Decentralized Exchanges (DEX) have been one of the main drivers of Decentralized Finance (DeFi), thus attracting considerable interest from institutional investors. But since DEXs are very different from traditional trading platforms, financial institutions should be aware of the opportunities and risks involved.
Decentralized Finance (DeFi) is one of the biggest success stories in the digital asset space, nearly killing the refrain that blockchain technology was a ‘solution in search of a problem’, after finding an initial focus on Ethereum, developments in interoperability and scalability on other platforms have enabled the segment to attract nearly 175 billion dollars in locked-in funds, up from less than $ 10 billion a year ago. In addition, DeFi is now attracting large sums in venture capital.
While virtually all of the new initiatives claim to offer something different, the majority of DeFi’s growth has been driven by two main segments: loan pools and decentralized exchanges (DEX). The latter has undergone several iterations over the years, but the integrated model is largely based on ideas pioneered by exchanges such as Uniswap and Bancor.
What exactly is a DEX?
In short, a DEX connects sellers and buyers and automatically calculates exchange rates and fees based on supply and demand. Rather than matching buyers and sellers through an order book like on a centralized exchange, smart contracts do all the trading. DEXs like Uniswap typically operate through cash pools that include a pair of tokens. Such a pool of liquidity could contain Bitcoin (BTC) and a US dollar stablecoin like Tether (USDT), for example.
In return for providing liquidity to the pool by “locking in” assets, users often referred to as “yield producers” earn a share of the transaction fees paid by traders who use them to trade tokens. The returns adjust according to the relative scarcity of assets in the pool. Going back to the previous pair, for example, if the USDT volume was low, 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 like Balancer operate multiple token pools, while Curve Finance focuses on stablecoins arbitrage.
While much of the growth in DEX use has been driven by the retail segment, there is growing evidence of institutional interest in the space, according to one. recent report by Chainalysis. However, DEXs are a very different proposition from their centralized counterparts and present a unique set of opportunities and challenges for institutional actors.
The advantages of DEX over centralized exchanges
First, their open and unlicensed nature means that DEXs can list an extraordinarily wide range of tokens, as anyone can launch their own pools of liquidity. At some point in 2020, Coindesk reported that Uniswap had added over a thousand new pairs of tokens in a single week. Therefore, DEXs give early investors the opportunity to start trading with sufficient liquidity before a token is listed on a central exchange. Additionally, since all activity on a DEX is governed by the underlying smart contracts, traders do not have to cede custody of their funds to a third party.
In addition, DEXs can offer greater reliability of execution during high volatility events caused by cascading liquidations of derivative positions on centralized exchanges. While CEXs may not be responsive at all for short periods of time due to API overloads, DEX trading remains functional and orders can be executed reliably, although the fees required to complete trades can increase significantly. short term (especially in the case of Ethereum based transactions).
Risks of using a DEX
Unfortunately, many of the benefits of using a DEX are a double-edged sword, and institutional users, in particular, face certain risks. On the one hand, most DeFi are currently unregulated and participants generally do not undergo KYC. Anyone can download a wallet like Metamask and start trading tokens immediately.
The lack of regulation acts like a honeypot for fraudulent token operators who start their own pools, and DEXs have also been implicated in money laundering. For example, after the centralized exchange KuCoin suffered a major hack at the end of 2020, the culprits used decentralized exchanges to trade nearly $ 20 million of stolen tokens. The absence of a legal framework that complies with the regulations creates a barrier to entry for institutions which are obliged to act within the limits of approved secondary markets.
Likewise, skidding and front-running are also common hazards on DEXs. Blockchain transactions are not instantaneous and in volatile cryptocurrency markets, prices can move over the time it takes to execute an order as a confirmed transaction. Chain trading is also prone to network congestion, which can lead to much higher execution fees than centralized exchanges.
Additionally, due to the open nature of public blockchains, anyone can view the pool of transactions pending confirmation. The pioneers set up bots to scan the pool for potentially profitable arbitrage trades, and when they spot one, they immediately complete the same trade, but at a higher price, making it more attractive for a minor the choice of the queue. Many DEXs and platforms have taken steps to address this risk, but it remains a persistent problem.
Additionally, the transparency of the smart contract code underlying DeFi protocols allows anyone to see it, but it also means anyone can find and exploit bugs and code vulnerabilities. As such, smart contract risk is a persistent problem for the DeFi industry, leading to a proliferation of dedicated DeFi insurance pools, such as Nexus Mutual or Opium Insurance, which provide cover for smart contract risk. It’s also increasingly common for projects to use the code auditing services of established cybersecurity consulting firms like CertiK or Kaspersky, as well as paying generous bug bounties to white hat developers.
A stimulating but improving user experience
Beyond the element of risk, institutions may also find that DEX user experience is lacking in several areas.
While it is theoretically possible to trade any token, only the largest pools have sufficient liquidity depth for large transactions. DeFi exists entirely separately from the traditional financial system, so there is no way to start on a DEX using fiat currencies. Instead, the user must first obtain the crypto using a centralized service before they can participate in DeFi.
DEXs also require self-custody, while many institutions may prefer to use a custody provider for digital assets. At the start of the DeFi wave, UIs often tended to be an afterthought for developers who focused more on smart contract code. This is evidenced by the user interface of services like Curve Finance which still looks like a DOS computer program from the 1980s.
Additionally, DEXs tended not to offer the range of order types, chart tools or technical indicators that are found on many of their centralized counterparts. However, this is changing rapidly. The more recent emergence of DEXs like dYdX and Perp offers decentralized, self-custodial spot and derivatives trading combined with a user interface similar to a CEX. This shows that decentralization doesn’t have to come at the expense of functionality and user experience.
Decentralized exchanges have made huge strides in recent years, moving from a niche concept to accumulating billions of dollars in fixed assets. While institutions are rightly intrigued by the concept and some wish to capitalize on the transformational potential of DEXs, they should be aware of the regulatory and operational challenges involved.