Decentralised Exchange — Understanding its Emergence and Growth
When it comes to trading in cryptocurrencies, it is still commonplace for many users to look at big exchanges like — Binance, Coinbase, Kucoin, CEX and Gate.io. These exchanges can be classified as Centralised Exchanges, which are very similar in design and nature to brokerages commonly found in web2 (Forex/Stock) financial service markets. These exchanges gained immense popularity in a short period of time as they were built on top of tried and tested strategies and methodologies found in traditional trading and financial services market. It is viewed as a very user-friendly option as its UI mirrors traditional retail trading platforms which give users an illusion of reliability. There is also an option for leveraged trading and custom-designed financial products such as futures and derivatives based on cryptocurrencies making it very popular.
But, Cryptocurrencies by default were designed with decentralisation as their core nature and focus. This meant a clear lack of regulation and a lack of central control authority over the growth and valuation of these tokens. These conflicting factors when combined together resulted in multiple flaws which made centralised exchanges an unsafe and unreliable option for trading with digital currencies. Some of the most evident risks associated with the centralised exchange are -
- Prone to hack attacks — tokens stored in third-party exchanges are often the target of hack attacks as they store a high volume of a variety of tokens in a single place. Some famous examples of hack attacks on centralised exchanges are — Mt.Gox (2011), BitFinex (2016), Binance & Upbit (2019), Kucoin (2020) and Curve Finance (2022)
- Influence from centralised government regulatory bodies. This is clearly visible from the US and European regulatory authorities’ attempts to control the listing of crypto assets on various centralised exchanges and their negative tone/biased/fear-inducing market-influencing attempts surrounding crypto assets.
- Losing custody of assets to a third party — A fine print point from the terms and conditions document of many exchanges that most traders fail to notice. When you think you are sharing your assets with a centralised entity, you are actually completely transferring your assets to a different wallet to which you don’t have access. While firms may promise that those assets are safe, these entities often use these assets to stake, yield farm or lend/borrow without the knowledge of the owner of those assets. Improper handling of such assets and certain fraudulent practices often lead to the complete loss of such assets. Famous examples of such instances include — the FTX/Alameda fiasco, the bankruptcy of Celsius Network, Voyager Digital and Three arrows capital.
- Higher Transaction Fees — The cost of transaction in centralised exchanges are very high as they charge fees in multiple forms such as order fees, maintenance fees, deposit/withdrawal fees and wallet transfer fees. Also when transactions of a higher volume of tokens take place in single or group transactions they charge a heft processing fee. While these fees also exist in traditional trading and investment financial services, the percentage of fees charged in crypto transactions when compared to fees for Forex/Stock trading is very high.
While centralised exchanges continue to remain popular, they continue to remain prone to the above-mentioned disadvantages. This is clearly evident from how the way of centralised exchange operations remains the same even after repeated examples of their counterparts suffering from various hack attacks and fraudulent practices. While these entities do announce to the public that measures are being taken to address them, there is no visible impact from such efforts. Meanwhile, despite being active for less than a decade, DEXs have shown tremendous growth as they learned and evolved from each of their mishaps and accidents making them a better alternative for DeFi operations.
The Emergence of DEX
Several repeated scams and rug-pull projects in the form of centralised exchanges resulted in traders and investors losing faith in centralised practices leading to the creation of Decentralised Finance and Decentralised Exchanges. Decentralised Finance is the emerging financial services practice that runs contradictory to centralised organisations and financial practices by abstracting away intermediaries relying on smart contracts and blockchains. This practice works well in alignment with the decentralisation ideology behind the creation of blockchains.
