The world has transformed in the past few years with lightning speed. The way people conduct financial transactions evolved, as well.
A strong need for financial inclusion together with opening the opportunities to preserve capital and generate wealth for people all over the world lead to the birth of a decentralized financial system. DeFi marks the new era of transferring value from traditional finance and preparing the world for a tokenized future.
In 2020 the blockchain market flourished with many decentralized exchanges and protocols. The cryptocurrency trading community has also grown significantly. DeFi wants and needs to attract users to gain mass adoption, however, it still loses traders to centralized solutions. The modern user has to settle for a compromise instead of a perfect product, no matter whether the choice is centralized or decentralized trading platforms.
Let’s go into details here.
Cryptocurrency markets can be divided into two categories: centralized (exchanges that always feature the orderbook) and decentralized (can be with or without the orderbook).
Centralized exchanges are well-known to any novice crypto trader. They belong to a particular company and require active market-making. The idea of orderbook markets came from traditional finance.
Centralized exchanges are called Orderbook markets because buyers and sellers can offer prices at which they are happy to buy or sell assets on the exchange, forming a book (or list) of future orders. The trade is executed if there is a match between one user’s buy order price and another user’s sell order price. This matched price becomes the asset’s new market price.
Both participants of the orderbook markets enjoy a wide range of benefits but at the same time have to compromise on some important aspects.
The main advantages of centralized exchanges are user experience and low latency.
Centralized exchanges are usually the most user-friendly, as a big part of their audience is newcomers to the crypto industry. Hence, the design is more intuitive and the platforms are easy to navigate even for traders buying crypto for the first time. Moreover, users can convert their fiat into crypto directly on the exchange.
Latency means the time that it takes to place or edit an order in the orderbook. Centralized exchanges are fast and can process a transaction in only about 20 milliseconds.
The main disadvantages or question marks in the trading experience on centralized exchanges are security and KYC.
Being the digital industry crypto has to be resistant to any hacks. As a trader or simply a cryptocurrency holder, you want to be sure that your funds are always safe and will not vanish from the exchange for any reason. There are two risks here: exchange getting hacked because its security was not top-notch and founders of exchange running away with your funds. While the latter can be eliminated by choosing a trusted exchange, the security issue of centralized exchanges does not have any real remedy yet.
Hence, keeping your crypto on the centralized exchange you have to fully trust the team behind the exchange and accept that your funds are always at risk. It is a very big ask from the user and many traders resort to moving their funds back and forth between the exchange and cryptocurrency wallets every time they want to trade. Such activity comes at a cost, as traders have to pay the fees for each transfer.
Another limitation of centralized exchanges is a KYC (Know Your Client) procedure. Each market participant has to go through a thorough process of submitting personal information including IDs to assure data security. While the traders might be comfortable sharing their data for KYC for a good cause, they don’t have full information about its further use. As a user, you definitely don't want your personal information to be leaked on the Internet or your data to be used for various purposes without your permission.
Decentralized exchanges emerged not so long ago to remedy the limitations of centralised competitors. These markets depend on passive market making and are controlled purely by supply and demand or AMM model (Automated Market Maker). Some of the well-known examples of such exchanges are Uniswap, Balancer and Sushiswap.
AMMs allow permissionless and automatic ways of trading digital assets and use liquidity pools instead of a traditional market with buyers and sellers. Liquidity Providers (LPs) are users who supply their crypto tokens and for a liquidity pool. In this case prices of tokens are determined by a constant mathematical formula.
Decentralized exchanges are open for trading 24/7 and do not rely on the traditional interaction between buyers and sellers. They are the embodiment of initial crypto ideas: no single entity is in control of the system, and anyone can build new solutions and participate. As a user, you trust the code instead of trusting the company.
Users of decentralized exchanges can forget about the risks of hacks and non-transparent KYC processes. Trading on a decentralised exchange, users need only to connect their wallet to execute the swap between cryptocurrencies of their choice. Funds are not kept on the exchange but move directly to and from the wallet, so security is not compromised at any point of the trading process. As the funds always remain with the user there are fewer risks involved and the whole system stays very secure.
It would be a great solution to the disadvantages of centralized exchanges if not all the negative properties of such markets. Decentralized exchange users suffer from a wide range of limitations of DEXes such as price shocks, slippage, frontrunning and arbitraging.
Let us explain the terms here.
Price Slippage happens when the user places a trade that is larger than the liquidity available in the market. Using a simple analogy, if you are trying to buy more apples in a market with limited supply, the price of one apple will increase. On the other hand, if we don't allow the seller to increase the price of the apples, then the seller is losing value by providing apples to the market and has more incentive to just hold on to his apples. Similarly, the AMM increases or decreases the price of an asset to protect the LP in case of mass buy or sell events in the market. This is outlined in the Uniswap model though limits for price slippage tolerance. The higher the slippage that you are ready to tolerate the easier your swap will go.
Arbitraging is a mechanism used to level the swap price with the market price of the given asset. An arbitrageur makes a profit from buying the asset at a lower price on one market and selling the asset at a higher price in another market. The LPs are paying the arbitrageur's profit, however, if somebody doesn't execute arbitrage then the AMM pool will continue to trade at a skewed price. There is no AMM model that can function without arbitraging.
Frontrunning is an issue related to the blockchain and not the AMM pool directly. Ethereum-like blockchains prioritise transactions with higher gas fees. As blockchain is transparent anyone in the network can see other transactions in the queue. Imagine that someone in the network notices that you are buying a lot of asset X. Likely that after your transaction the price of the asset will increase due to increased demand. Seasoned traders can execute their transaction before yours by setting higher gas fees for their transaction. In this case, your swap price will go up and you will end up purchasing the asset at a higher price than you originally intended.
High transaction fees are inevitable for exchanges based on the Ethereum network. Users are often spending over $100 to execute a swap transaction, hence, DEXes are becoming a less attractive option for smaller traders.
All in all, traders who use decentralized platforms don't have any other choice but to agree with the risks. Currently, there are no platforms that can prove they eliminated the mentioned issues in a decentralized environment.
Here is where the Polkadex idea started.