DeFi has been the buzzword in the crypto industry for months now. In the aftermath of the black Thursday crash in March, which saw Bitcoin crashing below 4000 USD, many DeFi applications successfully launched their main nets, which drew a lot of attention to the emerging space. DeFi related tokens like Compound’s COMP, Aave’s LEND, Balancer’s BAL or Synthetix’s SNX have since yielded astronomic gains for investors. But what exactly is DeFi and how do DeFi protocols work? Learn about it in our new six-part blogpost series “Demystifying DeFi”. New articles coming (at least) daily! Today we will cover decentralized exchanges, the pioneers of the DeFi industry.
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The DeFi sector started off with decentralized exchanges, also referred to as DEXes. The idea was to offer all functionalities centralized exchanges like Kraken, Binance or Coinbase offer, through a protocol running on a blockchain. On DEXes, no KYC requirements exist, users interact directly with the exchange’s protocol from their own non-custodial wallet, thereby reducing risk that coins get hacked or lost along the way as there is no central intermediary involved that needs to be trusted. Following the blockchain vision of a trustless and frictionless new economy.
In contrast to centralized exchanges, where the exchange knows everything you do but exclusively has access to this kind of information about its users trade behavior, on decentralized exchanges everything happens on-chain and is therefore recorded in the tamper-proof, immutable ledger that is the blockchain underlying the DEX (e.g. Ethereum). This makes everything traceable and transparent, while the cryptographic design of the respective currencies still ensures user privacy.
The biggest DEX out there currently is Uniswap, which has just recently, fueled by the ongoing yield farming frenzy, surpassed 1bn USD in daily trading volume. Other prominent DEXes include Kyber Network, Balancer or Curve. While the basic concept of trustless token swaps is always the same, the implementation of the various DEX protocols can heavily differ from each other.
While the idea behind trustless peer-to-peer token swaps has a revolutionary flavor, DEXes pose regulatory challenges due to the decentralization underpinning the concept. While the lack of a centralized counterparty conceptionally eliminates counterparty risk, decentralized exchanges bear technology risks, which might arise from smart contract bugs and/or failures that can result in the loss of user funds. A prominent question which is currently debated heavily therefore is who would be liable if such an event happens and users of a protocol incur financial damage as in contrast to the traditional world, there is no central counterparty to be held liable. So, in the context of decentralized exchanges one might think it’s the developer team that is liable for smart contract malfunction, while others argue it’s the user himself who is responsible to perform an adequate due diligence of the protocol. The non-existing KYC/AML requirements are another issue which might lead to regulator intervention at some point in the future once DeFi projects start to gain more user traction.
A recent study found that for most people that refrain from using DEXes due to the severity of the associated risks, while the main reason is not legal or technology risk but rather associated with liquidity fears, trading pairs and reliability issues (bugs & complexity).
Also, for the users it tends to be harder to figure out how to use a decentralized platform, as there is no central authority running it and providing customer support services. Moreover, DEXes are slower in executing trades than centralized exchanges. This has to do with the fact that every transaction happening on a DEX needs to be mined into a block of the underlying blockchain (e.g. Ethereum). This heavily limits DEX potential to allow for high frequency trading (which in the current state of the ecosystem is not possible on DEXes).
How fast a DEX executes token swaps is dependent on the protocol implementation. This includes settlement times (how many block confirmations do you have to wait for?) and settlement type (on-chain vs. off-chain).
Another important point in discussing DEXes and their potential is the transaction cost associated with token swaps using these exchange protocols. Smart contracts are not free. On the Ethereum Blockchain you have to pay gas for interacting (transacting) with a smart contract. This can make token swaps on DEXes quite unreliable in terms of fees in FIAT, as gas prices tend to fluctuate. As gas prices depend on the level of utilization of the Ethereum blockchain, large transaction volumes on the Ethereum blockchain can cause congestions that can leads gas prices to skyrocket. On September 1st 2020, Ethereum gas prices reached a new all-time-high on average per transaction (10 times higher than 6 months ago). A token swap on an Ethereum-based DEX like Uniswap is therefore likely to be about 10 times more expensive than it would have been 6 months ago. This problem doesn’t exist with centralized exchanges, where transaction fees and spreads remain constant, regardless of how heavily the trading platform is currently being used.
Stay tuned later tonight for another deep dive into decentralized finance!