Billion Dollar trading problem
In June ’22, BlueGrid joined forces with Krypton Labs. That was the first time I had heard of a vision for Krypton protocol, and the moment I faced a few questions from the finance and crypto worlds. The idea for this article is to introduce the vision and break it part by part to better understand it.
Krypton is the exchange protocol for decentralized finance (DeFi) that solves the billion-dollar problem in the context of trading.
So let’s start with the first question. What is decentralized finance (DeFi)?
To understand DeFi we should take two steps back. (DeFi <- CeFi <- TradFi)
Traditional finance (TradFi) represents the methods such as payments, borrowing, and lending via banks. These services are transformed with the introduction of blockchain technology. Before decentralized finance (DeFi) was introduced, centralized finance (CeFi) was the standard for trading and exchanging cryptocurrencies.
Within centralized finance, crypto investors will trade on a centralized exchange (CEX). That organization stores cryptocurrency and coordinates trading using a similar business model to stock exchanges in traditional finance. Those are marketplaces where many people simultaneously try to buy and sell the same type of asset. In traditional finance, famous exchanges are New York Stock Exchange and the London Stock Exchange. In the crypto world, some well-known CEXs are Coinbase and Crypto.com.
Now, let’s look at the third step. Decentralized finance (DeFi) allows people to make transactions directly with others (peer-to-peer) rather than through banks and central exchanges as on TradFi and CeFi. This is accomplished with smart contracts, the simply self-executing programs on a blockchain. Each party to a contract inputs conditions that allow the smart contract to be fulfilled without the need for a central authority. Some examples of use are sending funds to a particular account on a specific day, issuing a ticket, or registering a vehicle.
The last question (or not :) - What is the billion-dollar problem in the context of trading?
For easier reading, I’ve created an alias “the billion-dollar problem” for MEV.
So, the real question is - What is the MEV? MEV is an abbreviation of “Miner Extractable Value”. Before we jump deeper, let’s use the same tactic and take two steps back for a better understanding. (DeFi <- CeFi <- TradFi)
What are the issues with traditional finance (TradFi)?
Front-running is an illegal practice of using non-public information for buying or selling stocks ahead of a large order to benefit from the subsequent predictable price movement after the execution of such an order.
Adverse selection occurs when one party in a transaction processes more accurate information compared to the other party.
In centralized markets, the profits from these activities are captured by high-frequency trading (HFT) firms competing with each other. This competition requires significant investment in research, hardware, and software engineering to reduce the latency of market access. The high-frequency trading’s gains from front-running and adverse selection represent costs to regular traders such as pension funds, mutual funds, and retail investors. These costs are the primary reason for the existence of price impact. Price impact refers to the correlation between an incoming order (to buy or to sell) and the subsequent price change.
The high-frequency traders are responsible for most of the trading volume, producing a significant fraction of the total revenue for companies operating these exchanges. Exchange operators have no incentive to implement measures that limit HFT activity as doing so would lead to a substantial reduction in their own revenues. Exchange operators and high-frequency traders essentially share the proceeds from toxic trading.
Now, let’s quote Bruce Buffer from the UFC. “IT’S TIME!” for the question again - What is the MEV?
In decentralized, public blockchain systems, miners are responsible for selecting and aggregating transactions into blocks. This allows them to front-run each trade on every block they win. Miners can make the profits known as miner extractable value (MEV). Front-running and adverse selection are present in both traditional finance and crypto markets.
Why have I created the alias “the billion-dollar problem” for this article?
Because decentralized finance (DeFi) has grown from zero in early 2020 to an average daily trading volume of $3M, which has prompted the rise in realized MEV (Miner Extractable Value). MEV is one of blockchain’s most significant issues, with more than $673 million extracted from network users since Jan 1, 2021.
What is the solution?
The only way to solve the rising MEV crisis is to design mechanisms that make front-running worthless or impossible. And the solution is Krypton Protocol.
The ordering of trade execution is critical. High-frequency traders aim for low latency to front-run regular users. It allows them to take advantage of regular users such as mutual and pension funds. The same problems as in traditional finance.
Instead of executing trades in a signal instant, Krypton executes trades as continuous flows over time. Trades arriving in the same block are recognized at the same time. Traders can select a trading speed that is in line with their time to respond to a change in market conditions. Regular users can request a low trading speed to credibly signal the absence of an intention to monetize short-term information advantages. A trader who wants to front-run or profit from short-term information must request a high speed. On Krypton, the intention to trade fast reveals the information advantage before too much damage can be done.
Krypto is more economically efficient than anything else in CeFi or Defi today, as Michael Nowotny, CEO and Chief Economist at Krypton Labs, Inc., said.
This article is just a brief and simplified overview of Krypton’s vision. I’ll try to deep dive into the technology in further articles. In the meantime, visit Krypton, read the Light Paper, and join the community.