Decentralised Exchanges (DEX)
Decentralised Exchanges (DEX) are a return to the ‘roots’ of crypto currency. The decentralised finance (DeFi) revolution promised the potential to disrupt global markets. Centralised trading has removed some of that potential – which is where decentralised exchanges come in.
Cryptocurrencies are now collectively valued at over $2 trillion – a success by the numbers, but arguably a betrayal of the intended concept.
Today, cryptocurrencies are overwhelmingly traded on centralised exchanges (CEX) and are even listed on NASDAQ.
Decentralised exchanges (DEX), in contrast, remain closer to crypto’s DeFi intentions and have recently gained momentum, but they still lag far behind CEXs in volume of trades.
Touting trustless, peer-to-peer (P2P) transactions on the blockchain itself, DEXs have a devout following.
But limited liquidity and accessibility have prevented widespread adoption.
Now a developing innovation – automated market makers (AMM) – may allow DEXs to close the gap with CEXs and more fully realise a DeFi future.
Learn about the strengths and weaknesses of CEX and DEX, and explore whether AMMs are the future of crypto.
CEX Positives And Risks
CEXs host high-volume, escrow-based trades on public platform order books. They are backed by significant liquidity and able to convert to/from fiat currencies.
This makes them reassuring to beginning investors – and also makes them a big business.
With simple, inviting interfaces, deep customer service, tangible payouts, and speedily secured trades, centralised exchanges have attracted many casual traders and come a long way towards earning mainstream respect for the crypto markets.
They’ve also largely skirted regulatory scrutiny by registering with local governments, demanding participant identification through Know Your Customer (KYC) provisions, and complying with anti-money laundering (AML) restrictions.
Yet these same traits that have made cryptocurrency a commodity popular with retail investors have turned off the core crypto community and created a giant target for future regulatory issues and hacks.
Indeed, the inherent market fragility tied to threats of governmental oversight was illuminated recently when warnings by China sent crypto markets tumbling 25% in a single day.
DeFi disciples resent the power that state actors hold over centralised exchanges and decry CEXs’ KYC requirements, off-chain transactions, surrendering of keys, single-point vulnerability to hacker attacks, and high transaction fees.
For these reasons, they’ve turned instead to decentralised exchanges.
Decentralised exchanges came online in 2018 and quickly rose to prominence among the crypto counterculture seeking to preserve the DeFi legacy.
These DEX applications reside on the blockchain, enabling direct P2P trading without intermediaries or oversight.
Participants also retain possession of their keys at all times, preserving a higher level of security and permitting anonymous transactions – ideas central to the notion of decentralised finance.
This is increasingly important considering that DeFi has proven to be highly susceptible to hacks in 2020.
Protocols and practices are more complicated with DEXs.
Prices are set by vacillating smart contracts, execution requires mining verification, and interfaces are considered by some to be non-intuitive.
Functionality, however, is simplified, as direct transactions eliminate some of the more advanced investment strategies common with CEXs.
These factors have combined to limit traffic, with DEXs generally comprising less than 10% of the crypto transaction market, though that share is steadily rising.
This meagre adoption hampers further expansion, as limited participation means reduced liquidity, which in turn undermines exchange stability and matchmaking ability.
In many ways, DEXs are rough-edged pioneering upstarts compared to CEXs, just as cryptocurrency was a disruptor to traditional markets.
Similarly, it seems that decentralised exchanges have a bright future once innovation and adoption bolster the marketplace.
One emerging hope to combat current DEX shortcomings is the automated market maker approach, which employs incentives and algorithms to bolster exchange efficiencies.
Rather than a whole new marketplace, AMMs represent modified protocols designed to improve DEX performance and have become a dominant decentralised fixture since summer 2020.
The two most notable features of AMMs are their liquidity pools, which promote greater stability and attractiveness, and their purely mathematical approach to pricing, which streamlines the pairing and execution of transactions.
Without sufficient liquidity to back trading volumes, exchanges become unstable and subject to slippage and wild price swings.
