Decentralized Finance (DeFi) and Decentralized Exchanges (DEX) - State of Adoption in Decentralized Exchanges (DEX) (P.2)

 

1.  Decentralized Finance (DeFi)

The definition of decentralization was first introduced by the invention of Bitcoin, Satoshi Nakamoto referred to it as "A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution" (Satoshi Nakamoto).

The DeFi space's main idea is to "build for interoperability," which allows the ecosystem to benefit from individual achievement while continuing to drive decentralized finance forward (Andrei-Dragoş, 2020). DeFi applications can be linked into one another, similar to how legos fit together to form a building, earning them the moniker "Money Legos" (Joel John, 2020). Without any financial constraints or nation-state rules, it is feasible to apply for a loan on one platform, execute a leveraged trade on another, and then exchange it back to the underlying asset through a decentralized exchange. 

Based on the Diffusion of Innovation by Rogers, CoinGecko’s survey in 2020 is that DeFi was in stage of early adoption, with a large number of dApps supplied and ready to use by the community but low adoption (Erina Azmi, 2020). The survey also showed that the dominant group of DeFi users was the Millennial generation (68% of the participants) and Decentralized Exchanges appeared to be the most popular DeFi category. 

Fig. 4. Total monthly web visits to DeFi platforms by country Apr 2019 - June 2021 (Source: Coingecko.com)

The great bulk of web traffic to DeFi protocols originated from North America from April 2019 to about June 2020, with Western Europe adding a significant and growing percentage starting around September 2019 (Fig. 4). As the overall value supplied to DeFi systems began to skyrocket around June 2020, there was an increase in traffic from additional regions, particularly Central and Southern Asia (chainalysis.com)

Although the European Commission's proposal for a "Regulation on Markets in Crypto-assets (MiCA)" is a first step toward regulating non-trustless crypto-asset markets, it ignores the early-state DeFi trend (Eva, Isabell & Philipp, 2021). The total value locked in Defi at the time of this research increases seven times as much as this at the beginning of 2020 ( $77.238 billion as of 11 April 2022 compared with $10.414 billion as of  3 Jan 2020) (defipulse.com). However, the future of a fully decentralized finance system is questionable. Paech (2017) adds to this argument, claiming that finance will continue to rely on an intermediary-client model. On the other hand, Yan Chen & Cristiano (2020) believe that DeFi, as a new area of financial technology, has the potential to transform current finance and provide a new landscape for entrepreneurship and creativity.

2.  Ethereum blockchain and layer-2 solutions

Ethereum is the global blockchain with the second market capitalization only after Bitcoin in the crypto world. According to DappRadar, the total value of more than 83 decentralized applications locked in the Ethereum blockchain is $92.64B as of May 10th, 2022, which is followed by BNB Chain, Solana with $7.64B and $3.1B respectively.  Initially, Ethereum's consensus mechanism is proof-of-work similar to Bitcoin. Etherum provides a virtual machine (EVM) that performs smart contract code. Szabo (1996) invented the phrase "smart contract" and provided a working definition: “A smart contract is a set of promises, specified in digital form, including protocols within which the parties perform on these promises''. Smart contracts are accessible and transparent on Ethereum. Consequently, decentralized applications (dApps) can be built on Ethereum blockchain by utilizing smart contracts combined with user interface (ethereum.org). To predict the market and set payment, dApps use oracles which are data sources connecting Ethereum to real-world information. Any transaction on Ethereum is executed by miners and users pay gas fees which is denoted by gwei (1gwei = 10-9ETH). The Ethereum native currency, Ether (ETH), is used to pay gas fees. But when the ETH market price jumps dramatically, the gas fee paid by ETH is problematic, plus, the single-chain of proof-of-work consensus mechanisms works slowly to verify each transaction, in other words, pending time results in a negative user experience. To boost transaction speed without jeopardizing decentralization, scalability is proposed. Ethereum participates in Layer-2 scaling by upgrading Ethereum 2.0, replacing proof-of-work to multi-chain proof-of-stake. In this context, the Ethereum main chain is referred to as “Layer-1”. Smart contracts of layer 2 can function on top of layer 1 without modifying the core level protocol. As a result, Layer-2 scaling solution is designed to communicate with  Ethereum considerably faster, more cost-effective and to assist the Ethereum platform as well as DeFi achieve mainstream adoption. Some examples of layer-2 solutions are Polygon, Arbitrum, Optimism. Polygon is a layer-2 scaling sidechain linked to Ethereum. The purpose of utilizing a sidechain rather than a separate blockchain such as Ethereum is that clients can justify on the parent blockchain what happened on the child blockchain if its consensus breaks (Léo B et al, 2022) and to offer a far lower cost than transactions on the main blockchain. Polygon is the very first scaling solution to totally support the Ethereum Virtual Machine (EVM), Ethereum's blockchain-based infrastructure for building decentralized apps (dApps). Currently, there are 52 DeFi projects built on Polygon (defiprime.com) in which some of the leading DEXes go live on Polygon such as Uniswap, Curve, Balancer, Sushiswap, etc.

3.  Decentralized Exchanges (DEXes)

3.1. Decentralized vs Centralized exchanges

One of the sectors affected by the DeFi revolution is Decentralized Exchanges (DEXes) where cryptocurrencies are traded without intermediaries. Unlike centralized exchanges (CEXes), which are in the form of limit order books (LOB) similar to the stock market but are unregulated and lack adequate insurance for the assets held (Agostino, 2021); DEXes are secure and reliable, which means that all transactions take place through participant wallets utilizing smart contracts, with each transaction's settlement being outsourced to the blockchain (Angelo, 2021). 

