The State of Decentralised Exchanges, 2021

Decentralised exchanges provide peer-to-peer marketplaces that allow users to custody their own crypto, unlike centralised exchanges, which hold their users’ cryptocurrencies on their behalf. Proponents of decentralised exchanges lambast the lack of security and transparency of centralised exchanges.

For now, centralised exchanges remain the simplest way to trade funds, while decentralised exchanges can be costly or too technically complex for many users. In order to take advantage of the best of both worlds, some exchanges have built a hybrid between centralised and decentralised marketplaces.

Many actors have moved into the space to solve these problems in a decentralised manner. For instance, 0x, Ethfinex, (not decentralised, but non-custodial), and EtherDelta have generated strong interest in preceding years. The now-defunct EtherDelta was one of the first movers in this space, offering a straightforward user-interface and basic trading features (no margin trading, for instance), and quickly generated up to 25 million USD worth of daily transactions.

Whereas on a centralised exchange platform, users hand over custody (and therefore private keys) to a third party, decentralised exchanges empower users to remain in control of their funds by operating their critical functions on the blockchain. To date, most decentralised exchanges have not been fully decentralised, but instead semi-decentralised. Servers still host web interfaces and some even host order books. (It is still possible to interact directly with the underlying smart contracts if you are a power user, to be sure). They do not, however, hold private keys.

The central benefit of a decentralised exchange, theoretically, is that the platforms do not involve the trusting of third party platforms to secure funds. Security and privacy are generally considered strong, as long as the platform in question has undergone a code audit. But don't be fooled; these security audits don’t always mark a platform as safe because, in recent history, we’ve seen a number of yield farm products that have been exploited. DEX’s also suffer from some of the same scalability problems as the underlying blockchain upon which they’ve been deployed. Liquidity can be a problem on DEXs, and none offer fiat ramps, because there is no central entity to facilitate this and adhere to KYC/AML requirements.

Although there are concerted efforts to inform the public about the drawbacks of centralised exchanges, many are still not aware thereof or simply prefer the conveniences. Furthermore, many people remain uncomfortable with managing their own private keys, since on a DEX that responsibility falls at the feet of the users. DEX’s, therefore, are not user-friendly for many people.

There can be times at which congestion on a certain blockchain network undermines the ability to transact on said blockchain, such as the case when there has been network congestion on the Bitcoin and Ethereum networks. When transacting on a blockchain network, traders must wait for transactions to be confirmed by the blockchain. This can affect trading on a DEX. On centralized exchanges, withdrawals and deposits can be affected.

Until more traders adopt decentralised exchanges, there can also be a paucity of liquidity on decentralised exchanges, which is a drawback. Miners preview transactions on a DEX, because they provide validation. They will reorganise transactions in a block to take advantage of arbitrage opportunities, for example.

To date, the vast majority of cryptocurrency transactions go through centralised exchanges. Decentralised exchanges, however, are necessary for cryptocurrencies to realise their intended potential — that is, to decentralise the world of finance and provide censorship resistance. This ultimately increases the chances of mass adoption whereas centralised platforms carry many obstacles to overcome.

In the long run, centralised and decentralised exchanges will likely co-exist. Centralised exchanges will be necessary as fiat onramps and off-ramps, allowing users to receive transactions to their bank accounts. Additionally, some people probably don’t want to manage their own private keys.

Are DEX’s Secure?

Crypto exchange ranking platform Cer Live, released a recent report in which it argued that 14 of the top 25 DEX’s scored poorly in terms of cybersecurity. The report found fake token listings, a propensity of slippage, transaction confirmation delays, and a lack of data about listed trading pairs.

The report analysed whether exchanges had undertaken security audits, offered bounties to incentivise the public discovery of bugs, ensured adequate end-to-end security, and more and then assigned a score between 1–10 based on each venue’s security.