Deep liquidity is one main advantage that massive CEXs hold over fragmented DEXs, but AMMs seek to change that by enticing even non-traders to contribute tokens to back decentralised exchanges.
AMM-driven transactions aren’t executed directly between buyers and sellers, but against a collective pot of tokens (the liquidity pool) filled by contributors who earn fees from trades on the DEX.
This arrangement is reminiscent of the bricks-and-mortar banking paradigm where customers let banks use their savings to make loans and investments in exchange for interest payments.
But by adhering to DeFi conventions, AMM liquidity providers require no account and can remain entirely anonymous.
The other main innovation that AMMs bring to the DEX marketplace is asset pricing pegged to mathematical formulas rather than transactional agreements.
Whereas most DEX swaps were formerly negotiated between parties as peer-to-peer sales, AMM pricing is set by algorithms and executed essentially as “peer-to-contract” transactions.
Each exchange’s proprietary approach varies, with weight distributed among factors like availability, demand, liquidity, and rates on other exchanges.
This formula-based pricing increases transparency, confidence, and stability while also combating slippage and impermanence by locking prices into smart contracts against the pool.
The Future Of Crypto-Trading
Behind the scenes, AMM may seem complicated, but these same machinations make executions simpler, quicker, and more stable on their face.
Their elegant pricing solutions and inherent incentive structure have solidified decentralised trading and been quickly adapted by 93% of the DEX market.
The bigger question is whether decentralised exchanges will unseat centralised ones as the main players in crypto trading.
Given the performance, popularity, and comparative respectability associated with CEXs, the centralised exchanges appear firmly established.
But crypto trading is a volatile field with a fate that fluctuates daily.
The looming possibility of regulation hangs over CEXs, with investors uncertain whether such legislation would doom the market or lend it greater legitimacy.
CEX security concerns also spook investors hesitant to turn over keys to their assets.
Conversely, DEXs are more secure, less expensive, and promote DeFi principles of anonymous trading and cross-crypto trading.
But the protocols are not as user-friendly, quick, tolerant of high-volume trades, or available for fiat conversion.
Complementary services catering to separate consumer segments have precedence in the financial marketplace.
Alex Williams of London-based Hosting Data notes the comparable difference between stockbroker types:
“We divide stockbrokers into two main categories: full-service brokers or discount brokers – one gives personal attention and human advice, the other is retained at a discount and merely makes information available online, but each has their place.”
CEXs and DEXs may similarly fill respective niches.
The more likely scenario, however, is an evolution of hybrid exchanges capitalising on the strengths of each approach. Such models are already emerging through providers like Qurrex, Eidoo, and Legolas, and AMMs are helping to pave the way.
What remains unclear is whether “hybrid” will ultimately mean CEXs with greater security, on-chain swaps, and algorithmic pricing, or DEXs with deep liquidity, broader utility, and greater ease-of-use.
Perhaps a more realistic option is simply diversified platforms offering access to each type of exchange.
Predicting the future of the cryptocurrency market when it hardly has a past is a tricky proposition – especially in a field reliant on emerging technologies and operating largely without governmental oversight.
Just a few years ago, it seemed unimaginable that cryptocurrency would be a regular media subject available for purchase on our phones, but look at the market today.
CEXs and DEXs represent very different philosophies battling for the future of cryptocurrency.
The centralised exchanges are unlikely to wipe out DEXs – DeFi devotees will never surrender, and it would leave the overall market too vulnerable.
And decentralised exchanges won’t destroy CEXs, as they lack the reach, and (ironically) rely on centralised data to feed their AMM algorithms.
Ultimately, it may be a matter of where in the middle they meet on anonymity, liquidity, efficiency, security, accessibility, and openness to regulation.
Advances like AMMs, which bridge the gap in between the two, secure and illuminate a possible way forward. As with choosing a stock or a brokerage, do your due diligence to see what platform is right for you to help maximize your returns.