There are different ways to exchange one asset for another in the crypto space. It could involve using centralized exchanges or decentralized applications.
Centralized exchanges are custodial in nature, meaning that they hold the funds of users and have control over what occurs in the platform. As a way of safeguarding the crypto holdings of their users, they store a bulk of it in cold wallets.
A typical custodial exchange requests that potential users undergo the KYC process and without it, they are either not allowed to use the blockchain-based services or restricted on what services they can enjoy.
The introduction of decentralized exchanges changed many conventional precedents in the crypto landscape. With the introduction of decentralized exchanges, crypto holders could now move over the centralized exchanges by taking complete control of their assets.
The rising use of decentralized exchanges has been responsible for radical growth in attention towards DEX risks apart from their advantages. The examples of the hearings related to GameStop trading volatility showcase doubtful perceptions regarding mainstream adoption of decentralized exchanges or DEX.
What does DEX mean in crypto?
A DEX exchange is a trading platform that allows people to buy and sell their crypto assets and trade directly with other users. Traders use this type of trading platform when they want to exchange cryptocurrencies at market price without the intervention of a centralized authority.
Decentralized Exchanges tend to work with self-executing agreements, removing the need for a third party to hold the funds of different participants.
Usually, there is no middleman that can decide what occurs in the ecosystem. Gas fees are usually cheaper in this type of exchange, and some of them offer no withdrawal fees.
Doubts about Decentralized Exchanges
The use of decentralized exchanges has definitely presented a new array of possibilities for the DeFi sector. At the same time, people are also wondering about concerns like “are decentralized exchanges safe” for the right reasons. The issues pertaining to market access and discrepancies in methods for individual and institutional investors to access decentralized exchanges are some prominent mentions.
At the same time, the involvement of centralized third-party entities in the working of decentralized exchanges also presents questions. Furthermore, the role of blockchain in empowering decentralized exchanges to facilitate trading has also come under scrutiny. Even if blockchain can support the development of decentralized exchanges, it is important to look out for notable DEX risks before participating in the market.
Problems with Crypto Exchanges
Centralized exchanges control access to information and order flow. As we have seen many times, this creates misaligned incentives for privileged parties to abuse this control through internalization and Payment for Order Flow (PFOF). In essence, traders are playing against the house.
Additionally, exchanges have violated the custody of traders’ assets, repeatedly losing those assets to hacks or financial mismanagement.
DeFi was born largely due to the lack of trust in financial intermediaries. Meanwhile, mass market adoption of DeFi has been obstructed by the inability of DeFi to meet the expectations established by the tools of traditional finance.
Slippage and front-running create inefficiencies for large traders, and high gas/platform fees make them less accessible for smaller traders. Platforms lack composability, requiring bridges that are susceptible to hacking. Decentralized exchanges cannot compete with centralized and traditional trading without addressing predation, friction, risk, and fragmentation all together.
The failures of these systems manifest for different reasons, but affect traders similarly: risk is increased, and profitability decreases. Deepwaters combines the best of centralized and decentralized platforms while adding novel functionality to provide a service which is highly efficient, compliant with regulations, yet trustless.
Decentralized Exchanges Review
A decentralized exchange (DEX) is a specific type of cryptocurrency exchange designed to facilitate peer-to-peer transactions. Uniswap, SushiSwap, PancakeSwap, Kyber, and Balancer are among the most popular decentralized exchanges today, but there are many alternatives as well.
Because users transact directly with each other via blockchain and smart contracts technology, decentralized exchanges don’t act as an intermediary between the parties in the same way that traditional exchanges do.
For this reason, decentralized exchanges typically boast much lower transaction fees compared to traditional alternatives.
Another key difference between decentralized exchanges and centralized exchanges is the fact that decentralized exchanges are non-custodial. This means they do not take custody of a user’s funds. Instead, the end user is always in control of their assets and keys.
Any discussion on DeFi necessitates a conversation on the primary means of exchange in the decentralized world; enter DEXes.
DEXes have always commanded notable levels of TVL across DeFi and the category currently tops the charts in both TVL and number of protocols with over US$23B in TVL split across 470+ protocols.