Any score above an 8 was considered “high” by CER, 6–8 was “good”, and anything below 6 was considered “low” or “unsafe.” Of the 25 exchanges analysed, only two of the reviewed DEX’s earned a “high” security score: Uniswap and Synthetix.

CER noted that several exchanges failed to receive an audit after recent updates to their code. The crypto exchange ranking platform reduced scores for exchanges whose audits were considered out of date. Many exchanges did not release public audits whatsoever.

“6 exchanges (24%) failed to pass a security audit or did not publicly announce that they have undergone an audit,” reads the report. “It should be noted that an unaudited exchange cannot be considered safe.” We would note that not even audited defi apps can be fully trusted because even audited platforms have been exploited in ways not covered by the original audits.

Some of the exchanges contracted individual researchers rather than auditing companies, a practice which the report rankings punished. The report concludes that DEX users are more likely to be defrauded than be a victim of a hack. “Despite the fact that there haven’t been any significant hacks on decentralized exchanges in comparison to centralized platforms, DEX users are actually more susceptible to fraudulent attacks.”

CER researchers argued that 92% of the top 25 DEXs ought to place a stronger focus on security, encouraging these exchanges to follow best practices to ensure safe trading. In other words, just 8% of the exchanges were deemed secure.

Automated Market Makers

One of the big stories in the world of DEXs has been Uniswap, SushiSwap and other so-called Automated Market Makers (AMM). Use of Uniswap, an Ethereum-based DEX, ballooned and then deflated throughout the course of 2020.

In the closing months of 2020, liquidity incentives on the Uniswap decentralised exchange dried up. The platform offloaded 40% of its liquidity over just 48 hours as the UNI liquidity rewards program came to a close Nov. 17. This led to an exodus from Uniswap to Sushiswap, although the former has remained the leading AMM.

Uniswap’s success in the space is a testament to meeting demand and doing so well. It remains the largest platform by far, although critics suggest scams tend to issue a token for trading on Uniswap. With a liquidity decline on Uniswap, some of the platform’s token holders have banded together and issued a fresh governance proposal designed to implement a new rewards program. Since Uniswap went to a fully decentralised governance model in mid-September, however, not a single governance proposal has passed through its approval process.

Governance tokens, nonetheless, have put winds in the sails of DEXs. Proponents say that such tokens can help lock up liquidity in DEXs so as to develop next-generation DeFi apps. They can also be used to help a DEX’s community make decisions as a group.

Centralised and decentralised exchanges are not necessarily direct competitors, for individual users may be inclined towards a centralised exchange or they may be inclined towards a decentralised exchange. Moreover, centralised exchanges have altogether different value propositions than decentralised exchanges. If people don’t want to custody their assets, centralised exchanges are for them. Decentralised exchanges also provide privacy and trust, with no need for users to submit to KYC and AML procedures. If users want to custody their assets, decentralised exchanges are likely for them.

UniSwap and SushiSwap

Uniswap and SushiSwap have emerged as the leading next-generation DEXs. Each exchange works on the AMM principle (Automatic Market Maker). Whereas regular exchanges require orders to set the price of a trading pair, AMMs do not. Front-running and price discovery are often considered major issues in AMM exchanges.

“The growth of decentralized exchanges in 2020 has been phenomenal, but there is a hard ceiling with current technology” states Andrey Shevchenko from CoinTelegraph.

They also don’t require a buyer and a seller on opposite ends to execute a trade. AMMs instead use a liquidity pool wherein any user can access the pools to buy or sell tokens. The price is then determined by the ratio of the two assets within a trading pair’s pool. For instance, if the ETH/USDT pool has 100 ETH and 60,000 USDT, the 1 ETH price would be equal to 600 USDT (60,000/100=600). As users trade their ETH or USDT, the pool’s ratio adjusts, and this is reflected in the change of the price. The liquidity is also provided by users, and anyone can supply liquidity to a pool, and, in return, earn fees.

