DeFi Whitepaper #2: Are Decentralized Exchanges eating their centralized equivalents?
A Decentralized Exchange, or DEX, is an application that runs through smart contracts (self-executing code that we write about here) operating entirely on a blockchain and is used to swap one token for another. Since 2020 DEX’s have transacted over a trillion dollars in transactions and are amongst some of the most utilized applications in DeFi, representing 4 of the top 10 DeFi applications as measured by total assets in January 2023.
Many TradFi companies recognize the vast opportunity and have set up substantial operations in DEX trading, notably Jump Trading, DRW, and Citadel. DEXs also represent some of the largest investments by VCs into DeFi, with Uniswap reaching unicorn status when it raised USD 165M at a valuation of USD 1.66B in Q4 2022.
Volume Comparison
Comparing volumes across exchanges, both centralized (CEX) and DEX, we can see that whilst DEX volumes have increased a lot in absolute terms since 2020, they still represent a small fraction of the volume of their Centralized competitors. Binance alone holds over 60% of the total market share (as represented by volumes in Q4 2022).
The percentage of market share for DEX vs CEX appears to be somewhat stable, around 15%, even as DeFi adoption has grown and the overall market capitalization of crypto assets has oscillated.
Differences
One of the benefits of the ownership model of Web3 is that the underlying users of each application can be incentivized and rewarded for their use in the form of tokens. This has significant advantages in allowing DEXs to bootstrap users and grow quickly, ensuring competition between DEXs.
Like other Web3 and DeFi applications, DEXs require no password sign-in and KYC compliance checks. Instead, you need to connect your private wallet, which differs from CEXs that require stringent anti-money laundering checks.
There are also several key differences to highlight, notably transparency, custody, and market microstructure:
Transparency and Custody
When one purchases a specific cryptocurrency on a Centralized Exchange (CEX) such as Binance, Coinbase, Kraken, and more, tokens from many users are held together in centralized wallets controlled by the exchange and moved on an internal ledger from one account to another on a centralized database to reflect the trade.
Participants on Centralized Exchanges have to trust that said exchange holds all of the tokens they have deposited and traded and not lent them out or withdrawn from the exchange to engage in other activities. If the amount of tokens held is less than the total amount deposited, then there is a risk of a run on the exchange, causing insolvency. This notably occurred with the Exchange FTX in 2022.
DEXs offer open transparency; verifiable smart contracts visible on the blockchain display how many tokens are held and in which assets. When a transaction is made, a user's private wallet is automatically credited with the new tokens arising from the transaction.
As the saying goes, “Not your keys [private wallet], not your coins.”
Market Microstructure
Just as with traditional finance, on a Cryptocurrency CEX, trades are most commonly made on Central Limit Order Books (CLOBs), where participants place orders representing the levels where they would like to buy and sell. A trade occurs when a buyer and seller match an agreed price.
Running a CLOB system on a public blockchain is less efficient, as there would be constant gas fees and lags in orders sent depending on the network status and time to process each block. However, some protocols have worked around this by building sidechains or operating a hybrid structure where only some data is placed on the blockchain.
However, the largest DEXs, such as Uniswap, PancakeSwap, and SushiSwap operate differently using liquidity pools. These pools contain 2 (or sometimes more) tokens, e.g., ETH (Ethereum) and USDC (A US Dollar Stable Coin), making a ETHUSDC pair and allowing anyone holding ETH or USDC to deposit and withdraw from the pool subject to the smart contract rules. This is known as an automated market maker (AMM).
Typically, these pools have used the constant product formula, x*y= k, where x and y are the quantities of the two tokens, e.g., ETH and USDC.
To withdraw some amount of the ETH token, a participant must deposit a proportional amount of token USDC to maintain the constant k (before fees).
Importantly the AMM itself does not update the price. Instead, the market price only moves as the ratio of tokens in the pool changes, where arbitrageurs are incentivized to keep the price in line with other markets.
Holders of the tokens that provide liquidity to the pool also earn a return, or yield, on their assets due to the trading fees generated. However, they are susceptible to imbalances caused by movements in the divergence of the prices of the underlying assets in what is called “Impermanent Loss”. (For a complete guide about understanding AMMs, we highly recommend https://research.paradigm.xyz/amm-price-impact).
There are some general iterations around this basic model of AMMs:
- Different weights of the two assets (i.e., not keeping them equally balanced) as seen on Balancer
- Concentrated liquidity around specific price limit areas. Uniswap V3.
- More than two assets that are highly correlated to each other, Curve — the main DEX for stablecoin transactions
Areas of opportunity
The most significant area of opportunity for DEXs exists in the derivatives market:
In TradFi, derivatives dominate. The Bank for International Settlements (BIS) estimated that for the second half of 2021, the total notional amounts outstanding for contracts in the derivatives market was USD 600 trillion, dwarfing the cash equivalents. This is because the leverage built into the underlying contracts allows a more capital-efficient way to trade a security.
In Cryptocurrencies, this is inverted. Derivatives are still a tiny portion of the overall market. Yet futures and other types of derivatives contracts can also be coded into and carried out by smart contracts, and several applications such as DyDx and GMX cater to this. As a result, we expect further DEX Derivative platforms to be built and to gain further adoption in the quarters and years ahead, with DeFi following the market structure seen in TradFi.
DeFi is still in a nascent stage, and whilst DEXs are at the forefront of adoption, there are still hurdles to be overcome to grow the overall pie and also capture market share vs CEXs:
- Improvements in blockchain technology to allow a fully on-chain scalable CLOB for spot market
- Wider DeFi and Crypto adoption, in conjunction with enhanced security against smart contract hacks and exploits
- Familiarity with the difference in capital efficiency with an AMM model of exchange
- Regulatory clarity around trading and trading with leverage
Sources:
https://dune.com/hagaetc/dex-metrics
https://research.paradigm.xyz/amm-price-impact
https://www.risk.net/definition/central-limit-order-book-clob
