The Blossoming of Decentralized Exchanges

Decentralized Exchanges (DEXes) are almost as old as the ERC-20 token standard on Ethereum. However, only very recently they have gained sufficient popularity in order to compete with established centralized exchanges. The recent Uniswap Airdrop marked certainly a peak in DEX awareness. 

The Blossoming of Decentralized Exchanges

Let’s first define DEXes

The characteristics of a DEX are typically the following:

  • They operate in a decentralized way without any central authority
  • Trading takes place peer-to-peer without any intermediaries
  • Orders are executed through smart contract logic on a blockchain, typically the Ethereum blockchain
  • No KYC (know your customer) is required

Cross-Chain Swaps

Since most decentralized exchanges are built on Ethereum tokens that can be exchanged on a DEX are typically limited to Ethereum token standards such as ERC-20 tokens or non-fugible ERC-721 tokens

This means that Bitcoin for example can not be traded on the most common DEXes. However, smart minds have been aware of the absence of BTC in DeFi for a long time and have figured out a way to include it in Ethereum’s decentralized finance ecosystem.

Wrapped Bitcoin on Ethereum

Wrapped BTC (WBTC) is an ERC-20 token on Ethereum that is backed 1:1 with Bitcoin. It is fully transparent and verifiable for anyone that the ERC-20 token is backed by actual Bitcoin. The price performance of WBTC has mirrored very closely the actual price performance of Bitcoin so far.

Furthermore, WBTC lately has gained tremendously in popularity and has exceeded a market capitalization of one billion USD. This ranks the token among the 30 most valuable cryptocurrencies by market capitalization. 

Trading Innovation

The fact that decentralized exchanges operate on execution environments has enabled significant innovation in trading practices. Among the most remarkable novelties is Automated Market Making (AMM). 

Market Making on traditional exchanges was generally performed by investors with significant funds in relation to the overall volume. Those investors are commonly referred to as whales. Whales would make quotes for selling and buying an asset at a certain price. They would provide liquidity for the market in the hope of making a profit. 

AMM is eventually automating the process of market making through the deployment of algorithms that perform the market making tasks. These algorithms enable users to provide liquidity in a smart contract which is then used for automated market making.

Typically protocols reward users for providing liquidity which has fueled the recent yield farming boom. 

DEX market structure

According to Dune Analytics, a blockchain data intelligence provider, the five most popular DEXes include:

  1. Uniswap
  2. Curve
  3. 0x
  4. Balancer
  5. Kyber

Since users are paying horrendous transaction fees for a trade on Uniswap more and more people have been asking when it will become possible for DEXes to move to layer 2 scaling solutions.

So far it is not yet clear when Uniswap will launch version 3 and if layer 2 scaling will be included in version 3 of the protocol. In the meantime other DEXes are working on scalable trading infrastructure.

Injective Protocol

One of the protocols working on fast and efficient layer two trading is Injective Protocols. Injective Protocols raised a 2.6 million USD seed round in July 29. The round was led by Pantera Capital. 

The project is building a platform for decentralized spot, futures and margin trading. It is designed as a layer-2 sidechain and Cosmos Zone connected to Ethereum. Furthermore, the project plans to offer cross-chain trading. The exchange is projected to launch soon without any specified date. 

Project Serum

In contrast to Injective Protocol, Project Serum has already launched on August 11. The exchange is governed by the SRM governance token. The token can also be staked and used to pay for gas fees. The token price skyrocketed immediately after it was listed on Binance.

Project Serum is built on Solana but is designed to be interoperable with Ethereum. At the current stage the exchange is mostly used for trading Solana against stable coins. Note that the exchange volume is only a small fraction of the volume that is processed on Uniswap. 

Regulatory Outlook

It remains to be seen how DEXes will be treated in the future from a regulatory perspective. So far the CFTC (Commodity Futures Trading Commission) or the SEC (Securities and Exchange Commission) in the US have not pursued any actions against decentralized exchanges.

However, they have charged centralized exchanges such as the recent example of Bitmex has shown. Centralized exchanges are much easier to pursue since the responsibilities are clear.

Before you go …

Decentralized exchanges are certainly among the most remarkable innovations in distributed ledger technology. As soon as real world items are tokenized as NFTs and traded on DEXes those decentralized exchanges will be able to show their full potential.

In the meantime watch out for the adoption of scaling technologies since this will be the next big leap forward for decentralized exchanges.