DEX Aggregation: Closing the Gap Between Centralised and Decentralised Market Making
✍️ Author: Mr Rhomboid
Think about the most successful companies today, and names such as Amazon, Google, and Airbnb pop up. These companies leave every competition behind, yet they do not “own” the products or services they provide.
Amazon does not own the provided retail supply.
Google does not own the provided websites.
Airbnb does not own the provided real estate.
Ben Thompson explained the phenomenon of “aggregation theory” in detail in his 2015 post. In a world where aggregators don’t exist, every end-user needs to browse through different hotels, websites, or retail stores. Companies aggregating these resources for the end-user, ultimately leads to productivity gain — both for the supplier and the end-user.
Similarly, in decentralised market making, protocols “aggregating” liquidity sources for traders into one simple UI leads to productivity gain for both liquidity suppliers and the end-user.
With market making in crypto, CEXs currently are winning. They are winning because they provide a better trading experience than decentralised counterparts. Although centralised entities clearly have risks, traders seemingly are willing to take this risk in return for the better trading experience.
DEX aggregators are aiming to close the gap between centralised and decentralised market making by perfecting UX, resulting in the end-user profiting from an optimal trading experience, only this time in a decentralised manner.
Key Aspects of Aggregators
According to a 2020 survey, below we outlined the main reasons why Amazon is the preferred option of choice for retail end users:
- Fast and free shipping, e.g. transaction convenience
- Broad selection of goods, e.g. “They sell everything I need”
- Best pricing
Similarly, we can measure the value of a DEX aggregator as follows:
- Fast trading execution, e.g. trading convenience
- Broad selection of tokens, e.g. multi-token exposure
- Best pricing
Note that these numbers are ordered according to importance. As we shall see for example, while low trading quotations are important, trading convenience is perceived at least as important.
Market share of CEXs, DEXs & DEX aggregators
The statistics below offer some basic insight into the performance of CEXs, DEXs and DEX aggregators.
Comments regarding the statistics are:
- Data is obtained from theblockcrypto.com
- No difference is made between bot and non-bot trading activity
- No difference is made between whale and non-whale activity
- Data is obtained as of February 2022
In this article we aim to provide a general overview of volume division in crypto exchanges, insignificant details will as such be excluded.
‘DEX to CEX spot trading volume’ — DEXs capturing 11% of spot trading volume in comparison with CEXs, with September 2020 being a peak in DEX trading volume, climbing up to 18%. Although volatility is shown between DEX and CEX spot trading volume division, market share of DEXs is making a slow but steady upward trend since November 2020.
‘Aggregator share of DEX volume’ — DEX aggregator trading volume is accounting for $12 billion, while total DEX volume is accounting for $90 billion, concluding that DEX aggregation volume takes up to 13% of DEX volume. When looking at past performance, DEX aggregator market share in comparison with DEXs is swinging back and forth between 10 to 15%.
‘Share of DEX volume’ — Uniswap capturing 70% of DEX volume (Uniswap v2 and v3 combined), with its closest competitors being Curve and Sushiswap on the Ethereum chain. Serum DEX is leading on Solana, while Pancake is leading on BNB Smart Chain.
‘DEX aggregator market share” — 1inch capturing 60% of market share, with its two closest competitors being Matcha (25% market share) and Metamask (7% market share).
According to the statistics above, key takeaways are as follows:
An uneven distribution (e.g. power law distribution) is noticed between CEXs, DEXs and DEX aggregators, more specifically:
- CEXs capturing 10–20% of the spot trading market share;
- DEX aggregator market share in comparison with DEXs swinging back and forth between 10–15%;
- Uniswap capturing 70% of Ethereum market share in comparison with other DEXs;
- 1inch being the most dominant Ethereum DEX aggregator, capturing 60% of market share.
Notes:
Since September 2020, Metamask offers a native swapping feature that gets quotes from multiple DEX aggregators, offering users the best execution prices on-chain. Metamask, by this move, became an aggregator of aggregators — or a “meta” aggregator (credits to Delphi Digital).
