Evolution Of Crypto Exchanges
The Blockchain Sector @ 2023-09-09
Even in a bear market Binance has $5B daily trading volume. If you add the daily volume of all decentralized exchanges including Uniswap & Curve across all blockchains it would come to less than 10% of this.
Why Are We Still Using Centralized Exchanges?
I believe there are two reasons.
Liquidity, it’s hard to trade high volumes or employ strategies that require leverage effectively on decentralized exchanges. Perpetual futures have become the standard instrument for crypto day traders. Trading on DEX currently means higher slippage and more liquidity issues getting in and out of positions.
User Experience, the current state of DEX interfaces and wallet management is somewhat crude and technically demanding. Centralized exchanges can execute quicker on central limit order books to provide a better UX. Expensive slow transactions caused by limitations on block space make it difficult for developers to compete… currently.
Currently in DeFi automated market makers like Uniswap and Curve reign supreme. These exchanges are built to optimize for a blockchain environment with high transaction fees. This environment is about to change…
How Will This Change Over The Next Decade?
Blockchain space is currently at a premium, there isn’t enough capacity on Ethereum for everyone to do whatever they want for next to no cost. Later this year we will see EIP4844 roll out which will introduce proto-danksharding and make L2’s much more efficient. By creating temporary blockspace on mainnet, it’s possible for L2’s to reduce their costs by an order of magnitude.
The $0.30 transactions on Arbitrum now might cost $0.03 in the future. Or another L2 chain, perhaps zero knowledge based will capture attention. Either way on-chain data is going to become faster and cheaper. Bringing Web3 backend technologies in touching reach of competing with Web2 server→database infrastructure.
This opens up an opportunity for decentralized exchanges to compete on par with centralized incumbents.
Why Would Traders Want To Use DEX’s?
Three letters sum this up, FTX
One of the standout features of DEXs is the self-custody of assets. When you use a DEX, you retain direct control over your assets until the moment you trade them. You are not required to surrender your assets into a pooled fund where they can be misused, as with centralized exchanges.
I’m a big fan of CZ and how he carries himself in a industry where he has to put up with abuse from all angles. However I wouldn’t bet against regulators eventually finding comingling of assets or some kind of malpractice within Binance’s books. What went on at FTX is probably widespread throughout the industry on a less obvious scale.
There is also the permissionless, censorship resistance aspect. Regulators aren’t seen as working in the interests of traders.
A 24/7, smart contract based, digital exchange where every user has the same rights and no single entity has admin privileges, should be appealing.
How To Overcome The Liquidity Issue
I believe this is a chicken and an egg problem. Users aren’t trading on decentralized exchanges outside of AMM’s like Uniswap, so market makers aren’t as active and there isn’t as much liquidity.
Combine this with transactional costs and slow block confirmation times and market makers can’t quote tight spreads on decentralized order books. Some of this can be solved by technical improvements to the data layer which are coming.
If adoption increases, more traders turn up and click buttons, there will be more programmatic traders turn up to provide liquidity.
DeFi needs users.
How To Overcome The UX Issue
Users need UX.
We’ve already spoken about the potential for Ethereum scaling to make backend data more efficient. But on the frontend there are road blocks as well. Perhaps none more pertinent than the centralized app stores that have a dictatorship over the mobile economy.
App stores currently enforce a 30% commission on crypto deposits which makes crypto apps for the most part impossible to roll out. That combined with the inherent centralization and potential for censorship, means we need an alternative solution.
In the last newsletter I spoke about the Friend.Tech progressive web app and I believe this might be the missing part of the puzzle to creating seamless Web3 experiences.
Block confirmation times are another issue for UX. When writing data on-chain such as adding an order it takes around 10-15 seconds to get a confirmation response on Ethereum mainnet. Layer 2’s bring this down to around 1 second already and in time RPC performance will likely improve to a point where it’s comparable to Web2 backends.
Timeframe For DEX Adoption
There are obvious benefits to decentralized exchanges but the timeframe for their adoption isn’t clear.
If Bitcoin made a new all time high tomorrow, I think retail would return to trade risky assets on even more risky centralized exchanges. The technology hasn’t quite caught up yet to make it possible to trade on decentralized exchanges with equal UX to centralized competitors.
By the time EIP4844 rolls out towards the end of 2023 we will be one step closer. The next generation of zkRollups and dedicated appChains will be another step towards getting the fundamental infrastructure in place. More widespread use of progressive web apps would be another big stepping stone in place.
We then just need one “killer app” to take off and attract users, which will create liquidity, further attracting sophisticated market participants. This flywheel would bootstrap liquidity which would solve the other side of the challenge.
Uniswap really captured attention in the last market cycle but they are moving further towards centralized, censored solutions such as RFQ systems. Their use of business licenses on software built upon the efforts of the open source community has also created some negative sentiment. Although they have the biggest brand and first move advantage, I don’t believe Uniswap are in the best position to capitalize on future DEX adoption. The automated market maker was a temporary solution to high gas fees which are going to become a thing of the past.
There is an opportunity in 2024/2025 for decentralized trading of digital assets to take off in a big way and it’s something I’m going to be following very closely.
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Very good article on "Timeframe For DEX Adoption" and with you on that. have a look to https://app.dexfinance.com/ as they might be exactly something to solve this.