Since the launch of the Ethereum network, there have been a lot of rumors inside the cryptocurrency industry about the imminent collapse of centralized exchanges and the full transition to decentralized exchanges (DEX). Listing.Help analysts share the answer to the question of whether this can happen.
What is DEX?
A decentralized exchange is an exchange that operates on a blockchain, does not store funds and personal data of users on its servers, and acts only as a platform for working with user orders to buy or sell assets. Trading on such platforms takes place directly between participants (peer-to-peer) without any financial intermediaries. The first decentralized exchanges appeared in 2014, but they managed to gain their slice of the pie only recently.
What’s the difference?
Most trading is performed on a centralized exchange where one platform holds customer funds, matches buyers to sellers and offers services to manage deposits and withdrawals.
But the centralized exchanges have some problems. They are located in certain geographic locations and subject to specific jurisdictions, require clients to open accounts, deposit their funds, set limits and restrictions on their clients’ actions, and are targeted by attackers.
Centralized exchanges are managed by a specific company or person who is focused on profits. Managers of exchanges are responsible for protecting user data and trading information, fully controlling the platform, and independently making decisions essential for the development of the project.
In contrast, decentralized exchanges are automatically or semi-automatically managed, with platform members involved in making important decisions (the DAO concept has been discussed in the latest article). Such platforms provide a technical possibility of direct interaction between the participants and use blockages for storage and processing of all data.
As a result, decentralized exchanges are ahead of the centralized ones in the fields of:
- safety: funds are never transferred to third parties, users trade directly from their wallets (for example, Uniswap exchange interacts with Metamask wallet);
- global: decentralized exchanges are still outside jurisdictions (or in a “legal loophole”), and there are no restrictions on who can interact with them;
- personal data security: no account registration or personal data is required to work with DEX.
However, decentralized exchanges still do not dominate the market, as they have problems:
- UX: trading on DEX is done through non-custodial wallets (funds on them are not transferred to third parties), with which many users are confused and repelled by their complexity;
- Speed and scalability: all transactions occur on a blockchain, so its performance limits them. (f.e. Ethereum’s throughput is 12–15 transactions per second).
- The number of trading pairs: only assets created on one blockchain can be traded between them on DEX. For example, it will be difficult to implement BTC-ETH pair trading on DEX because they are found on different blockchains (Bitcoin and Ethereum blockchains, respectively).
- Regulation: although DEX is designed to decentralize and relieve any regulators pressure, some hybrid models have experienced problems (e.g., EtherDelta and Qingdao). Increased attention and pressure from regulators may put barriers for the development of decentralized exchanges.
We can divide DEX into two main segments:
- How are orders settled?
DEX uses either the traditional model of the orderbook or the model of an automatic market maker (AMM).
The orderbook (for example, at Kyber exchange) matches bids of buyers and offers of sellers (here everything is quite similar to centralized exchanges).
AMM models compare each transaction with a pool of assets in a smart contract, where the price of the transaction is determined by the ratio of assets in the pool (f.e., Uniswap). This model does not require a specific counterparty in each transaction (the code of a smart contract executes transactions). This makes AMM models ideal for more illiquid tokens. As a concern, traders tend to suffer from higher slippage when trading significant amounts.
- Where are the orders made?
Trading within a DEX takes place either on-chain (usually Ethereum) or for more throughput on the sidechains (off-chain solution) at first, and then the state is verified on the main blockchain.
Today, almost all popular DEXs operate directly on the Ethereum blockchain, due to its significant developers’ activity, ecosystem and large community. Working through sidechains shows promising results. However, this often raises security and centralization issues.
The surge of popularity
Despite all the problems associated with the scalability and UX, DEX became a new trend and gained trading volume much in mid-2020.
According to The Block, the total trading volume on Decentralized Exchanges (DEX) was over $4.3 billion, much higher than in previous months.
Compared with June, the trading volume on DEX increased by 174%. Decentralized exchange Uniswap is leading by a wide margin — it accounted for 41% of the total trading volume. Curve and Balancer follow it in the top three by popularity.
The main thing from all this statistic is that the non-custodial Uniswap exchange surpassed Gemini, Poloniex, and Binance US in terms of trading volume, reaching one-third of Coinbase volume.
As a result, such an increase in trading volumes testifies to the growing popularity of DEX sites. The number of users of such exchanges is already comparable to the number of people trading on centralized platforms.
In our opinion, DEX problems are quite specific and can be overcome. They come down to issues with products and technologies and have clear ways to be resolved. Therefore, soon, we expect DEX to develop in the following directions:
- UX improvements: the most simple and clear services will significantly increase the number of users ready to trade on DEX;
- Interoperability: the ability to trade assets on different blockchains will expand the offer of trading pairs on DEX;
- Scalability: work to improve the performance of the blockchains, as well as their second level scalability solutions (sidechains, state channels, etc.) will significantly accelerate the work of DEX;
- Regulatory issues: on the one hand, if regulators start to press centralized exchanges, DEX may be the only option for a part of the market. On the other hand, if regulators start putting pressure on developers and DEX teams, these platforms may slow down;
- Use cases: thanks to DEX and related services, new derivatives (f.e. flash loans) and synthetic assets (collateralized stablecoins) can be created combined with other DeFi services to adopt a wide range of products.
How close are we to these changes? It is hard to say certainly, but given the long period of research, development, and improvement of the blockchain, Listing.Help’s analysts suggest that there are still a few years left before the full DEX revolution.