By Hugo Renaudin, CEO of LGO
In an industry built on an ethos of decentralization, we've seen centralized custodial cryptocurrency exchanges lead the charge, until now. Despite giants like PayPal entering the space and bringing thousands of new users, there have been consistent security failures, like the recent KuCoin hack, which resulted in a loss of at least $150 million.
Decentralized trading platforms like Uniswap offer an alternative by promising greater security, transparency, and accessibility. The DeFi hype appears to be benefitting decentralized exchanges (DEXs). Last month’s trading volumes on decentralized exchanges surpassed $11 billion and during September, Uniswap’s trading volume was higher than on Coinbase.
With the DeFi craze reaching a fever pitch, will decentralized exchanges finally gain widespread adoption?
Defining DEXs
Centralized exchanges rely on a private infrastructure to match supply and demand, which is managed internally in their own servers. In contrast, decentralized exchanges (DEXs) bring buyers and sellers together. Most are permissionless, meaning that anyone can access them and trade without intermediaries. Transactions are carried out with open smart contracts. Without third-party involvement, users maintain full control over their cryptocurrencies throughout the trading process.
Unlike centralized exchanges, DEXs are fully transparent. Volumes cannot be faked, and the technology powering DEX smart contracts is open source and auditable by anyone.
Sounds like a winning combination, so what’s the catch?
Liquidity remains a key concern
DEXs have struggled for years to create levels of liquidity similar to centralized exchanges. To address this issue, some DEXs have recently adopted a new liquidity model: Automated Market Makers (AMMs).
The AMM model is an elegant innovation in capital markets, the “silver bullet” that solves both the issue of liquidity and yield generation for non-liquid assets. How? It allows users to put their assets to work by providing passive liquidity. This has the added benefit of democratizing market making and liquidity provision because anyone, regardless of trading skills, can participate.
Despite its massive value proposition, the AMM model does not replace the precision and performance of centralized order books with centralized liquidity. For instance, it’s impossible to add liquidity at a specific price in AMMs. Liquidity providers are impacted by large price variations through what are called “impermanent losses.” On the other side, investors cannot decide to buy or sell an asset at a specific limit price – this is a key feature of a centralized limit order book.
Is a hybrid model the answer?
Research by TokenInsight indicates that, as of Q1 2020, trading volume on DEXs accounted for only 2.68% of spot trading across the whole crypto market. It is clear that, for the time being, decentralized platforms are only complementing centralized exchanges, which hold “the lion’s share.” One of the main reasons is regulation. Centralized platforms are gatekeepers; their services are required to change fiat to crypto before the user can trade on DEXs. While DEXs can work very well in full crypto-to-crypto transactions, centralized exchanges will continue to be the onramp providers until regulations change.
Also, DEXs provide deeper but less precise liquidity, and centralized exchanges provide much more precise and performant prices. In the very near future, centralized exchanges will start using smart contracts to complement their infrastructure. They could implement AMMs to allow users to earn a yield on their exchange deposits while providing more liquidity to the exchange itself.
So which exchange model is likely to prevail?
In the foreseeable future, the two models will continue to coexist. While transparency, security, accessibility, and passive yield generation will weigh in favor of DEXs, centralized exchanges will start closing the gap by adopting smart contracts and AMMs.
With the great influx of institutional investors into the crypto market, especially Bitcoin, that we are seeing at the moment, it is safe to assume that centralized exchanges will stay ahead in the mid-term. However, there is no doubt that leaps in technology, like DeFi, will keep pushing DEXs forward. Various hybrid models and complementary applications are likely to emerge. In the future, the two models will probably work together or merge more fully.
Hugo Renaudin, CEO and co-founder at LGO
Hugo Renaudin is the CEO and co-founder at LGO, which is designed to be a fair and transparent digital asset exchange for institutional investors. Prior to this, Hugo worked in FX trading, equity derivatives and fund management. His first venture into cryptocurrency was at BitSpread, where he was a Portfolio Advisor for the $100M+ AUM cryptocurrency hedge fund.
Hugo holds a Master of Science degree from Columbia University and a Master of Science degree from École Polytechnique in France. An expert on finance, cryptocurrencies and blockchain, Hugo has been seen on different shows from BFM TV to Nasdaq.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.