Metamask charged a fee of 0.875% factored into each quote — which is exorbitant by defi standards — resulted in plus $ 300 million revenue as of March 2022. Note that the customer acquisition cost of Metamask is close to zero, leading to virtually zero costs in relation to revenue. Hence, the power of aggregation: Metamask — being the most popular Ethereum wallet — aggregating liquidity resources to its exorbitant user base, ultimately leading to exorbitant profits.
On one hand this proves that swapping fees — although important — may not be the most important element in the equation when traders decide where to execute the swap (similarly to Amazon, where they often offer good prices, but not always the best prices).
On the other hand, the question remains if Metamask can aggregate liquidity to millions of users with such a business model, ranging to a similar scale of popular CEXs and DEXs. As a comparison, Binance is charging a 0.1% fee per transaction, while Uniswap fees are ranging between 0.01% — 1%.
In addition, a greater presence of whales is noticed in volume share on DEX aggregators in comparison with whale presence on Metamask. We used statistics presented by IOSG to verify this.
Closing the Gap
At the beginning of this article, we outlined the key aspects of aggregators — Amazon taken as a real-world comparison — these being: fast and convenient trading execution, multi-token exposure, and decent pricing.
Subjectively taken, the more decentralised exchanges improve these three aspects, the better the trading experience for the end-user, and the higher the possibility of DEXs catching up with CEXs.
Below we shall expand upon these aspects, together with recent improvements we are watching.
Fast and Convenient Trading Execution
1inch being the leader of DEX aggregation (as of February 2022), we can observe how the protocol aims to make constant improvements in order to provide better trading execution.
In order to improve trading execution, we must first verify which elements are worsening trading execution, leading to some well known hurdles in decentralised finance, including but not limited to:
- Frontrunning, leading to slippage where quotation differs from execution
- Failed transactions, leading to frustrations on time-sensitive swaps
- Erroneous display of token prices
1inch aims to solve frontrunning attacks by implementing virtual rates. After performing a swap, the swap rate changes only for further swaps in the same direction. If however one intends to perform a swap in the opposite direction following such a trade, the rate gets “virtually” adjusted for some period of time, as such that the execution conditions are matching the previous swap. As a result, this prevents front-runners from performing a “sandwich-attack,” eventually resulting in higher price accuracy.
An improvement 1inch offers in order to reduce failed transactions, are partial and dynamic fill mechanisms. After submitting a swap, 1inch aggregates liquidity across different resources. If rates on a protocol change unfavourably, that particle branch of the route can be cancelled, and only the favourable branches get fulfilled (e.g. the order gets partially filled).
Furthermore, dynamic fills allow amounts of unfavourable branches to be distributed across favourable branches, resulting in the swap being able to be fully completed at the advertised quotation.
1inch’s spot price aggregator arose as not all tokens listed by 1inch were supported by existing price information services. Their spot price aggregator tool consists of smart contracts that communicate directly with DEXs, in order to receive a token’s liquidity-weighted spot price. As the spot price aggregator supports multiple DEXs, it therefore displays all tokens traded on those DEXs, resulting in a more accurate pricing display of listed tokens.
Other features 1inch is offering are zero-fee limit orders, meaning the trade gets executed when the market reaches a predetermined price — typically used by a more advanced spectrum of traders. How this works is as follows: the user places a limit order, 1inch adds the order to its centralised database, and these orders can then be filled by other users (including CEXs and the orders created by Pathfinder protocol). Takers of limit order cover the gas costs in addition to the trade’s value, making it a “zero-fee” order for the user.
The functionality of limit orders opens up many benefits in decentralised market making, such as:
- Stop loss orders, which automatically close when the price reaches a certain limit
- Trailing stop orders, where the limit “trails” the market price by a fixed amount when rising, while the price is remaining unchanged when it drops
- Auctions, where the price is set according to the best bids for a specific order size
On top of that, version 2 of the limit order which 1inch is offering, facilitates gasless limit orders for ETH, enabling users with zero ETH balances to swap tokens, lowering the entry-barrier for new users, facilitating adoption of decentralised exchanges.
