Why should we care about capital efficiency?

Capital (e.g., fiat or cryptocurrencies) will go where it is treated best. In 2021, decentralized exchanges (DEXs) accounted for less than 5% of the trading volume of the entire crypto market — centralized exchanges (CEXs) accounted for all remaining trade volume.

Decentralized Finance (DeFi) is a revolution that won’t happen until greater participation in decentralized markets and a tidal wave of capital comes with it. Capital efficiency is the most important factor needed to engage most retail and institutional investors that remain on the fence about DeFi.

The Basics

Chances are, as an investor, you practice capital efficiency intuitively — choosing to delegate to a staking pool with the highest APY% is one example. In the simplest terms, capital efficiency is the return on capital spent or at risk — maximizing efficiency maximizes returns. It is quantifiable as a risk to reward ratio: if you invest one ADA and receive one ADA, the capital efficiency is 1:1. If you invest one ADA and receive five ADA, the ratio is 1:5.

Think of capital as the life force of the market. The more of the market capital can reach or even create, the more life there is. When capital is freed up, it can be applied to activities such as developing novel business ideas, lending, creating information flow via arbitrage, financial analysis, research, and providing liquidity to exchanges.

Capital working efficiently is good for everybody, investors and developers alike. At the macro-level, capital efficiency stimulates market growth and innovation while increasing participation and the overall investment opportunities for everyone. At the micro or individual level, it means your money makes more money.

The market activity we invest in, the market-making protocol a DEX uses, or even the blockchain an asset runs on can make what on the surface level appears to be a good investment an inefficient use of capital.

We see many examples of inefficiencies in today’s DeFi ecosystem. High gas fees on a blockchain push investors to hold off trading as they wait for gas fees to drop, keeping the capital on DEXs idle. Inefficient Automatic Market Makers (AMMs) on DEX protocols tie up far more liquidity in oversaturated liquidity pools (LPs) than is necessary, limiting capital’s ability to reach smaller projects. The same inefficient AMMs create impermanent loss, where price volatility impacts the ratio of assets deposited into a LP, causing an investor’s total capital value to fall compared to if they had simply held the assets outside of the LP. These inefficiencies and others like them, coupled with the limited range of financial tools currently available on DEXs, reduce overall market participation in DeFi — but this is something we as a community can fix.

What is needed for efficient decentralized markets?

The current generation of DEXs, while revolutionary, are not efficient. Efficient markets need deep liquidity (fast, stable and consistent prices and trade execution), equal accessibility to trading information and strategies, a wide range of order types, and high levels of market participation.

Current generation DEXs use simple algorithms that pool large amounts of capital (too much) to satisfy inefficient AMMs and create the potential of impermanent loss for users. Both can be solved using more sophisticated LP models that concentrate liquidity around an asset’s true value (the price range it is traded in most of the time), creating deep liquidity for trading pairs without user inputs.

To take advantage of deeper liquidity, a DEX should have a broader range of order types than just a swap: limit/market/stop-loss/take profit orders, etc. These tools allow users to automate trades that would otherwise require constant monitoring of price fluctuations, drastically reducing the risk of losses or missed profits. The reduced risk encourages more trading and, therefore, more capital and participants flowing into the market.

Trading strategies take advantage of market inefficiencies to create returns, and a more comprehensive range of investment tools creates more opportunities to take advantage of inefficiencies. This may sound like a bad thing but what it means is that as traders use these strategies to capitalize, the market corrects, eliminating the inefficiency in the process. The result is a fairer market, which again encourages more participation and capital. Think of it as a debugging process facilitated by empowered traders.

As areas of the market become more efficient, they benefit other market areas, creating a positive feedback loop. Efficient markets make fairer prices, fairer prices attract more participants, more participants create more stability, more stability increases security, increased security brings more participants looking for lower-risk investments — and the cycle continues.

More and more retail and institutional investors will make the jump to DeFi as the next generation of DEXs starts to treat capital better and create efficient markets.

Closing thoughts

Capital efficiency isn’t just about creating higher revenue-generating potential, it’s about creating an environment for innovation in a new space and expanding access to the market for as many people and projects as possible. The DeFi revolution is here, we just need to build it.