The internet most of us know and use is highly centralized. Every user can act as a consumer or creator, publish and distribute information but not as the owner of it or a contributor to the service.
The operation is concentrated in the hands of corporations which creates room for censorship imposed by national governments, company management and even application stores.
In the end, users comply with rules they didn't vote for, have little control over the data and accept the fact whenever a company decides to shut down an app or change the conditions.
In opposition to the centralized internet (also commonly referred to as Web2), the industry is working on Web3, a decentralized internet where information is stored in a completely different manner and is accessible to all.
By Web3, people mean a network that operates through decentralized protocols and blockchains; its development is often associated with the introduction of Ethereum, EOS, Tron, and a few other chains.
The decentralized nature of blockchain created an opportunity for new economic and business models to emerge, which in turn facilitate the development of Web3.
Among the top driving forces in the blockchain industry and a decentralized internet as a whole, there are decentralized exchanges (DEXs).
What is a Decentralized Exchange (DEX)?
Unlike centralized exchanges (CEX), DEXs allow users to exchange crypto assets on a peer-to-peer basis, through on-chain or off-chain order books or via an automated market maker approach (liquidity pools).
The exchange is regulated by smart contracts and the DEX doesn't have control over the funds. To conduct a trade, users don't need to register or go through KYC, thus can access the protocol from anywhere in the world.
The first DEXs had many restrictions: users could only swap tokens for ETH, direct asset-to-asset trading was not yet possible and the price feeds could be manipulated.
The year 2020 brought some impressive changes with the launch of the second version of Uniswap, the launch of the DEX aggregator 1inch Exchange, SushiSwap, PancakeSwap, Bancor v2, and the evolution of DEXs as we know them today.
Decentralized exchanges account for roughly 1–4% of the total trading volumes. The total trading volume on the top 10 DEXs is significantly inferior to the volume on the top 10 CEXs, with a ratio of $0.104 trillion to $1.44 trillion respectively, as of March 2021.
Source: CoinGecko Quarterly Report Q1 2021
Yet, DEXs are having a greater impact on the development of the blockchain space and the decentralized internet.
DEX liquidity powers the whole of DeFi
The growing demand for DEXs was sparked by the level of security and privacy that they could offer the users. Decentralized exchanges also have a much deeper level of integration into the overall DeFi industry and provide a greater diversity of assets.
Centralized exchanges control the cryptocurrencies they list, often to avoid legal or security issues and to ensure maximum profitability. CEXs only list coins with positive traction and large trading activity.
Whereas listing on a DEX fully depends on its community - any user or project can create a pool and provide liquidity to start trading. Thus, many altcoins and tokens with small market caps are only accessible through DEXs.
The Balancer DEX interface
For example, the centralized exchange Coinbase supports only 53 cryptocurrencies and some assets are only available on the Coinbase Pro tier or in certain regions.
In contrast to this, SushiSwap DEX supports 774 tokens and 987 pairs and is accessible without any restrictions. For many crypto traders, DEXs are the only chance to get into altcoins, find small gems and invest early in promising projects. While for DeFi platforms, decentralized exchanges are the only gateway to their audience.
Listing on DEXs gives a boost to projects that are in the early stages of their development. Project teams can use DEX liquidity pools as one of the means to incentivize the holding of their token until it has real utility.
Liquidity volume in a pool in turn signals to investors that they can always close their positions. Investing in emerging projects gets easier if you know that you won't be left with illiquid funds.
The liquidity accumulating on DEXs is still a small fraction of the volume that centralized exchanges can offer, but the funds are more flexible.
DEX-based Yield Farming activity
DEXs are one of the main components of the DeFi space, Uniswap alone supports over 200 DeFi integrations. DEX native tokens account for half of the DeFi ecosystem market cap and the yield aggregator pillar is also mostly based on DEX activity.
Source: CoinGecko Quarterly Report Q1 2021
One of the forms of yield farming is when a user provides liquidity to a pool on a decentralized exchange and then stakes LP tokens in a farm to earn its native token, while still receiving swapping fees.
