DEXs in the spotlight

Major financial specialists are watching the evolution of DeFi and the projects that adopted it. Prominent cryptocurrency exchanges around the globe have opened their doors broad to the new evolution, adding multiple tokens to support the growth of DeFi today. And Decentralized exchanges (DEX) have been a structural development in the decentralized finance (DeFi) industry these last few months.

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DEXs come in a variety of forms, but share one common quality: non-custodial. DEXs use smart contracts to manage funds on-chain, so users never have to trust a third party with their money. Funds are traded in a direct peer-to-peer (P2P) manner via automation without any form of central authority. DEXs have the advantage of being trustless, meaning that users do not need to trust the exchange or a third party to hold their funds, as users retain custody of their own funds until the trade occurs. They are also highly private, as users do not need to disclose their personal details to trade.

Decentralized exchanges recorded an incredible performance in the past quarter. DEXs that were trading in the single-digit millions at the start of the year managed to surpass $1 billion in a single day.

The protocol Uniswap accounted for more than 90 percent of all DEXs volume last quarter, up 60 percent from the start of the quarter and 20 percent from the beginning of the year. Most users gravitated towards DEXs rather than centralized exchanges, as they enabled a faster and more streamlined way to interact with DeFi. Uniswap has a total of $2.79 billion of value locked into the protocol as of November 6, 2020, increasing from around $12 million at the beginning of the year. This amount not only shows a skyrocketing increase but also makes Uniswap the top decentralized application (DApp) available in the world, holding an impressive 24.15% of the total DeFi market.

The last quarter saw a huge increase in the use of automated market makers (AMMs) and liquidity pools. The AMM design is a creative response to the limits of hosting an order book on-chain. Liquidity pools are alternatives to order books for representing liquidity on these platforms.

In finance, order books are used to derive asset prices or match buyers to sellers. But order books have been largely avoided by DeFi products as public networks have proven to be too slow and too costly to support them, necessitating intermediary infrastructures.

An AMM is a type of DEX protocol that relies on a mathematical formula to price assets. Traditional market making usually works with firms with vast resources and complex strategies. Market makers help you get a good price and tight bid-ask spread on an order book exchange. Automated market makers decentralize the process and let essentially anyone create a market on a blockchain.

AMMs have played an important role in DEX development, addressing key performance issues by removing the order book altogether, and pricing assets using a static, on-chain function. However, there are several downsides to automated market makers (AMMs). Notably, liquidity cannot be provided unilaterally and must be provided for both sides of an exchange. Also, prices cannot be set, only the current market price is an option which can lead to slippage.

New projects have recently appeared to propose new approaches, specifically regarding the ability to decentralize order books. Protocols like Serum or Injective have developed order relays with on-chain settlements. These are decentralized, censorship-resistant order books storing and relaying orders for spot and derivatives trades. This new order book methodology could invalidate the misconception that order books cannot occur efficiently or effectively on the blockchain. This is quite a programmatic achievement, as order books are some of the most computationally intensive tools on the blockchain.

However, at its core, trade matching and execution is a problem of consensus to determine who came first, which trades should be executed, and in which order. A decentralized network, which by design has to come to consensus across a number of different nodes, can hardly compete at the same level as their centralized counterparts.

Other hybridized models (like IDEX 2.0) aim to combine the power and performance of a centralized exchange, with the security of decentralized custody and settlement. By pairing the high-performance trading engine of a centralized exchange with the on-chain custody of a DEX, users can get the same trading experience they know and love without having to put their funds at risk.

But there are still quite a few types of DEXs, making it difficult to discern which protocol is the best. And with these, new scams, exit schemes, and frauds appear. The ease of listing DeFi tokens on DEXs, which require no listing fees or centralized review processes, have led to an increase in malicious actors targeting gullible investors with attractive token schemes.

New research suggests that DEXs themselves might be lagging behind in terms of security and safety features, with a majority being flagged on an independent audit published by crypto-security firm Hacken. The DEX ratings show that the DeFi market, despite its popularity and coming-of-age, leaves much to desire from the standpoint of competing with centralized exchanges.

The DEX hype cycle

In the second half of October, DEXs saw the worst week in terms of trading volume since August. Weekly volume dropped from the $8 billion record in the first week of September to roughly $3 billion from Oct. 19–25. Uniswap is still leading the pack with a 56% market share of all DEX trading volume.

DEX volume is highly correlated with the DeFi market in general. This market is now returning to a more rational level, thus lowering DEX trading volume. When the market cools down a little, DeFi yields are adjusted accordingly to reflect market consolidation in a healthy way.

However, the amount of money still staked in DeFi smart contracts has not vanished alongside the decline of trading activity on decentralized exchanges. On Uniswap, where users staked assets to facilitate token swaps, liquidity has increased from about $1 billion in the middle of September to about $3 billion recently. And the amount of money invested in DeFi smart contracts is also on the rise, with around $13.5 billion in Total Value Locked.

Source: Uniswap, November 2020

Source: DeFi Pulse, November 2020

But the hype around decentralized finance recedes, and Bitcoin is coming back in the spotlight in the meantime. Bitcoin price has soared roughly 24% since the start of October, with multiple high profile bets being made by corporate giants like Square and Paypal.

With investors shifting their focus back to Bitcoin, some wonder what the future holds for decentralized assets. The total value locked in DeFi has remained high, but this may change due to the reduced trading volumes on exchanges.

Since a significant part of rewards on DeFi protocols is linked with trading volumes, lower volumes could lead to lower yields for liquidity providers and further diminish investor’s interest in DeFi. However, from a fundamental perspective, nothing has damaged the story of DeFi and DEX growth.

New projects keep being developed on a recurring basis. Evolution in DEXs has come closer to delivering a product capable of both performance and security. The future could see DEXs challenge centralized exchanges by finally separating the custody from the exchange altogether.


Report finds majority of DeFi exchanges have poor security - CryptoGibraltar ; Oct 30, 2020 [1]

Declining DEX volumes reflect DeFi investors shift to Bitcoin, data shows - Cointelegraph ; Oct 29, 2020 [2]

Decentralized Exchanges From A DeFi Perspective: A Comparison - Hackernoon ; Oct 27, 2020 [3]

Ethereum DEX Volumes Fall Off Cliff as DeFi Incentives Dry Up - Decrypt ; Oct 23, 2020 [4]

Rampant DeFi speculation makes DEXs the undisputed winners of Q3 2020 - Cryptoslate ; Oct 21, 2020 [5]

What Is an Automated Market Maker (AMM)? - Binance academy ; Oct 8, 2020 [6]

CEXs vs. DEXs: The Future Battle Lines - Coindesk ; Oct 4, 2020 [7]