Skip to main content

State of adoption in Decentralized Exchanges (DEX) (P.1)

 The change from a centralized server-based internet infrastructure to a cryptography transparent network is at the heart of blockchain, the breakthrough technology behind Bitcoin. As of 2022, more than ten thousand cryptocurrencies have been created worldwide (Raynor de Best, 2022). The Block Legitimate index recorded $2.23 trillion in cryptocurrency exchange volume in the crypto crash in May 2021 (Fig.1) (Fireblocks), and total market capitalization of cryptocurrencies reached a peak of about $2.62 trillion as of October 2021 (Tradingview.com). 

cryptocurrency-exchange-volume-monthly (1).png

Fig. 1. Cryptocurrency Exchange Volume (Source: theblockcrypto.com)

 For this reason, crypto trading intermediaries have emerged. The vast majority of crypto transactions are now processed through centralized exchanges (CEX) that function similarly to limit order books with the dominance of Binance, Coinbase and FTX (Coinmarketcap.com). However, they encounter worries about being vulnerable to a single point of failure, which might result in a major loss of cash if attacked (Bhaska, Qi & Eugenio, 2021). Mt.Gox exchange (2014) hack of 850,000 bitcoins (BTC) is one of the biggest attacks in crypto history (Rao & Sandeep, 2021), and 119,756 BTC was stolen from Bitfinex (2019) (Higgins & Stan, 2016). These demonstrate apparent systemic risks. 

The centralized exchanges, furthermore, suffer from a fear of financial power concentration. The rise of Decentralized Finance (DeFi) on blockchain smart contracts was a disruptive model to construct or change traditional financial products into reliable and transparent protocols that operate without the use of intermediaries (Popescu & A.D., 2020). Additionally, the limit order book mechanism that centralized exchanges are taking advantage of is challenging to implement in a decentralized manner (Bhaska, Qi & Eugenio, 2021). Nevertheless, the primary source of systemic risk in the cryptocurrency market is attackers who frequently target exchanges because they operate as centralized portals into private accounts, and hackers simply get beyond the exchange’s security to access extremely damaging data. Decentralized exchanges (DEX) have recently emerged as an alternative to CEX in the DeFi space, in order to minimize the systemic risks by allowing users to trade trustlessly and by shifting the security burdens from a single custodian to individual users (Will & Amir, 2017). The peer-to-peer model of DEX is impossible to be attacked since the funds of users are not kept in the crypto system’s online wallets, users have more autonomy when performing transactions. Then, if intending to attack, hackers have to hack every single account. DEX applications constitute 31% of the total value locked (TVL) in DeFi at the time of writing and have experienced tremendous growth, going from around $268 million in TVL in July 2020, with the so-called “DeFi Summer'' and attained the highest point of about $34.5 billion as of November 2021 (Defipulse.com).

Blockchain-based decentralized exchanges utilize an Automated Market Maker (AMM) with a price-adjustment model for supply and demand, in which trades are performed quickly as soon as orders are logged on the blockchain (Lioba, Ye & Roger, 2021). The AMM's advantages include availability (it is always ready to act as a counterparty, but the spot price it gives may be lower than what a more traditional exchange would offer) and ease-of-integration with external smart contracts that need to execute market orders (Will & Amir, 2017). A plenty of decentralized applications (dApps) have built on Ethereum smart contracts for peer-to-peer trading.

From the demand side, since the beginning of its experiments in 2018, DeFi user growth has been exponential with over 4.4 million unique addresses interacting with Ethereum DeFi. The number of Uniswap (the most dominant DEX) users account for more than 3.7 million (approximately 84% of total DeFi users) (Fig. 2)

Fig. 2. The number of Uniswap users (Source: Dune Analytics)

Crypto users now have new investment opportunities in the cryptocurrency ecosystem, not only as traders but also as liquidity providers to get rewards. The profits and losses of providing liquidity in various types of pools differ significantly (Lioba, Ye & Roger, 2021). 

In general, by utilizing liquidity solutions such as liquidity pools, decentralized exchanges allow cryptocurrency investors to keep their keys while trading. The majority of them provide a means for consumers to make profits on their cryptocurrency deposits (Agostino & Ruizhe, 2021). They also give the community actual power to influence the development and general outcome of how the decentralized exchange will work in the present and future. However, DEXes aren't perfect, this is why CEXes are still preferred. DEX has a lower level of liquidity than CEX and the excessive gas fee on the Ethereum layer-1 blockchain, the transaction cost are the key reasons for DEX markets' price inefficiencies (Andrea & Angelo, 2021). 

In this research, a three-step strategy is used to examine the current state of adoption in Decentralized Exchanges from both sides (supply and demand sides) and the next improvements of DEX to fix liquidity and transaction fee issues for mass adoption. 

Comments

Post a Comment

Popular posts from this blog

Uniswap V3 Breakdowns - State of adoption in DEX (P.8)

  On 23 March 2021, Uniswap team announced the details of their upcoming V3 release but it officially launched on 5 May 2021.  As a result, all analysis of Uniswap V3 would take place from May 2021 onwards.  Fig. 47.  Number of market supported on Uniswap V3 A day after its launch, about 280 new pools were formed in which the 0.3%-fee market had 151 pools because users were becoming accustomed to the general fee of the previous version. Besides, users also created many new pools in the 1%-fee market with 99 new pools. Other lower fee tiers were not of favor to liquidity providers, 0.05%-fee market has only 31 new ones, while no pool was in 0.01%-fee market. Up to now, the number of pools created on V3 has been fairly limited, averaging only about 2 to 20 pools established daily (Fig. 47). It is insignificant when compared to V2.  Fig. 48. Daily positions created in Uniswap V3 in May 2022 In May 2022, on average, more than 300 positions were generated every day;...
Post a Comment
Read more

State of adoption in DEX (P.10)

  A powerful incentive of AMM-based DEX for liquidity provision The results from analyzing the operation of Uniswap V2 and V3 reveal answers to the research question. In most circumstances, exchange operators have a motivation to attempt to and enhance the observed volume on a certain exchange. Increased volume indicates increased liquidity and trust, which will attract more people. This motivation may differ for completely decentralized exchanges, but it is a significant aspect to consider for most existing ones. According to the previous section, V3 market is extremely active when gradually occupying the market share of its predecessor, especially recently when the number of users participating as traders in both versions has become equal. Although the number of pairs made on V3 cannot be compared with a huge variety of pairs on V2, it does not affect the number of swaps executed on V3, particularly in May 2022. All these aspects are facilitating V3 to be an attractive market for...
Post a Comment
Read more

Concentrated Liquidity Market Maker (CLMM) - State of adoption DEX (P.5)

Concentrated Liquidity Market Marker Curve finance (Micheal 2019) adjusts the pricing curve to tackle the capital inefficiency of CPMM, both Balancer and DODO have constructed a new oracle-based pricing curve; while Uniswap has innovated version 3 with a new definition of “Concentrated Liquidity Market Maker” or CLMM that enables liquidity providers more power over the price ranges in which their fund is utilized, with minimal impact on liquidity dispersion and gas inefficiency (Adam et al, 2021). Whitepaper of Uniswap V3 (2021) provides several innovative features:  Concentrated Liquidity: LPs are given the authority to limit their liquidity within an arbitrage price range. This increases the capital efficiency of the pool and enables LPs to estimate their chosen reserve curve but remain optimally aggregated with the rest of the pool.  Adaptable fee: The transaction fee is no longer fixed at 0.3%. Instead, the fee level for each pool is determined at the time of initiation wi...
Post a Comment
Read more