At the time of writing, Uniswap currently holds $1.33 Billion USD in locked liquidity…Sushiswap, on the other hand, holds $838 million in locked liquidity. Uniswap reached a maximum liquidity level so far in its history on Nov 14, 2020, with $3.07 billion. Sushiswap reached on Sep 12, 2020, a high of $1.43 billion.

SushiSwap users enjoy 72 coins in 90 different pairs, whereas Uniswap offers users a whopping 24,528 pairs listed, though most have died due to failure in some form, have been closed, or are no longer actively trading.

The latter has a distinct advantage, insofar as nearly each new Ethereum-based project leverages it to raise liquidity. Whereas in the past new token projects depended upon exchanges on centralized exchanges, this is no longer the case due to AMMs.

Uniswap and SushiSwap are each dependent upon their community to provide the liquidity to lock up funds. Liquidity providers can, in turn, earn fees on transactions. Uniswap and Sushiswap both charge users 0.3% in trading fees, each paying these fees out different to the liquidity providers on the platform, though the experience for the end-user is the same on both. Uniswap pays the fees to liquidity providers, while Sushiswap only pays out 0.25% to the liquidity providers. The other 0.05% are reserved for the SUSHI token holders.

Uniswap generally offers less slippage than SushiSwap, simply because liquidity is higher on the former. However, constructive mechanisms to compete are moving fast at SushiSwap. One exception is the SUSHI/ETH pair on Sushiswap, which features lower slippage than trading it on Uniswap.

Liquidity providers can earn passive income by farming UNI or SUSHI tokens. Uniswap ended farming on Nov 1, 2020, while SushiSwap still allows the practice. Farming SUSHI pays out 80.39% APY at the time of writing. Some consider this an advantage for SushiSwap. To farm on the platform, liquidity providers stake their SLP (Sushi Liquidity Pool) which can provide very attractive yields.

The UNI token is a governance token. It intends to transform Uniswap into a decentralised, community-owned protocol. Its only function is voting on proposals regarding the protocol. SUSHI is similar to UNI in function, with the added benefit that it enables the coin holders to share 0.05% of the exchange fees.

Uniswap is the most popular and widely used DEX. It is also the best from a user’s perspective. Liquidity providers might earn more on Sushiswap, however, when they farm SUSHI. As for the tokens themselves, barring any price fluctuations, SUSHI comes with the added benefit of earning fees passively for the token holders.

Bitcoin-Inspired DEXs?

Bitcoin sidechain RSK is also working on potential competitors to other DEXs. Defi protocol Money On Chain, a lending platform and stablecoin issuer, announced the launch of TEX, an automated tokens swap platform based on an order book.

On the platform, orders are processed in batches based on a slight variable interval of a few minutes. Each execution is called a tick, and it matches the order submitted to the blockchain. Trades which occur in a given tick are performed at the same average price between all orders submitted by traders, and limit orders submitted by users indicate the maximum or minimum acceptable price. A limit order to sell Bitcoin for $18,000, for instance, will not be triggered if the average price is $17,900.

The system uses an oracle system and, when it comes to “market maker orders,” traders express a price with a certain percentage offset from the reference rate obtained by the oracle so that orders track the changes in price occurring between ticks. The system’s design is based on the London Spot Fix, which is a pricing mechanism for gold where a committee deliberates the price of gold twice per day.

TEX was designed to ensure fair price discovery — even at low volume — and eliminate front-running. The Money On Chain team argues their system needs less liquidity to operate than AMMs and, therefore, suffers less slippage.

Why Decentralised Exchanges?

When Bitcoin became well-known, one of the common refrains to describe the technology was that it allowed holders to become their own bank. Decentralised exchanges are a continuation of this ethos. They give users control over their money, whereas exchanges usurp that. You literally give control over your money to exchange, who all too often get hacked or fail to provide access to user funds. Decentralised exchanges will only become increasingly efficient

ChartEx is a leading provider of full Candlestick charting for markets on Uniswap, the largest Decentralized Exchange running on the Ethereum Network.