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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. 

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