Decentralized Exchanges (DEXs) have undergone a significant evolution since the debut of NXT Asset Exchange, one of the pioneer DEXs to launch in 2014. At the time, using decentralized platforms for exchanging tokens was quite complicated and may in hindsight even have been a little ahead of its time.
The perception towards DEXs greatly changed with Uniswap’s Automated Market Making (AMM) genius, in 2018, which would later set the standard for most DEXs that exist today.
Automated Market Makers
The Automated Market Makers (AMM) model was born out of the idea of automating the entire market-making operation of digital asset exchanges. Unlike their centralized order book counterparts, which require users to list a buy and sell order for each token pair respectively; the AMM model leverages a smart contract-powered price algorithm that defines prices mathematically based on the forces of demand and supply for each given pair. In return, liquidity providers are rewarded with a small portion of the transaction fee, which in most cases is paid out in the form of a native token.
This groundbreaking market-making protocol has since given birth to a number of interesting developments in the DEX space.
DEX 4-year market performance
At the time of writing, the top 100 DEXs combined have an average of $5 Billion daily trade volume. Also, the block’s on-chain DEX data, tracking 21 of the most used DEX, shows an impressive growth trajectory. From just about $859 Million in trade volume in April of 2020, the DEX volume reached an all-time high of 200+ Billion dollars in trade volume in only 15 months.
As evident, the average monthly volumes of DEXs have been on a downtrend this year following the effects of the ongoing bear market. For instance, Uniswap, which is currently the largest DEX, recorded over $80 billion in monthly trading volumes at the peak of the 2021 bull market. However, as it stands, the volumes have dropped almost by half, with the latest figures from November showing an average of $42.6 billion for the whole month.
So, what has been happening on the fundamental front? DEXs still have a mile to go before they can catch up with their centralized counterparts. Let’s take a deep dive into some of the drawbacks that are hindering mass adoption.
5 Biggest Hurdles for DEX Mass-adoption
In this section, we will try and cover the five biggest issues that persist with the use of DEXs over CEXs.
- DEX Liquidity Still Maturing
Each DEX protocol or exchange reveals the need for liquidity when compared to its centralized counterparts. For some context, at the time of writing, Binance, which is the biggest CEX, has an average daily trade volume of $10+ Billion while Uniswap’s daily volume stands at $690 million. This lack of liquidity prevents bigger traders to rely too much on decentralised exchanges as market depth remains a top priority. On the brighter side, there are several solutions to DEX liquidity drawbacks such as DEX aggregators, these are decentralized protocols that allow accessibility to liquidity on several DEXs regardless of the chain. - Scalability and High-Fees on Layer-1 Protocols
While Uniswap’s meteoric rise was a game-changer in the digital asset trading market, the transaction fees on Ethereum have not been so friendly to the average crypto user. As recently as May 2022, the average network fee peaked to over $150 on the Ethereum network, which is over and above what most people find reasonable for a single transaction. Fortunately, the rise of alternative Layer-1 chains like Polkadot, Solana and Cardano, the boundaries for scalability are continuously being pushed. In addition to these, we also have Ethereum Layer-2 solutions such as Polygon and Arbitrum. - User-Experience is Still Not There
Another massive hurdle that stands in the way of mass adoption is the many user experience issues that persist with operating with a DEX. For starters, users of DEXs need to familiarise themselves with wallet solutions such as Metamask in order to interact with the exchange platform. Even for a technically adept person like myself this is not easy, and will require hours of effort before you get the gist of how the interconnection works. - Protocol and Security concerns
Given DEXs are by nature autonomous in the way they work and have historically been plagued a lot by various forms of security issues, the topic of security remains core for the sector. According to blockchain security firm Certik, over 1.6 Billion dollars was reported lost to DeFi-related exploits, hacks and scams in 2022 alone.Some of the most common attacks include bug exploits, oracle attack, flash loan attack, front-running and the typical phishing attacks. This year, Axie Infinity’s Ronin Bridge was swindled over $620 million through an elaborate phishing scam that involved a fake LinkedIn job offer. Unsurprisingly, this is just one of the many DeFi exploits that have taken place in 2022. - Appropriate AML Measures
Perhaps more requested by regulators than users and venues, the DeFi space is often criticized for not applying strict enough AML measures. As the topic about compliance is becoming more and more a focus for regulators, it is clear that DEXs also will need to focus more on this in the future, which may prove cumbersome on technical levels.
Post FTX Collapse: The Growing Need For Self-custody and Transparency
A relevant theme that has been reignited with the whole FTX Saga is the need for good custody, and the old crypto mantra “Not your key, not your coins” seems more relevant than ever. In the time past the FTX collapse, crypto users have been withdrawing their funds from exchanges at a very consistent pace. A look towards the net balance of exchanges Glassnode reports that more than 500.000 BTC has left exchanges in total, making it very clear that users are reacting to the instability in the space and resorting to self-custody rather than trusting their balance with exchanges.
This trend is likely to not die out immedietly as regulatory probes and similar risk continue to loom over big exchanges such as Binance. In other words, the whole debacle may be a blessing in disguise for DEXs such as Uniswap and DyDx, which have witnessed a significant increase in volumes since the collapse of FTX. The former saw a spike in volume earlier in November when the FTX news broke and more recently on December 14th, hitting a high of $1.2 billion in daily trading volumes.
DEX Improvements to Look Out For
Clearly, there is an increasing demand for functional DEXs fueled by issues of the CEX industry such as lack of transparency and custody security. Ultimately, it is the users who will decide where the flow of trading will go, and given the developments and the increase in distrust towards CEXs, it seems like a fair assumption that more volume will flow into decentralized platforms in the future. Two fundamental improvements worth looking out for in the near future are the following:
- The rise of Hybrid DEXs’Uniswap V3 upgrade for the first time, included the order-book exchange arrangement into the picture, with the goal of optimizing capital efficiency on the exchange. Uniswap v3 upgrade compared to its predecessors v1 and v2, with better capital efficiency and flexible fee structures. The major driver for liquidity is a better LP system that incentivizes liquidity providers more and also provides low slippage in trade execution. This trend is likely to become a trend when it becomes a lucrative incentive source for the LPs providing liquidity.
- The rise of DEX aggregatorsThe biggest setback for DEX operators is liquidity. Aggregator protocols address this problem by giving a user’s wallet access to several trading liquidity pools via a single dashboard to allow users access to low-volume assets. A very common DEX aggregator is 1Inch and it is slowly becoming a trend to solve illiquidity challenges on some DEX.Given some controversies about the efficiency of introducing order books, some DEX users in the future may prefer AMM-type DEXs over hybrid DE involving order books. Also, as aggregator operations improve, they may become the status quo with DEXs in the future. Overall, this all depends on how efficient they turn out and less efficient individual DEXs become.