It’s clear that 1inch is producing major efforts by improving UX to capture market share from CEXs. However, a key but nevertheless essential element which will facilitate mainstream DEX adoption, is the possibility of frictionless cross-chain swaps, which 1inch does not offer at the moment.
Multi Token Exposure
A main reason why people order on Amazon is simple: they aggregate the widest array of goods. As a result, multi token exposure is a highly important element in terms of aggregation. In a world where many chains and tokens exist, traders naturally want to be able to trade these assets across chains, resulting in tremendous opportunities for DEX aggregators who provide frictionless cross-chain token swaps.
A protocol in this field we are watching is THORSwap.
Making cross-chain native L1 swaps possible already, THORSwap will add Aggregation in multiple phases as outlined— more specifically, phases V1 until V5 — and it will cover nearly all the cross-chain liquidity after full execution. Phase V1 — supporting swaps between Ethereum long-tail assets and native assets on THORChain — is done and has been audited by Peckshield.
Phase V2 is soon to be released, supporting the following improvements:
- Terra aggregator with Astroport and Terraswap aggregation, THORSwap functioning as the first aggregator on the Terra ecosystem.
- Single-sided staking with vTHOR token, where 75% of protocol revenue is distributed to vTHOR holders. This will happen in the form of ‘Buy-back & distribute,’ where fees will be used to buy THOR on-market, create buying pressure on the token and distribute (pro-rata) to vTHOR holders.
- New V2 interface providing improved UX for cross-chain trading.
THORSwap has been discussed in detail in our previous post, which can be found here.
The rise of alternate L1s has opened up a new dimension of growth in the DEX aggregator space. Metcalfe’s law states that the value of a network is proportional to the square of the number of connected users of the system. The first protocol that’s able to connect users of different blockchains in one simple interface will benefit from a tremendous value capture.
Decent Pricing
A third important element in aggregation is decent pricing. Note that decent pricing does not necessarily mean best pricing, as again: Amazon does not always offer best prices, yet they’re able to capture the whole retail market because of their huge moat (as we notice with Metamask too). But still, pricing is critical, and protocols offering the best prices will likely benefit from an expanding user base. Uniswap is an example:
After implementing the smart order router, Uniswap started to execute trades across different pools in order to provide users with the best price possible. Viewing the statistics below, Uniswap accounting for 60% of volume routed through 1inch, we can conclude that users would lose value 40% of the time when interacting with Uniswap directly instead of using a DEX aggregator.
Additionally, as most smart order routing mechanisms of aggregators do not include MEV-generated slippage in their calculations, when upgrading this smart order logic, we may experience lots of volume being exported to slippage-free, alternate liquidity sources.
Alternative liquidity sources may include Requests for Quote (RFQs). Especially when combined with cheaper chains and rollups, RFQs may be able to quote more aggressively because of faster block finality, less slippage, and lower gas, causing DEX liquidity losing ground.
Chainflip takes this approach one step further with JIT AMM. The incentive behind JIT AMM is to flip front-running on its head, incentivising professional market makers to front-run each other in order to provide the best prices for the end-user.
In traditional liquidity provision, every liquidity provider benefits from accomplished trades as long as the trade happens within its liquidity pool. Uniswap v3 took this one step further with concentrated liquidity, incentivising more active liquidity provision.
JIT AMM expands on Uniswap v3, as only the market maker who aggregates the best pricing execution for the end-user, benefits from the trading fee. Whether aggregation happens through CEXs, OTC desks or derivatives markets does not matter — only price execution counts.
The downside of this approach is that the protocol cannot guarantee execution prices beforehand, as the protocol does not know which pricing conditions the winning market maker has to offer. However, prediction models on user front ends will inform users about the likely outcome of their trades.