According Binance Research Crypto Market Review, having peaked near US$25B of TVL earlier this year, Curve is the largest DEX in DeFi. Curve is an AMM-based DEX, which focuses its attention on stablecoins and other stable pairs and thus maintains lower fees, slippage and minimizes impermanent loss when compared to other competing protocols. Curve also maintains composability as an aim and has integrated with Compound, Yearn Finance and Synthetix among others.
The Curve DAO, controlled by the CRV token, is also a major part of the puzzle and the accumulation race for the control of DAO has led to the aptly named ‘Curve Wars’.
Curve has been actively deploying across chains and is currently active across both L2 and alt-L1 chains. In the first half of 2022, Curve has integrated with Optimism, Moonbeam, and most recently with NEAR Protocol’s Aurora network.
With stablecoins demonstrating considerable growth over the last couple of years, and generally expected to grow in size with increased crypto adoption, the future looks bright for this behemoth of the DEX space.
Very close in TVL is another leading DEX in the space; Uniswap. To be precise, Uniswap is an automated market maker (“AMM”) based liquidity protocol and is one of the most widely used dApps in all of DeFi.
In terms of DEX volume, June data for Uniswap v3 shows a ~57% market share, just slightly below an all-time peak of 58% (although that was for Uniswap v2).
The protocol is governed via the UNI token and, through its recent v3 upgrade, is now deployed on the Ethereum mainnet, as well leading L2 scaling solutions, Polygon, Arbitrum and Optimism.
Uniswap has seen its market share grow this year and very recently announced the acquisition of NFT marketplace aggregator Genie. While not their first foray into NFTs (they offered NFT liquidity pools in 2019 i.e. “Unisocks”), the move is notable and will allow users to buy and sell NFTs directly on the Uniswap web app. They will also integrate NFTs into developer APIs and widgets and thereby make “Uniswap a comprehensive platform for users and builders in web3”.
To round off our section on DEXes, we have BNB Chain’s largest AMM and yield farm, PancakeSwap. Originally a Uniswap fork, PancakeSwap rapidly rose the ranks and has at many points been the leading DEX in the DeFi space.
While offering the conventional exchange and liquidity providing functions, PancakeSwap rapidly expanded its product offering to include yield farming, and the somewhat tempting “syrup pools”, among many other features.
PancakeSwap has been credited for bringing yield farming to the masses, at least partially through gamifying the process and offering a beginner-friendly UI.
Furthermore, the native CAKE token further differentiates the project, offering far more use cases (primarily in yield-generation protocols) when compared to the governance-focused UNI token.
PancakeSwap team further introduced a roadmap (updated quarterly) and has been making headway across various product lines, including perpetual trading and fixed-term staking. PancakeSwap also became the first DeFi project to launch through the Mini-Program, which allows users to access the platform via its mobile application. The initiative aims to attract CEX users to experience DeFi within a trusted environment and provides a tremendous opportunity to educate newcomers about DeFi and what it can offer.
With BNB Chain continuing to grow and take market share, alongside its continued focus on manageable growth, including the recent launch of the BAS scaling solution, the top DEX in the ecosystem remains in good standing for further growth and development.
What are the types of decentralized exchanges?
Decentralized exchanges come in different formats. Some are automated market makers, order books decentralized exchanges, and decentralized exchange aggregators.
Order Book DEX
This type of DEX crypto exchange has a record of every buy and sell order for different pairs. When a trader makes a buy order, it means that they want to buy or bid for a cryptocurrency, and a sell order states that the trader is interested in selling. Order book DEX comes in two types, and they are the off-chain order books exchange or the on-chain order books trading platform.
Automated market makers (AMMs)
AMMs use smart contracts to solve their liquidity issue. Trades are executed on this platform through smart contracts that are holding tokens. It does not use order books of any kind, instead, pre-funded pools of assets are utilized. The pre-funded pools of assets are called liquidity pools.
This type of DEX crypto exchange allows users to exchange one asset for another without having to trade with any other person. It is a peer to contract type of trade. In this case, crypto enthusiasts trade with smart contracts.
Liquidity pools are filled with cryptocurrencies by different people who are called Liquidity Providers. Liquidity providers are rewarded with the transaction fees earned from those that trade on the exchange. Anyone is allowed to deposit their tokens in a pool and they are given LP tokens to showcase their percentage of ownership of the funds in the pool. Usually, the rewards are shared based on how many tokens the user provided in the pool.
