Decentralized exchanges (DEX) have always been one of the main driving forces of decentralized finance (DeFi), which has aroused great interest from institutional investors. However, since DEX is very different from traditional trading venues, financial institutions should be aware of the opportunities and risks involved.
Decentralized finance (DeFi) is one of the biggest success stories in the field of digital assets, which almost killed the statement that blockchain technology is “searching for solutions to problems”. After finding the initial home on Ethereum, interoperability And scalability on other platforms to enable this segment to attract close $175 billion Locked up funds, which was less than $10 billion a year ago.In addition, DeFi is now attracting Large sums of money In venture capital.
Although almost every new plan claims to offer something different, most of DeFi’s growth is driven by two main components-lending pools and decentralized exchanges (DEX). The latter has undergone many iterations over the years, but the embedded model is widely based on ideas pioneered by exchanges such as Uniswap and Bancor.
What is DEX?
In short, DEX connects sellers and buyers, and automatically calculates exchange rates and fees based on supply and demand. Unlike matching buyers and sellers through an order book in a centralized exchange, smart contracts execute all transactions. DEXs like Uniswap usually operate through a liquidity pool consisting of a pair of tokens. For example, such a liquidity pool might include Bitcoin (BTC) and USD stablecoins, such as Tether (USDT).
In return for providing liquidity to the mining pool by “locking up” assets, users often referred to as “yield farmers” get a portion of the transaction fees paid by traders who use it to exchange tokens. The rate of return is adjusted according to the relative scarcity of the assets in the pool. Going back to the previous example, if USDT’s trading volume is very low, the rate of return will automatically increase to incentivize users to provide more liquidity. The goal is to create a decentralized and automated trading system. Other exchanges such as Balancer operate multi-token pools, while Curve Finance focuses on stable currency arbitrage.
According to a report, although most of the growth in DEX usage is driven by the retail sector, there is increasing evidence that institutions are interested in the field Recent report From chain analysis. However, decentralized exchanges are completely different from centralized exchanges, which present a series of unique opportunities and challenges for institutional participants.
The advantages of DEX over centralized exchanges
First of all, their openness and permission-free nature means that DEX can list a lot of tokens, because anyone can start their own liquidity pool. Sometime in 2020, Coindesk Report Uniswap added more than a thousand new token pairs in a week. Therefore, DEX enables early investors to start trading with sufficient liquidity before tokens are listed on a centralized exchange. In addition, since all activities on the DEX are governed by the underlying smart contract, traders do not have to give the custody of their funds to a third party.
In addition, DEX can provide higher execution reliability during high volatility events caused by cascading clearing of derivative positions on centralized exchanges. Although CEX may not respond at all in a short period of time due to API overload, DEX transactions are still valid and orders can be executed reliably, although the fees required to complete transactions may increase sharply in the short term (especially in the case of Ethereum) ) Based on transactions).
Risks of using DEX
Unfortunately, many of the benefits of using DEX are a double-edged sword, especially institutional users face certain risks. On the one hand, most DeFi is currently not regulated, and participants generally do not accept KYC. Anyone can download wallets such as Metamask and start trading tokens immediately.
The lack of supervision has become a honeypot for scam token operators to launch their own mining pools, and DEX has also been involved in money laundering activities.For example, after the centralized exchange KuCoin suffered a major hack at the end of 2020, criminals used the decentralized exchange to trade Nearly 20 million U.S. dollars Stolen tokens. The lack of a compliant legal framework creates barriers to entry for institutions that are forced to operate within the permitted secondary market.
Similarly, slippage and preemption are common risks of DEX. Blockchain transactions are not instant. In a volatile cryptocurrency market, prices may change as the order takes as a confirmation transaction execution time. On-chain transactions are also affected by network congestion, which may result in higher execution fees compared to centralized exchanges.
In addition, due to the openness of the public blockchain, anyone can view the transaction pool waiting for confirmation. Leaders set up bots to scan the pool for potentially profitable arbitrage transactions. When they find one, they will immediately make the same transaction but with higher fees, which makes it more attractive for miners to pick from the queue. Many DEXs and platforms have taken measures to deal with this risk, but it is still a long-standing problem.
In addition, the transparency of the smart contract code based on the DeFi protocol allows anyone to view it, but it also means that anyone can find and exploit code errors and vulnerabilities. Therefore, smart contract risk is a long-term problem in the DeFi field, leading to a surge in dedicated DeFi insurance pools, such as Nexus Mutual or Opium Insurance, which provide protection for smart contract risks. It has also become more and more common for projects to use code audit services from well-known network security consulting companies such as CertiK or Kaspersky and to pay generous bug bounties to white hat developers.
A challenging but improved user experience
In addition to risk factors, institutions may also find that the DEX user experience is lacking in several areas.
Although in theory any token can be traded, only the largest mining pools have enough liquidity to conduct large transactions. DeFi is completely separated from the traditional financial system, so it is not possible to start DEX with fiat currency. Instead, users must first use a centralized service to obtain cryptocurrency before they can participate in DeFi.
DEX also needs to be self-custodial, and many institutions may prefer to use custody service providers to custody digital assets. At the beginning of the DeFi wave, for developers who were more focused on smart contract code, the user interface was often an afterthought. The user interface of services such as Curve Finance proves this, and it still has the look and feel of the DOS computer program of the 1980s.
In addition, DEX often does not provide a series of order types, charting tools or technical indicators that many centralized counterparties have. However, this situation is rapidly changing. The recently emerged DEXs such as dYdX and Perp provide decentralized, self-custodial spot and derivatives trading, combined with a user interface similar to CEX. This shows that decentralization does not necessarily need to be at the expense of functionality and user experience.
In recent years, decentralized exchanges have made great progress, from a niche concept to the accumulation of billions of dollars in locked assets. Although institutions are very interested in this concept, and some institutions are keen to take advantage of the transformative potential of DEX, they should be aware of the regulatory and operational challenges involved.