Side note: liquidity mining isn't limited to DEXs, some aggregators like Beefy Finance support single asset pools and leverage lending protocols to farm more of the initial tokens. Another option is to farm on lending protocols where the platform distributes rewards for providing liquidity to its pools.
Liquidity mining based on Uniswap, Curve, and other established platforms made the adoption of yield farming easier, as the protocols were already functioning and known before the launch of the liquidity mining programs.
Networks evolve to sustain the load on DEXs
The first decentralized exchanges to ever launch didn't even support asset-to-asset trades. Now, DEXs aggregate multiple features under one platform, for example, SushiSwap released its lending platform Kashi for margin trading, PancakeSwap issued its NFTs, 1inch launched its farming program.
The evolution of decentralized exchanges creates a never-ending cycle:
as platforms become more user friendly and meet more of traders’ needs, the network becomes congested
heavy load on the Ethereum network (the primary chain of many of the first DEXs) highlights its shortcomings, pushing the development team into coming up with updates and scalability solutions
taking advantage of new functionality, DEXs create more use cases and the process starts all over again.
At the beginning of 2021, the DEX trade volume hit a new record. Amid high demand and load on the network, Ethereum Gas fees have risen by almost 400%.
Source: duneanalytics.com/hagaetc/dex-metrics
The problem of scalability and high transaction fees is not new to the network. But this time, it has facilitated the development of Ethereum-alternatives such as, Layer 2 solutions and Binance Smart Chain, where the main driving force is yet another DEX i.e. PancakeSwap. PancakeSwap now processes over 2 million transactions a day, which is more than the whole Ethereum network.
Source: DappRadar
In answer to the competing blockchains eating out Ethereum’s market share, the Ethereum development team has come back with a set of Layer 2 scaling solutions. The team is working on Optimism, ZK, xDAI and Polygon rollups. And here's how it comes back down to DEXs. Uniswap and Synthetix have already announced that their protocols will integrate the Optimism solution. Market actors suggest that many DeFi projects would also prefer Optimism over other rollups, just to stay integrated with the bigger projects and their liquidity.
DEX competition pushing things further
The DEX market is still heavily dominated by Uniswap, accounting for more than 30% of the total trade volume. But it takes extensive advancements to stay in the top 10 and to compete with other platforms and solutions across other networks.
Source: www.theblockcrypto.com/data/decentralized-finance/dex-non-custodial
By design, all DEXs fulfill the same function - to enable P2P exchange of tokens, yet in terms of strategic development, every platform has its own focus and unique functionality.
For example:
- SushiSwap focuses on liquidity pool expansion and incentivizes staking in small token project pools through its Onsen program. The protocol distributes extra rewards in SUSHI for providing liquidity.
- Uniswap v3 prioritizes capital efficiency by introducing a concentrated liquidity feature and allowing users to deposit funds at custom price curves.
- Curve focuses on stablecoin pairs and has introduced Metapools or pools-of-pools, allowing users to get exposure to several tokens in the pool by depositing just one of them and the platform to listless liquid assets.
The general development of decentralized exchanges is motivated by solving issues that are relevant to the whole DeFi industry. The next milestone for DEXs is the successful launch of a cross-chain decentralized exchange that will facilitate interoperability.
Closing thoughts
The evolution of decentralized exchanges is linked to the advancement of the whole blockchain industry and greatly affects the development of the decentralized internet. DEXs fuel the whole ecosystem of DeFi services that are now starting to include more decentralized applications, decentralizes SaaS, facilitate tokenization of assets and adoption of the P2P model.
Despite all these advancements, we're still in the early stage of Web3 development and adoption. Users still encounter many obstacles: it's hard to interact with the protocols from a phone and the desktop versions require additional software like wallet extensions.
There are also problems of scalability, cost of operations, user experience and security. But this is common for newly emerging technologies and mechanisms, especially the ones that bring economic and financial value.