Decentralized exchanges (DEXs) have been one of the main drivers of decentralized finance (DeFi), thus increasing considerable interest from institutional investors. But since DEXs are very different from traditional trading venues, financial institutions need to be aware of the opportunities and risks involved.
Decentralized finance (DeFi) is one of the biggest success stories in the digital asset space, but all but one refrained that blockchain technology was a “solution in search of a problem”, after finding an initial home on Ethereum, interoperability. And developments in scalability have enabled the segment to draw closer to other platforms. $175 billion in lock-in funds, down from $10 billion a year ago. Additionally, DeFi is now coming in significant amount in venture capital.
Although almost every new initiative claims to offer something different, much of DeFi’s growth has been driven by two main segments – Lending Pools and Decentralized Exchanges (DEXs). It has gone through several iterations over the years, but the embedded model is largely based on ideas pioneered by exchanges such as Uniswap and Bancor.
What exactly is DEX?
In essence, a DEX connects sellers and buyers and automatically calculates exchange rates and fees based on supply and demand. Instead of matching buyers and sellers through a centralized exchange such as an order book, smart contracts execute all trades. DEXs such as Uniswap typically operate through a liquidity pool consisting of a pair of tokens. For example, such a liquidity pool could hold bitcoin (BTC) and a US-dollar stablecoin such as Tether (USDT).
In exchange for providing liquidity to the pool by “locking in” assets, users, often referred to as “yield farmers”, earn a portion of the transaction fees paid by merchants who use it to swap tokens. do for. Yields are adjusted according to the relative scarcity of assets in the pool. For example returning to the previous pair, if USDT volume was trending lower, the yield would automatically increase to encourage users to provide more liquidity. The goal is to create a decentralized and automated trading system. Other exchanges such as Balancer operate multi-token pools, while Curve Finance focuses on stablecoin arbitrage.
Much of the growth in DEX usage has been driven by the retail segment, according to one, with increasing evidence of institutional interest in the sector. recent report From Chainalysis. However, DEXs are a very different proposition from their centralized counterparts and come with a unique set of opportunities and challenges for institutional players.
Advantages of DEX over Centralized Exchanges
First, their open and permissionless nature means that DEXs can list an extraordinarily large number of tokens, as anyone can launch their own liquidity pool. At one point in 2020, Coindesk informed of That Uniswap has added more than a thousand new tokens in a week. Therefore, the DEX gives early investors the ability to start trading with sufficient liquidity before the token is listed on a centralized exchange. Furthermore, since all activities on the DEX are governed by the underlying smart contracts, traders are not required to give custody of their funds to a third party.
In addition, DEXs can provide high performance reliability during high volatility events due to the cascading liquidation of derivative positions on centralized exchanges. Although CEX may not be liable at all for a short time due to API overload, DEX trading remains functional and orders can be executed reliably, although the fees required to complete the transaction may increase in the short term ( Especially in the case of Ethereum based transactions).
Risks of using DEX
Unfortunately, many of the benefits of using a DEX are a double-edged sword, and institutional users, in particular, face some risks. For one, most DeFi is currently unregulated and participants usually do not go through KYC. Anyone can download a wallet like MetaMask and start trading tokens immediately.
The lack of regulation acts as a honeypot for scam token operators launching their own pools, and DEXs have also been implicated in money laundering. For example, KuCoin suffered a major hack in late 2020 after centralized exchanges, criminals used decentralized exchanges to conduct business. about $20 million Stolen tokens The lack of a regulatory compliant legal framework creates an entry barrier for institutions that are forced to operate within the confines of licensed secondary markets.
Similarly, slippage and front-running are also common risks on the DEX. Blockchain transactions are not instant, and in volatile cryptocurrency markets, prices can be moved in the time required to execute as a confirmed transaction. On-chain trading is also subject to network congestion which can lead to very high execution fees compared to centralized exchanges.
Furthermore, due to the open nature of public blockchains, anyone can view the pool of transactions awaiting confirmation. Front-runners set up bots to scan the pool for potentially profitable arbitrage trades, and when they see one, they immediately make the same transaction, but for a higher fee, than queue up for a miner. Make it more attractive to go out. Many DEXs and platforms have taken steps to address this risk, but it remains an ongoing problem.
Furthermore, the transparency of the smart contract code underlying the DeFi protocol allows anyone to view it, but it also means that any code can find and exploit bugs and vulnerabilities. Thus, smart contract risk is an ongoing problem for the DeFi sector, resulting in the proliferation of dedicated DeFi insurance pools such as Nexus Mutual or Opium Insurance, which provide coverage for smart contract risk. It’s also becoming increasingly common for projects to use code auditing services from established cybersecurity consulting firms like CertiK or Kaspersky, as well as paying generous bug bounties to white-hat developers.
A challenging, but superior user experience
Beyond the risk element, institutions may also find that the DEX user experience is lacking in many areas.
Although it is theoretically possible to trade any token, only the largest pools have enough liquidity for large trades. DeFi is completely separate from the traditional financial system, so there is no way to get started on a DEX using fiat currencies. Instead, users must first obtain crypto using a centralized service before participating in DeFi.
DEXs also require self-custody, while many institutions may prefer to use a custody provider for digital assets. At the beginning of the DeFi wave, the user interface often became a consideration for developers who focused more on smart contract code. This is evidenced by the user interface of services such as Curve Finance, which still has the look and feel of DOS computer programs of the 1980s.
In addition, the DEX did not offer the range of order types, charting tools, or technical indicators found on many of its centralized counterparts. However, this is changing rapidly. The recent emergence of DEXs such as dYdX and Perp offer decentralized, self-custodial spot and derivatives trading combined with a user interface similar to CEX. This shows that decentralization is not needed at the expense of features and user experience.
Decentralized exchanges have made great strides in recent years, growing from a niche concept to accumulating billions of dollars in locked-in assets. While institutions are rightly attached to the concept and some are keen to capitalize on the transformative potential of DEXs, they should be aware of the regulatory and operational challenges involved.