Decentralized Exchanges (DEXs) have gained immense popularity and are considered to be the foundational layer of DeFi. Many blockchain experts believe that the market share of decentralized exchanges would increase significantly in the future. Infact many established centralized crypto exchanges are also currently working on a decentralized version of their applications due to the growing demand of DEXs. In this paper, we take a look at the characteristics of the different types of crypto exchanges and where they stand in terms of numbers at present. The scope is limited to DEXes on Ethereum blockchain.
Centralized exchanges (CEXs) as the name suggests have a centralized way of operations in which users store their crypto assets on the exchange (a central entity). The wallet is centralized, is controlled by the exchange and beyond the user’s control. This creates a central point of failure because the private keys' ownership rests with the exchange. There is a risk of total loss of users’ funds in case the exchange is compromised. Cases of this kind are rare but have occurred with losses in the millions.
Another issue with centralized exchanges is that they are under the control of regulators, third-party providers, and legal regulations. This could mean that regulators can exercise control over CEX and even have them shut them down. Further, to prevent money laundering, operators are required to collect extensive data about their customers (KYC) by regulators. This is contrary to the basic idea of blockchains and anonymity. On the good side, CEX are known for their relatively better user experience, multiple trading features and interoperability to allow trade of tokens from across all blockchains.
In the case of Decentralized exchanges (DEXs) users truly have complete ownership of their assets. In the case of DEXs, users need not trust a centralized authority but instead do their trades on a decentralized protocol. While CEX users have no control over their private keys, a DEX does not have an integrated hot wallet, and the private keys remain in possession of the users at all times. With DEXs, users not only fully control their assets, but also get unprecedented levels of security, and do not need to go through KYC procedures.
A DEX offers the core trading function of a CEX through order books or Automated Market Maker (AMM). The difference to centralized exchanges is that all these functions are highly secured due to the decentralized nature resulting in no single point of failure. This is because a DEX is not based on internal servers or its own IT infrastructure but resides as decentralized application (Dapp) on a blockchain.
Users of DEX use these exchanges also because they offer anonymity as no user data is needed for trading. Only a public address is required to trade on a DEX. There are no authorities or financial regulators monitoring or imposing regulations on the exchange that is a decentralized application.
The volume of orders and transactions on CEXs is significantly higher than on DEXs as can be seen from Figure 1 and 2 below. Figure 1 shows the trade volume of Uniswap with respect to two of the biggest centralized exchanges Binance and Coinbase. Figure 2 shows the total trade volume as percentage of total crypto trade volume.
As per our research, following reasons could be potentially responsible for the low volumes of DEX in comparison to CEX:
One of the most popular metrics used in DeFi is the TVL (Total Value Locked). TVL or Gross Value Locked shows the total amount of assets locked in various DeFi applications. It represents the total value in USD of all ERC-20 tokens and ETH locked in a protocol's smart contracts. To avoid double counting, Net Value Locked excludes assets that are double-counted in multiple protocols. It's important to note that the term “locked” does not necessarily mean that assets are locked for any specific time, but that assets are simply “secured” in the protocols’ smart contracts. TVL is a good indicator of signaling how much capital is actually in “use” in a particular protocol.
Figure 3 shows the Total or Gross and Net Value Locked in the entire DEX space. We can see a considerable rise in the TVL this year, going from $20B to $80B approx. This shows a rise of 400% in TVL year to date which is significant and implies increasing user adoption.
Figure 4 shows the distribution of TVL across various DEXs. We can see that at present Curve appears to be the clear leader with a TVL of more than $10B, followed by Uniswap v2 (TVL $5B approx.) and Sushiswap (TVL $4B approx.).This implies that Liquidity Providers (LPs) are preferring to provide liquidity in stable token pair pools possibly to avoid impermanent loss. This could potentially indicate a problem in the future for DEXs relying on multi-pair pools such as Uniswap as they may face liquidity crunch.
Figure 5 shows the volume of trades in terms of USD on various decentralized exchanges. We can see on average the total volume on all DEXs appears to be around $60B monthly. At present, Uniswap V3 has the most trading activity followed by Uniswap V2 and Sushiswap. This is potentially because Uniswap offers a wide variety of crypto trading pairs and pools and is one of the pioneers in this space. The interesting thing to note is that while most of the traders are preferring multipair pool AMMs, the LPs as indicated by Figure 4 are preferring the stable pair pool AMM (Curve). This shows that DEX protocols need to address the requirements of both LPs and traders to ensure consistent supply and demand, because if supply stays on one protocol whereas demand is on another protocol, this would lead to inefficient market conditions.
Figure 6 shows the percentage market share of DEXs with respect to trading volume. Uniswap V3 since its launch in Apr 2021, seems to have become the preferred exchange for traders with a market share of 50% followed by Uniswap V2 (19%) and Sushiswap (16%) approx as of Sep, 2021.
DEX aggregators connect to many DEX protocols and offer users best prices. The need for aggregators stems from the inefficiency in manually checking for the best trading prices on all the DEXs such as Uniswap, Curve and others before placing a trade. DEX aggregators work by searching other DEXs for the best trading price and instantly delivering an optimized trade.
Figure 7 shows the volume of DEX aggregators in USD. On average DEX aggregators have performed trades worth approx. $12B monthly which is about 20% of the monthly trading volume of DEXs as shown in Figure 5. The leading aggregator is 1inch followed by 0xAPI.
It is important to highlight that by offering a better trade to users, aggregators can potentially facilitate user adoption of DEXs. However, aggregators themselves are largely dependent on the efficiency of DEXs and their systems.
Fee generation is the primary earning model of any DEX. Fees charged on every trade varies from exchange to exchange ranging from 0.04% to 1%. Major portion of the fee is distributed among the LPs whereas a small amount is kept by the DEX. As of Sep 2021, Uniswap has crossed $1 Billion in fee generation while Sushiswap has generated $360M in fees approximately.
DEXs are seeing increasing user demand and Ethereum is currently the leading base layer blockchain for these users, thus seeing a considerable increase in transaction gas costs as a result. However, without additional scaling solutions, the increasing costs are and will continue to impede trading activity.
Figure 8 shows the trend of Tx costs on Ethereum. On average it costs approx. $5 to perform a trade on Ethereum. The implication of this is that small size trades on DEXs are currently prohibitively expensive. However, for trades of larger size, these transaction costs can be justified and are still on par with centralized exchanges. This indicates that DEXs are more suited for large scale traders or institutional trading at present. It also shows that scaling solutions are crucial for DEXS in order for them to become leading exchanges for both retail as well as institutional traders.
Given that DEXs have grown considerably in terms of volume and adoption in the last year, it is likely that they will continue to capture more of the target market in the coming years. Since passive income can be earned from supplying liquidity to these exchanges, it’s likely that more and more users will realize the benefits of using DEXs. However, in order to become truly competitive to CEXs and overtake them, DEXs need to resolve certain issues such as scalability and gas costs. The release of ETH 2.0 and other L2 solutions are crucial to resolving issues related to scalability, high costs and transaction speed. DEXs also need to find ways to address interoperability across blockchains and accessibility to fiat transfers. Educating users and better marketing efforts are also needed to drive user adoption.
Though it seems that centralized and decentralized exchanges will continue to co-exist for a while given their own unique advantages, in the long run switching to decentralized exchanges seems like a necessity in order to fully utilize the composability of the DeFi ecosystem and the ethos of blockchain.
Also Read: DeFi Lending - A Primer