Fig. 5. Monthly DEX volume divided by CEX volume (as a percentage) (Source: theblockcrypto.com)

As of September 2020, this ratio hit the highest point by 18.77% from 0.94% as of May 2020. Despite the fact that DEX spot trade volume is around one-tenth that of CEX as of Q1 2022 (fluctuates between 13.46 percent to 10.6 percent), the daily trade volume of the largest DEX - Uniswap (Statista, 2022) is competing with the second largest CEX - Coinbase (Coinmarketcap.com) (Fig. 6). For the time being, it is evident that decentralized platforms are just serving as a supplement to centralized exchanges, which now control “the lion's share”.

Fig. 6. Comparison of daily trade volume between Uniswap, Coinbase and Binance (Chart uses 7-day moving average) (Source: theblockcrypto.com)

Even in the first quarter of 2022, Uniswap's daily trade volume sometimes exceeds Coinbase's. For example, $5.91 billion was traded in Uniswap at the end of January, whereas $4.38 billion was transacted on Coinbase (theblockcrypto.com). ​​DEXes have become a more popular alternative as DeFi infrastructure has grown in popularity. 

Trading volume, the key metric used to rate cryptocurrency exchanges on CoinMarketCap, the most extensively used cryptocurrency data and pricing platform (Coinmarketcap.com) is one of the most widely used metrics that is viewed as an indicator of an exchange's adoption and importance. However, according to Micheal F (2019), many digital exchanges began inflating volume through deceptive trading tactics in order to compete on volume. In another research published in May 2019 (Matthew H et al, 2019) by Bitwise Asset Management, 95% of stated Bitcoin volume is fraudulent, consisting of counterfeit printing or wash trade. Hence, this study aims to investigate whether the growth in trading volume of DEX can be tied to its real adoption by better understanding DEX design.

3.2 Features of DEXes

In comparison to CEXes, DEX infrastructure offers plenty of advantages. First of all, on-chain settlement is unique to DEXes, which allows users to verify their trade and complete custody of the assets without the third party. Consequently, users may take full benefit of the censorship-resistant and trustless nature of crypto assets based on blockchain technology (Pagnotta and Buraschi, 2018). Secondly, users can supply liquidity to the exchange to get passive income. Users of cryptocurrency ecosystems are increasingly interested in providing liquidity to DEXes (Lioba & Ye, 2021) because it does not require the investment of expensive hardware or the development of complex algorithms as in LOB-based exchanges (Foucault et al., 2017). Early adopters take this financial opportunity of various crypto assets as one of the motivation and goals to participate in DeFi space (Eva & Isabell, 2021).

Thirdly, tokens that have just been issued can be exchanged on a DEX, CEX, or both at the same time, however, many of them will never be listed on a centrally regulated exchange, leaving the DEX as the sole viable alternative for secondary trade. Tokens must be compatible with the protocols that power DEXs, with the ERC-20 standard on the Ethereum (ETH) blockchain being used by the majority of tokens and DEXs (Angelo, 2021). 

However, DEXes based on AMM have failed to achieve market liquidity levels comparable to centralized exchanges. Furthermore, transactions on DEX are subject to a time delay determined by the speed of the underlying blockchain, higher gas fee is the reason for price inefficiency of DEX (Andrea, 2021).

3.3 Type of DEXes

Although the DEX landscape is as diverse as it is broad, there are three primary sorts of DEXs. 

The automated market maker (AMM) category encompasses the vast majority of popular DEXs. AMMs don't have an order book, and they don't usually support more complicated order types. However, they usually allow users to add their assets to liquidity pools in exchange for a percentage of the fees generated by trades that use these pools as a source of liquidity. The AMM mechanism is exactly one of the main features of DEXes. Uniswap is one of the first AMM-based exchanges using the popular form of AMM - Constant Product Market Maker (CPMM) and the most well-known AMM on Ethereum blockchain that allows users to swap ether and any liquid ERC-20 token (Daniel, Coinmarketcap). 

The orderbook-based exchanges operate similarly to centralized exchanges in which traders can make their best bid or ask price for a particular asset. Orderbook-based DEXs are often preferred by individuals who prefer a more traditional exchange experience (Daniel, Coinmarketcap). A large range of decentralized orderbook-based exchanges is presently operating such as dYdX on Ethereum, Serum on Solana. The hybrid DEX platforms blend the best parts of AMM and order-book. 

Fig. 7. Market share of different DEX mechanisms (Source: theblockcrypto.com)

At the time of this research (April, 2022) Constant Product (CPMM) mechanism is dominant with 73.3% of market share, followed by Hybrid model with 22.33% of the total (Fig. 7). Market share of orderbook-based exchange accounts for only 4.37% of the total, however, the leading orderbook-based exchange dYdX is competing with the leading AMM-based exchange Uniswap V3 to become the top 1 DEX. According to Coinmarketcap, dYdX has trade volume (24h) three times as much as that in Uniswap V3 (data accessed on 13th Apr, 2022). 

According to Abdulhakeem and Hu (2021), blockchain technology does not need to replace the current system, but rather enhance it. That a variety of hybrid models and complementary applications arise demonstrates DEX and CEX will continue to coexist. This also creates many hypotheses for the adoption of Decentralized Exchanges. After analyzing the market share of different DEX mechanisms (Figure 6), I aspire to achieve more insights by including AMM as a dominating market-making algorithm on DEXs in equilibrium assessment.