Thursday, 18 March, 2021
Decentralised Exchanges – Trustless and Secure
Centralised Exchanges have played a pivotal role in the crypto asset ecosystem, acting as fiat ramps, custodians, exchange, market makers and VCs, thereby consolidating a lot of power and responsibility. On several occasions, however, they have lost investor money through hacks or fraud. Algorithmic smart contract-based decentralised exchanges offer a non-custodial solution, providing liquidity and value exchange without compromising the sacred tenet “not your key, not your cryptocurrency”.
Centralised and decentralised exchanges
Bitcoin started in 2010 as the first crypto asset, and the only way to acquire it initially was through mining or transacting with a miner. Mt. Gox, launched in July 2010, soon became the leading exchange to buy and sell bitcoins for US dollars. Enthusiasts did not have to mine or barter with miners to acquire bitcoin anymore. As the crypto universe grew and more assets populated the space, exchanges became increasingly pivotal as facilitators of transactions between crypto assets and against fiat. Today, about 300 exchanges support more than 8,000 crypto assets and 35,000 fiat and crypto pairs300 exchanges support more than 8,000 crypto assets and 35,000 fiat and crypto pairslink1. New tokens are launched and listed every day, and exchanges play a crucial role in promoting the token and its price discovery.
Picture 1: EtherDelta was the first DEX that allowed permissionless listing and trading of assets on the Ethereum blockchain
Source: EtherDelta Twitter
However, Etherdelta’s UX was slow and clunky, with investors first needing to transfer assets to the exchange contract and all orders, fills, and cancellations being settled on the blockchain. There was also limited liquidity. Subsequently, there were attempts by the teams at 0x, Bancor and Kyber Network; however, no solution was elegant enough to gain serious traction. Relay by 0x had similar problems to Etherdelta with slow order flow and low liquidity, Bancor and KyberSwap needed central approval for listing and transacting, and because of lack of traction, they had high spreads. There was also the problem of needing a CEX to move value between crypto asset and fiat as they only allowed for transfer between assets on the Ethereum blockchain.
Uniswap launched its upgraded version 2 in 2020 and became the first major DEX to provide a serious and decentralised solution to compete with centralised exchanges. It works as an Automated Market Maker (AMM) and has led the DEX space in users and volumes since. Following Uniswap’s lead and model, other exchanges have come up offering similar services and filling the gaps in Uniswap's model. The success and popularity of DAI and USD-equivalents like USDT, USDC and wrapped assets like WBTC enabled value transfer between assets on the Ethereum blockchain with fiat and BTC, allowing investors to at least change the risk profile of their portfolio if not exit the space entirely. The assets remain in the users' custody, and any exchange is settled within a single block with traders acting as "takers" to the Liquidity Provider "makers". Please refer to the Digital Investorthe Digital Investorlink1 for more on how the participants' interplay.
Figure 1: Constant Product Model where the product of inventory levels x*y remains k = 100
Popularised by Uniswap, AMMs are the most popular type of DEX. Instead of using order books, assets are priced algorithmically using a constant product formula xy=k. Liquidity providers (LPs) pool their tokens against which traders can input their trades and earn a fraction of the trade value as fees. The product of the pool of tokens (xy) must remain the same after the trade (i.e. equal to the constant k), which is why it is called the "constant product formula".
Figure 2: Stableswap curve, constant product curve and constant sum curve
Source: Kyber Network DMM paper
The constant product AMM has different relative prices at all inventory levels and, therefore, does not work well for highly correlated assets, like wrapped tokens, synthetic tokens, and stable coins. For this, Curve pioneered a modified constant sum model, which allows for a 1:1 exchange for most inventory levels. As illustrated in figure 2, the modified constant sum model is linear with the same slope for a large part of the curve allowing for a constant exchange rate, while the constant product model has a variable slope and a variable exchange rate at every point. Only at extreme inventory levels is the price is considered de-pegged from the other pool asset, and the price is allowed to change.
Picture 2: Routing provided by 1inch for a 100 ETH to WBTC transaction utilising Uniswap, Sushiswap, Kyber Network and a Private Market Maker
Source: 1inch Exchange
The Case for Decentralised Exchanges
Now that we understand the different types of decentralised exchanges, it is also important to understand the need for them and what makes them better than centralised custodial exchanges.
The case for DEXes is the same as the case for bitcoin, being in charge of your funds. There will always be a need to move between assets and increase and decrease risk based on market conditions. Centralised exchanges currently provide this service. But decentralised exchanges will continue to grow as limitations like transaction cost, slippage, order books, margin trading, options and leveraged positions are addressed. There are already upcoming projects or improvements in current projects addressing one or more of these limitations. It is only a matter of time that decentralised exchanges start controlling a higher share of volumes. Even centralised exchanges understand this and are already looking to diversify by offering decentralised solutions like Serum by FTX or Binance Smart Chain by Binance. However, the incumbents with an already established user base will likely capture most of the volumes as we advance. Please refer to the Digital Investor to learn more about the specific DEX projects, what differentiates them and how they accrue value.
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