Why the DEX World is Broken
What are DEXes
Decentralized Exchanges or DEXes are marketplaces where traders can exchange cryptocurrencies without any 3rd party nor middlemen involved. Relying on smart contracts, DEXes are secure, trustless and censorship-resistant. Unlike centralized exchanges, nobody can prevent traders from trading, nobody can freeze or steal your funds, there can be no wash trading (at least not for free), and everything is transparent.
The first DEXes were blockchain implementations of CLOB (central limit order book), but suffered from multiple deficiencies. In 2017, Bancor launched one of the first DEXes based on Automated Market Making (AMM) technology. In 2018, Uniswap simplified the AMM trading by lowering gas fees and introducing direct pairs between tokens, and took the technology mainstream.
Uniswap, and later Curve, Balancer and several Uniswap clones took the crypto world by storm. Uniswap is now consistently ranking in the top 5 of all exchanges by daily volume, and the AMMs are here to stay.
We recommend this series of posts by IDEX to catch up on the DEX history, and this excellent piece by Haseeb Qureshi for an in-depth explanation and analysis of AMM-based DEXes.
What’s wrong with AMM Liquidity?
AMM on Uniswap works great for large pairs that are part of the top 5. Uniswap’s deepest liquidity is in the pairs like WETH-USDC, WETH-USDT, WETH-WBTC, WETH-DAI and WETH-SUSHI.
However, when trading assets that are outside the top 5, in many cases there isn’t direct liquidity between the two tokens, and the trade has to go through a third token. For example, buying MATIC for USDC on Uniswap requires first selling USDC for WETH, and then converting WETH to MATIC. We call such trade a triangular trade, since it can be visualized by a triangle:
That means double the fee, double the slippage and double the gas. Not very efficient, is it? In some cases, triangle is not even enough, and trades are executed in three or four steps.
At VirtuSwap, we are doing a lot of research on DEX activity. We have created a dataset that currently contains detailed information about swaps on Uniswap V2 and V3, Curve and protocols that use forks of Uniswap V2 or V3 pools, such as SushiSwap, as well as trades originating from aggregators such as 1Inch, ParaSwap, 0x and others. We will be sharing more about our methodology at a later time, for now let’s look at some initial insights. The subsequent analysis is based on Uniswap V2 and V3 and its clones running on Ethereum blockchain.
How big is the phenomenon of indirect trades?
Our data shows that over the last 12 months (June 2021-June 2022), indirect trades accounted for over 24% of the total trade volume. The monthly chart is shown on Fig. 2 below.
However, that’s only part of the story. A large amount of trades on DEXes is performed by MEV bots — highly efficient trading machines lurking the DeFi world for opportunities of arbitrage. If you want to learn more about MEV bots, we recommend this article by Stefan Stankovic as a great starting point.
While MEV Bots are an essential part of the ecosystem, we really care more about the other players — regular human traders, investors and speculators. Removing MEV bot trades from analysis yields an average figure of staggering 37% over the past 12 months. Moreover, we can see that the percentage of indirect trades was steadily growing in the past 4 months.
Clearly, the volume of an indirect trade includes all the intermediate steps, and therefore it is two or more times larger than the volume the trader actually intended to swap . For example, swapping 100 USDC to 100 MATIC (for simplicity, I assume the price being close to $1) would generate a total volume equivalent to $200: $100 in USDC -> WETH, and another $100 in WETH->MATIC.
The chart below shows the monthly breakdown of the intended trade volumes between direct and indirect trades, and the percentage of indirect trades in that volume.
So, looking at May 2022, indirect trading volume of slightly over $7B reflects actual intended trade volume of less than $3.5B.
The additional billions in intermediary trade volume generate redundant fees of $106M in the past 12 months. In addition, the intermediary trades resulted in redundant price impact totaling over $294M, and gas costs of over $90M. The monthly breakdown of all the redundant costs is shown below.
While the redundant fees hurt traders, at least they go to LPs and stay in the pools. The price impact losses however are captured by arbitrageurs, essentially being taken out from the system and draining it of liquidity.
Thus, absence of direct liquidity for every intended pair results in this tremendous amount of waste, hurting the tradability of almost every coin outside the top 5.
It’s time someone addresses that, and that’s exactly what we are building. Stay tuned to learn more.
About VirtuSwap
VirtuSwap is a new kind of DEX with unrivaled efficiency.
VirtuSwap team is comprised of finance professors and crypto veterans, and backed by industry heavyweights.
We are on a mission to make DEXes dominate the crypto trading landscape, and we are accomplishing it through research, financial engineering and data science.
