Are DEXs Finally Become the Bedrock of Crypto Trading?

17 May 2024

Cryptocurrency was born from the dual principles of decentralization and autonomy. Nonetheless, it would be hard to arrive at this conclusion if all you had to go on was the distribution of crypto trades across centralized and decentralized exchanges.

Decentralized exchanges (DEXs) still account for only a fraction of the total trading volume of cryptocurrencies. In fact, ten times more trading happens on centralized exchanges (CEXs) than it does on DEXs.

This is despite the fact that an important reality isn’t lost on most investors. CEXs represent a major compromise of the founding values of crypto. And with growing concerns surrounding the business practices of CEXs, many are calling for a return to crypto's roots.

Could this potential shift become a new reality?

Clarence Lim, the Co-Founder and Head of Trading at Herring Global – a global crypto market-making firm specializing in altcoin liquidity profiles & strategies, was happy to lend valuable insights into this billion-dollar question.

An Increasingly Favorable Option

Only a tenth of the global cryptocurrency trading activity occurs on decentralized exchanges. However, DEXs are becoming more attractive than ever, suggesting that the tide may well be changing. And this is down to some of the superior advantages afforded by DEXs.

“While CEXs offer a more familiar trading environment, users are increasingly accepting the smart contract risk associated with DEXs in exchange for greater control over their assets, enhanced privacy, and access to a wider range of tokens,”

Clarence says. He also points out the growing role of on-chain analytics tools in empowering traders:

“With the development of on-chain analytics tools, traders now have even more powerful resources at their disposal. These tools enable traders to analyze on-chain data more effectively, helping them identify trends, anomalies, and opportunities that were previously inaccessible. This advancement in analytics tools enhances the ability of traders to extract on-chain alpha, further solidifying the importance of data-driven strategies in decentralized exchanges.”

FTX’s collapse mounted concerns around the practices of centralized exchanges. In fact, in the months following the collapse, the DEX to CEX spot trade volume (%) rose to nearly 15% as users sought more transparency and control over their assets.

Many traders now find that interacting with smart contracts, with all the complexity and risks that accompany them, is a more favorable alternative to trusting centralized actors who present a single point of failure and may well be misusing user funds behind the scenes.

However, the advantages of DEXs - namely decentralization, transparency, and control - have been apparent since the early days of decentralized finance (DeFi). Still, they haven’t been enough to drive the kind of adoption that proponents are hoping to see.

It is safe to say that, even assuming further CEX failures in the future, these advantages alone will still not be enough. More is required.

Becoming More User Friendly

There is one big reason behind most crypto trades occurring on centralized exchanges: the user experience (UX). CEXs have been attracting more users largely because they have been easier to use and always had more features than DEXs.

So, DEXs competing with CEXs has also largely been a question of DEXs matching the levels of UX that their centralized counterparts have achieved. And they are doing that to an increasingly high degree.

“CEXs are often much more beginner-friendly than DEXs,” says Clarence, “but the latter has made strides to improve accessibility.”

Early DEX versions were relatively simple platforms with simple interfaces. However, they lacked advanced order types and trading tools. They also struggled to attract liquidity, which meant that trading tended to cost more than on DEXs.

Fortunately, things have only gotten better since then. The introduction of Layer 2 (L2) scaling solutions like Arbitrum, Optimism, and zkSync has helped to reduce costs in the spot market by alleviating congestion on the Ethereum network.

DeFi platforms offering a trading experience similar to that on a CEX are also becoming common. Decentralized derivative platforms such as dYdX, Vertex, and HyperLiquid have gained traction for offering a full suite of order types.

“We are also seeing DEXs beginning to experiment with new concepts such as intents to bring about advanced order types,” adds Clarence. “Overall, ongoing innovations in DEX functionalities are making them more competitive against CEXs in terms of user-friendliness and features.”

Admittedly, though, progress with more sophisticated order types, such as stop loss and stop limit, has been slower despite Automated Market Makers (AMMs) like Uniswap adding support for limit orders in Uniswap v3.

Additionally, migrating liquidity from older DEX versions like Uniswap v2 to newer ones like Uniswap v3 poses its own set of challenges to users. This brings us to the problem of liquidity which has long been a thorn in the side of DEXs.

Addressing the Liquidity Problem

DEXs have traditionally faced liquidity challenges stemming from several factors. For one, market fragmentation across different pools and blockchains led to less efficient pricing and potential slippage for larger trades.

Early AMM models also required liquidity providers to deposit equal amounts of assets. This formula dictates that the product of the quantities of each asset in the pool remains constant, a design that leads to capital inefficiency, as significant price fluctuations in one asset leave a large portion of the paired asset underutilized for trades.

This is, fortunately, ceasing to be the case. Uniswap v3 introduced a solution that allows liquidity providers to choose a specific price range within which they want to provide their liquidity. Called concentrated liquidity, it essentially concentrates liquidity around expected price zones, creating more efficient markets.

And things will only get better. One of the biggest expected updates is Uniswap v4 and its introduction of hooks and custom pools. These features are expected to empower developers to add new functionalities and modify trade-off decisions related to liquidity provisioning, allowing for more flexibility and customization in liquidity provisioning.

However, these solutions are not without cost.

The Challenges

“Concentrated liquidity pools, such as those introduced in Uniswap v3, have been instrumental in improving capital efficiency by allowing liquidity providers to concentrate their funds at specific price ranges but at the cost of user-friendliness,” says Clarence.

Liquidity providers now need a deeper understanding of how AMMs work and how factors like price ranges and trading volume impact yields and impermanent loss risk. This leads to a more complex user experience than in older AMMs.

Clarence also discussed concentrated liquidity, stating,

“Managing LPs in the concentrated liquidity space can indeed be complex and time-consuming for many on-chain participants, but processes can definitely be streamlined. For example, at Herring Global, we collaborate with industry leaders like Range Protocol and established DeFi proprietary trading firms such as Tokka Labs to develop automated strategies. These collaborations aim to simplify tasks and reduce complexity associated with concentrated liquidity, enhancing efficiency and dynamism in LP management.”

Promising Progress but Challenges Remain

“While the DEX landscape continues to innovate and offer compelling advantages, it is important to recognize that centralized exchanges will remain a significant part of the trading ecosystem. Factors such as regulatory compliance, fiat onramps, and user experience ensure that CEX and DEX will coexist, each catering to different needs and preferences within the trading community. Understanding the strengths and limitations of both models will be key for participants navigating the evolving landscape of digital asset exchanges.", Clarence concludes.

DEXs have come a long way from the simple yet clunky platforms of years gone by to the feature-packed, efficient, and easy-to-use platforms of today. Nonetheless, there is still work to be done.

For instance, the capital efficiency vs user-friendliness tradeoff will become more important in a multi-chain world where liquidity will need to be deployed across protocols and chains.

This means that finding an interoperable solution that allows liquidity providers to seamlessly move their capital between different platforms and protocols, maximizing their ability to capitalize on the most lucrative opportunities across various DEXs, will be key to driving the next stage of growth in DeFi.