Decentralized Exchanges
Note: Data in this section last updated March 13th, 2022
What are Decentralized Exchanges?
Decentralized exchanges (or DEXs) are peer-to-peer marketplaces where users can directly trade with one another without the need for banks, brokers or any other financial intermediaries.
Monthly DEX Volume
They have hosted nearly $1T of trades over the last 12 months, and are even catching up to centralized exchanges, with Uniswap recently averaging over 50% of Coinbase’s volume and 10% of Binance’s volume.
How Are Decentralized Exchanges Different from Traditional Exchanges?
Traditional exchanges, such as the NYSE, Nasdaq or Coinbase, provide a platform to match buyers and sellers of securities. This begs the question, what happens if there’s a temporary imbalance between the two?
Enter market makers. Market makers, who are often brokerage houses, hold onto a “reserve” of assets that they are always ready to buy or sell. Instead of trying to profit on the movement of a security, they profit from the difference in the buying price and the selling price, known as the bid-ask spread.
These professionals are essential because they ensure that traders can always immediately buy or sell during trading hours, providing much needed liquidity to the markets.
A new breed of decentralized exchanges, however, is removing the need for these middleman and allowing direct peer-to-peer trading through what is known as an Automated Market Maker (“AMM”).
Instead of needing to match buyers and sellers in real-time, the participants of an AMM contribute their tokens to a centralized reserve known as a liquidity pool. This eliminates the need for a market maker as prospective traders can now directly through that pool, depositing what they want to sell and taking what they want to buy.
For example, let’s say you wanted to trade ETH for UST on Uniswap. You would simply go to the site, access the ETH-UST pool, send in your ETH and receive UST in return. The price is controlled by a simple algorithm that raises the price of a token when demand increases, and lowers it when demand falls.
The decentralized nature of these AMMs have several unique benefits:
Anonymity: DEXs don’t require sign-ups, KYC information or any customer information at all
24/7/365: The unique liquidity pool structure of AMMs means that trading never shuts down
Deep liquidity: Although DEXs have not yet caught up to their centralized competitors, the fact that anyone can provide liquidity creates huge potential for the market
Personally, I believe that one of the most beneficial aspect of DEXs today is that they’re not subjected to the limitations of Coinbase and Binance. Unfortunately, the two largest centralized exchanges often have arbitrary and stringent rules for listing coins, so it’s not uncommon to be blocked from purchasing a popular token. With over 50,000 trading pairs listed on Uniswap, however, you can almost always find what you are looking for!
While extremely elegant and seemingly much more efficient than traditional exchanges AMMs are not without their risks, which include:
Smart Contract Risk: It’s vital to remember that these AMMs are nothing more than lines of code, and code can be very vulnerable. For instance, if there’s a bug or if a hacker finds an exploit, participants could easily lose all of their funds. That’s why some of the largest exchanges hold reimbursement funds.
Impermanent Loss: Impermanent loss is a complicated concept whose mechanics are outside the scope of this article. But in essence, it’s a form of opportunity cost, where a liquidity provider loses out on potential gains because his or her funds are locked in a liquidity pool
Who are the Key Players in the DEX Market?
At the time of writing, the three largest by volume are Uniswap, Sushiswap and Curve.
Last updated