Protocols providing solutions to make gas fees less of a problem, together with the aggregation of new liquidity resources, are expected to strengthen the position of aggregators as critical pieces in on-chain trading.
The Value Capture of DEX Aggregation
The on-chain spectrum is getting more and more complex, resulting in a bigger need for aggregation, removing complexity for the end-user.
In a scenario where DEX aggregation wins in popularity, it’s likely that a DEX customer is not the trader who never interacts with the DEX itself, but rather the liquidity provider. Thus, in order to win market share for these DEXs, they must focus solely on owning their supply-side. For DEXs to own their supply side, a race to the bottom between primary liquidity sources is likely.
For the aggregation layer, UX and creating a loyal user base is all that matters. As noticed with Metamask, once this moat is built, users sometimes seem to be willing to pay the extra fee for convenience.
Moreover, more scalability solutions and a decrease in gas costs, will allow aggregators to split between various liquidity sources at a negligible cost, further enhancing UX for the end-user.
In terms of value capture for DEX aggregators, let’s make a quick calculation, considering the data as of February 2022:
- Monthly CEX volume: $757b (89% of total spot trading volume)
- Monthly DEX volume: $90b (11% of total spot trading volume)
- Monthly DEX aggregator volume: $12b (13% of total DEX volume)
Consider the next 4 scenarios playing out:
- Scenario 1: DEX aggregators catching 20% of DEX spot trading volume instead of 13%.
- Scenario 2: DEX aggregators catching 100% of DEX spot trading volume, assuming that overtime DEX aggregators become the preferred option of choice for traders.
- Scenario 3: DEX aggregators catching 20% of the entire spot-trading market, assuming a proper power law division, with 80% of spot trading volume still controlled by CEXs.
- Scenario 4: DEX aggregators catching 50% of the entire spot-trading market, meaning an equal division of centralised and decentralised market making.
Looking at the rate of progress DEX aggregators made lately, scenario 1 is a cautious prediction, especially considering protocols aggregating increasingly cheaper liquidity resources overtime. DEX aggregators catching 20% of DEX volume would mean a monthly volume of $18b and an increase of 150% for the DEX aggregator space.
Scenario 2, in the long run arguably more probable of playing out, would mean that the aggregation layer would be the preferred option for spot trading. This would mean a monthly volume of $90b for DEX aggregators, resulting in a 750% increase.
Scenario 3 assumes that CEXs lose ground, with an exact power law division of 80/20, DEX aggregators catching 20% of spot trading volume. Not impossible as we saw a nearly similar division playing out in summer 2020, with DEX to CEX volume being 18%. For DEX aggregators this would mean an increase of 1412% together with a monthly spot trading volume of $169b.
Lastly, considering scenario 4, we would see decentralised market making flourish at the same level as centralised market making. This would mean that DEXs offer the same (if not a better) trading experience than centralised counterparts. This scenario playing out, would result in a $424b monthly trading volume, a 3529% increase of the DEX aggregator space.
As a side-note, bear in mind that these volumes do not take into account spot trading volume during and after a next secular bull market.
To conclude with, in order to offer the same trading experience as CEXs, frictionless cross-chain swaps are an absolute necessity for DEX aggregators. Furthermore, convenient trading and low fees are likely to be essential elements to attract consumers too. As soon as DEX aggregators offer a similar (if not a better) trading experience in comparison with CEXs, combined with the benefits of decentralisation, then there’s a bright future ahead.
After all, in the new era of trading, the end-user and not the distributor, is king.
Disclosures:
This article has not been sponsored by any of the protocols mentioned. It has been published for informational purposes only and is not investment advice, thus should not be solely relied upon to make investment decisions. Members of 0xVentures have invested in THORSwap. This statement is intended to disclose any conflict of interest and is not a recommendation to purchase any of the mentioned tokens. Where relevant, direct quotes & passages have been taken from the sources cited. The information within the report is current as of 22 March 2022.
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