CEXs Vs. DEXs: The longer term battle strains
Since the official launch of Ethereum in 2014, the network has exploded with products that allow users to transact directly with one another without having to rely on third parties.
One of the most common use cases is decentralized exchange (DEX), an idea that dates back to Vitalik Buterin's unveiling of Ethereum in 2014. By studying the history of DEX development, you can find out where and how DEXs are going to compete with centralized exchanges.
What's in a DEX?
DEXs come in different forms, but they have one common quality: non-depot. DEXs use smart contracts to manage funds in the chain so that users never have to trust a third party with their money.
However, the replacement part of a DEX – the way buyers and sellers find each other – can vary widely from implementation to implementation. When thinking about the future of DEXs, it is helpful to understand their past first.
Alex Wearn is the co-founder and CEO of IDEX, a high-performance DEX. He has spent his career in software development, among others at Amazon, Adobe and IBM. He has been hacking crypto startups since 2014 and switched to full-time with the launch of IDEX in 2018.
The earliest Ethereum DEXs like EtherEx and OasisDex built a traditional CLOB (Central Limit Order Book) exchange entirely from smart Ethereum contracts. Developers and users quickly realized that order management and trade execution are not well suited for a blockchain. In particular, the placement and cancellation of orders by market makers and the interaction of traders with the on-chain order book were expensive and error-prone due to the high costs and latency of on-chain transactions.
Order books out of the chain
In mid-2016, a new exchange, EtherDelta, innovated this model and removed the order book from the chain. This design eliminated the cost of order creation and reduced the latency and gas costs of order placement.
While this was a major improvement, users still incurred the cost of canceling orders – a fee that prevented market makers from providing liquidity on a large scale. In addition, buyers transmitted their own trades to the network, creating “trade collisions” in the chain, with multiple buyers competing for the same order. On peak days, up to 30% of trades failed due to these collisions in the chain.
Although the first iterations of DEXs faded over time, they were innovative, forward-thinking, and laid the foundation for the models in use today.
Off-chain execution, on-chain settlement
The next generation of DEXs, including IDEX and DDEX, improved upon the earliest DEX models and explored a hybrid approach. This draft moved both order books and commercial execution off the chain. When executing off-chain, users reconcile their own orders but send them to the exchange which executes the trade and forwards the order to the network for settlement. This approach eliminates the problems of chain trade collisions, gas charges for canceled orders, and front running. This model was the dominant trading model for almost two years.
However, this design is not without its flaws. Without a suitable engine, trade execution suffers, and gas settlement costs and network congestion remain problematic. Recognizing these drawbacks points to even more user-friendly DEX models in the near future.
While this design reached the most users and volume, a novel DEX model in Uniswap and Automated Market Makers (AMMs) joined the battle.
The rise of automated market makers
The AMM design is a creative answer to the limitations of hosting an order book in the chain. As mentioned earlier, many of the early CLOB DEXs struggled as it is both expensive and slow for users to update their orders using a blockchain.
Uniswap responded by completely removing the order book and replacing it with a simple formula in the chain.
This architecture ultimately allowed Uniswap to grow phenomenally. The permissionless “always on” liquidity made it a great solution for other applications to build on. The fully decentralized architecture has led to a revival of ICOs in the form of Uniswap direct listings, as projects can easily use their own pool of liquidity to expedite trading in a new asset. The liquidity pool structure also makes it easier for non-technical users to tie up capital and receive a passive reward from trading fees and liquidity depletion.
Despite these numerous benefits, experts speculate that AMMs in their current form are just a stepping stone on the path to DEX design, and many are questioning their long-term viability. Typically, these products provide a less flexible version of market making than their centralized counterparts and will be left behind in markets that require sophisticated analysis and human intervention.
Despite the many advantages of the Ethereum network, it is clear that the traditional CLOB exchange does not work well when working in a decentralized network with such high latency and low throughput. As a result, DEX development will continue primarily in three ways: new AMM types, CLOBs in faster chains, and updated hybridized models.
New AMM models
AMMs have played an important role in DEX development. They addressed key performance issues by completely removing the order book and valuing assets using a static on-chain feature. Uniswap used the first example of this, the constant product function, which creates a certain type of price curve. Competitors like Curve have experimented with various features. In this case, they have chosen one that is better suited for assets where the market expects an equal price, e.g. B. Stable coins or different types of wrapped Bitcoin.
As these products evolve and address more specific use cases, they will likely be in demand due to their availability in the chain and the ease with which liquidity is provided. However, it is unlikely that they will replace CLOBs as the dominant form of trade, as they are fundamentally a less flexible form of exchange than CLOB.
It has been a few years since the first iteration of a crypto exchange, but systemic issues persist that cause multi-million dollar problems for merchants.
Instead of adapting to the limitations of the network, new projects like Serum are trying to move to a different network where the limitations are not as severe. By using a more capable underlying network with higher throughput and faster consensus times, the team hopes to eliminate the UX issues that plague the V1 order book DEXs.
At its core, however, trade matching and execution is a consensus problem to determine who came first, which trades should be executed in which order. A decentralized network, which by its very nature must reach consensus across multiple nodes, can never compete on the same level as its centralized counterparts.
Hybridized models such as IDEX 2.0 aim to combine the performance of a central exchange with the security of decentralized custody and processing. By combining the high performance trading engine of a central exchange with the on-chain custody of a DEX, users can get the same trading experience they know and love without putting their money at risk.
See Also: KuCoin CEO Says Suspect Identified in $ 281 Million Hack; Authorities on the case
DEXs have come a long way. From clunky on-chain approaches in the earliest days of 2014 to today's diverse options, every DEX evolution has come closer to delivering a product that offers both performance and security. Regardless of their tastes, DEXs will challenge the centralized exchange in the future by permanently separating custody from the exchange.
It has been a few years since the first iteration of the crypto exchange, but systemic issues persist that cause multi-million dollar problems for merchants. Just this week, a hacker drained Kucoin with crypto assets valued at around $ 150 million. This was followed by the US Commodity Futures Trading Commission (CFTC) and the Department of Justice (DOJ), which filed a series of criminal charges against BitMEX for negligence by AML and KYC.
All of these issues form the backdrop to the ongoing battle between CEX and DEX environments. Regulatory and safety concerns underscore the growing need for traders to maintain custody of their assets and comply with regulators. Where CEXs are often convenient for traders, they are often associated with a security / seizure risk. DEXs, while more absolute in terms of asset control and security, offer little in terms of regulatory oversight.