Decentralised Exchange is an entity in DeFi that enables the exchange and trading of digital currencies and assets without the use of any intermediaries. These exchanges are very new to the market and rose to prominence in the last few years. DEX facilitates the peer-to-peer exchange of digital currencies and tokens relying on automated smart contracts to facilitate trading practices. This means that users have control over their tokens and other digital assets at all times. Some of the other notable advantages of DEX-based trading in DeFi markets include — self custody of assets, faster transaction timing on trades, insulation from the control of regulatory bodies, fraud prevention (data manipulation), prevention of market manipulation by large entities through practices such as fake trading and round trip trading and anonymity owing to lack of KYC requirements. While there are advantages, DEX is a growing piece of decentralised financial technology and it has its own flaws such as increased use-case scenarios for criminal activities, price volatility stemming from illiquid market situations, complex user interface and usability issues for new users, lack of an option to convert crypto assets to fiat currencies and limited chances to implement traditional trading strategies.
The Growth of DEX
As DEX became an increasingly popular option to pursue crypto trading activities, its disadvantages became more evident. This resulted in an evolution of DEX operating mechanisms underlying architecture.
The first DEX that came into operation focused on order book-focused trade activities. These orders can be both On-chain or Off-chain trade orders. In an Order Book-based DEX, both buyers and sellers mention the price at which they wish to buy or sell tokens in their possession. The DEX then compiles a list of prices quoted by the buyers and sellers for each token supported in their platform and matches them to facilitate trading activity. But this type of peer-to-peer exchange had a huge disadvantage in the form of liquidity. The trades can only be processed when a buyer or seller is available and is ready to match the pricing resulting in the volatile pricing of tokens. It is very rare to find DEX today which purely focuses on order-book-based trades.
The second stage of DEX growth saw an increase in DEX which used smart contracts to process transactions and is classified as the — AMM DEX (Automated Market Making). These AMMs’ operations heavily depended on liquidity pools and used automated smart contracts for tracking the price of tokens and fulfilling trade orders. The trade transaction requests are processed by sourcing liquidity from a pool of available tokens. These liquidity pools contain tokens supported by a particular DEX or group of DEXs. The price of each token is determined by the ratio of the volume of tokens available in the pool. A token with a higher volume available in the pool is priced cheaper than a token which has a lower volume in the pool. Traders make money in this type of DEX by choosing to buy tokens from a DEX which has a higher volume of selected tokens in its pool and selling it in a DEX whose pool has a lower volume of the same token. The traders here made a profit by trading the price difference.
AMM DEX is the most commonly found DEX in operation today. While AMM and liquidity pool-based trading helped improve the flow of liquidity to a certain extent, the price of tokens continued to remain volatile as it was very rare and difficult for traders to immediately identify a DEX which priced tokens at desired price levels. This led to the third and final stage of DEX operations in practice today — the DEX aggregator. These Aggregators operate similar to a search engine by looking up and comparing prices from multiple DEXs they are connected to. Whenever a transaction request is placed, the aggregator uses their proprietary algorithm to look up prices from a wide range of DEX and choose the best price available. This helps traders save time as they don’t have to look for multiple DEX for each transaction. This also helps in lowering trading costs in form of native token gas fees and transaction costs as users have to access just one platform instead of multiple DEXs. Aside from this users are able to minimize slippage on large orders by providing lower spreads.
Kana Labs — DeFi Revolutionised
While the three stages of evolution helped simplify the otherwise complex usability process associated with DEX trading activity, the overall volume of tokens available to traders was still limited in volume as crypto markets in DeFi remain fragmented across multiple blockchain networks. Kana Labs helps address this issue by building a multi-chain DeFi product suite with liquidity aggregation and cross-chain capabilities.
By facilitating the cross-chain transaction across multiple chains inside a single platform, traders gain access to an increased number of tokens and more traders in a single DeFi platform compared to any other DEX/dApp currently operating in the market today. More traders and an increased number of tokens naturally result in an even better flow of liquidity and the lowest spreads for token pricing on large trade orders in today’s DeFi market. Another thing to note is that Kana Labs provides more than just DEX operations, Users can stake their tokens, Lend or Borrow tokens across both same-chain and cross-chain transactions all under a single platform with liquidity aggregation capabilities. This means users get some of the best pricing, the lowest transaction costs and the fastest transaction speed on their DeFi operations for a wide range of tokens across all blockchains supported by our product suite.