Decentralized Exchanges Risks:
- DEX Security Risks
- DEX Front Running Risks
- Limited Recovery Ability of DEX
- Limited Support for DEX Trading
- DEX Scalability
- DEX Liquidity Risks
1. DEX Security Risks
According to 101 Blockchains Review, decentralized exchanges are not completely immune to all threats, and you need to identify the threats clearly to use them wisely. The people who have proposed the decentralized version of crypto exchanges would have focused on private keys. In the case of DEXs, the private keys are a notable reason for concerns like “are decentralized exchanges safe.”
Investors could get the privilege of maintaining direct custody of their private keys and showing direct ownership of crypto assets. Therefore, the decentralized exchanges can show a clear difference from the fiat-based options.
However, it is important to wonder about the feasibility of such a model in encouraging widespread adoption of DEXs.
The centralized exchanges and different third-party entities provide an important value improvement through the use of custodial services. The custodial services are readily popular among market participants and garner more trust from DeFi participants. With respect to security aspects as Decentralized Exchanges risks, one would wonder whether investors want to take responsibility for managing the assets in their ownership.
2. DEX Front Running Risks
People are worried about questions like “Can decentralized exchanges be hacked?” to such an extent that they forget crucial concerns. One of the foremost critiques of the existing centralized exchange model refers to the necessity of making payments for order flows. Investors have to pay for order flows in centralized exchanges, which is interestingly a notable mention among DEX risks.
Miners or the mining pools could obtain a preview of transactions while confirming and validating them on decentralized exchanges. With the help of these previews, miners could find opportunities for engaging in market manipulation.
You should keep in mind that DEX trading bots scraped more than $100 million in just 30 days. So, there is no way you could undermine the threat of such decentralized exchanges risks to your assets.
The practice of payments for order flows has become more commonplace and taken center stage recently.
Therefore, it is reasonable to wonder about threats due to mining pools engaging in market manipulation by front-running trades. In addition, one should also note that DEXs would run on a public blockchain by default. Therefore, you can find the mining pools anywhere in the world, thereby creating geopolitical risks in decentralized exchanges.
3. Limited Recovery Ability of DEX
The doubts about “are decentralized exchanges safe” could find some promising answers in the fact that DEXs do not have any ability to recover lost, misplaced, or stolen funds. The lack of a KYC process and the ability to cancel transactions generally leads to issues in recovering data or their assets. You could not rely on a support team for notifications about a lost private key or missing funds. Refunds are incompatible with the general smart contract-based model of DEX networks, thereby creating issues in recovery.
4. Limited Support for DEX Trading
Another formidable setback associated with decentralized exchanges refers to the limited functionality for trading. How? The DEX risks of reduced transaction settlement speed could create obstacles for participating in trading on DEXs. Furthermore, decentralized exchanges have become popular only in recent times with a focus on simple purchasing and selling orders. On top of it, users could not find advanced functionalities for trading such as lending, stop losses, and margin trading on majority of decentralized exchanges.
5. DEX Scalability
Addition among risks in decentralized exchanges would turn the focus towards scalability issues. Decentralized exchanges or DEXs have frequently experienced the issues of network congestion due to scalability concerns.
With blockchain networks such as Ethereum as the foundation of decentralized exchanges, the scalability issues of Ethereum translate effectively to decentralized exchanges.
Without scaling solutions, the decentralized exchanges cannot prepare for mainstream adoption where trading volume would increase by radical margins. DEXs still continue to follow the first-layer network transaction limits, thereby causing discrepancies in scalability. However, DEXs would soon employ transformative network upgrades with scalability solutions for a larger capacity to resolve such issues.
6. DEX Liquidity Risks
Decentralized exchanges are also vulnerable to risks due to liquidity. Liquidity is an important requirement for all financial instruments and assets traded on a specific exchange. However, the need for liquidity is still a formidable concern for different decentralized exchanges on grounds of different reasons.
You could notice that DEX risks related to liquidity emerge from the information gap for non-expert users.
Another important factor leading to liquidity risks on decentralized exchanges refers to the average trading volume on DEXs. The average trading volume continues to be a small share of the trading volume in centralized exchanges.
The trading volume in centralized exchanges is higher due to the fact that DEXs are relatively new. At the same time, the overall crypto-economy has not expanded in scope to enable improved trade volume on DEXs.
……………………………
by Peter Sonner
