Decentralized exchanges, also known as DEX, have been hugely popular since early 2020, and both their user base and volume are growing rapidly. The sector is currently being driven by so-called “Automated Market Makers” (AMMs).
In short, these exchanges eliminate the traditional order book and custom price orders. Instead, The price of an asset is determined by a mathematical formula that depends on the relative share of the asset in liquidity funds. When a user makes a transaction, it changes the balance of the assets in the pools and the price goes up or down slightly. This mechanism enables MMAs to track market price movements.
Bancor was the first live implementation of an AMM, although many others such as Uniswap, Balancer, Mooniswap, and Curve later built similar systems. Yield farming, and the subsequent surge in decentralized financing (DeFi), has helped drive daily volume to over $ 400 million.
Matthew Finestone, director of business development at Decentralized Layer Two Exchange Loopring, told Cointelegraph that MMAs “have a product market fit“A term used for startups that are finding traction. However, the current iteration of the DEX has a number of issues that could significantly limit the size of this market.
On-chain performance and target market
DEXs based on Ethereum are currently among the largest gas consumers on the blockchain. This helps gas prices rise to over 250 Gwei, while in quiet times they can be as low as 2 Gwei.
The skyrocketing gas prices suggest that current volumes are close to the maximum that existing DEX can achieve without completely excluding middle users. The growth of MMAs was already a direct result of Ethereum’s relative slowness, as Finestone put it: “[Los AMM] Ways have been found to effectively resolve the fact that market makers cannot place quick and accurate orders on Ethereum“.
While some of these issues could be resolved with a better on-chain scaling solution, Paolo Ardoino, chief technology officer at Bitfinex, the cryptocurrency exchange, told Cointelegraph The processing in the chain could never compete with centralized comparison machines::
“The current solution for decentralized exchanges, even if Ethereum grows to Ethereum 2.0 and the speed of transactions is, say, 10,000 transactions per second, it will still be many orders of magnitude slower than a single centralized exchange.” .
Ardoino explained why the problem with processing in the chain “is only the speed of light”. When nodes around the world have to agree on a single block, no network improvement can outperform, for example, the common location of the trading infrastructure in the exchange’s data centers. These performance limitations could be a serious barrier for professional traders, especially high frequency trading companies.
Dan Matuszewski, co-founder of CMS Holdings, shared his experience with DEX in Twitter: “First of all, the experience sucks, there is no way you will convince me that it ain’t sucks, I won’t have itExplaining the point, he said DEXs are expensive and the terms of a transaction are only clear after it has been resolved. “I could pay 5% of the offer [spread] and have a little idea“, addedeven though he noticed In today’s environment, “it’s not that bad.” The relatively slow execution speed, however, wasn’t a big problem for him.
However, Matuszewski told Cointelegraph that DEXs are not currently suitable for professional traders. “”It is for the small amateur traders to play“said.
Another problem is front running. Because of the completely transparent nature of the blockchain, there is a class of front-line bots to place cheap trades between the submission of a transaction and its inclusion in a block in the window. While this approach is generally used for arbitrage, it can also be used to take advantage of upcoming market moves.
A November 2019 study published in Cryptoeconomic Systems examined the effectiveness of Uniswap as an award oracle. While the conclusion was largely positive, the researchers relied on the presence of arbitrage agents motivated by profit to match their price with the rest of the market. Mikhail Melnik, a DEX 1-inch aggregator developer, told Cointelegraph: “Current MMAs will definitely be ineffective without an arbiter as arbitrage is used as the price discovery mechanism.“.
Hence, today’s most popular DEXs cannot be useful without having order book based markets, which are currently largely centralized. Also, The arbitrage mechanism results in the issuing of unforeseen losses that divert a significant portion of the profits from liquidity providers.
Some of the problems on the WMA exchanges can be resolved without fundamental changes. The solutions to fix inconsistent losses are currently used by Bancor V2 and Mooniswap, the DEX developed by 1 inch. Both try to limit the arbitrators’ winnings by using the award oracles on the one hand and a virtual balance on the other that smooths the price changes over a five minute period. According to 1inch, its solution has the added benefit of making it essentially impossible to run from the front.
In terms of performance, Uniswap founder Hayden Adams, considered as The introduction of smart contract-enabled Optimistic Rollups on the Ethereum network is one way to improve performance. The Layer 2 solution would create a ubiquitous environment in which Solidity Smart contracts are executed over the blockchain. Uniswap can then be deployed in this environment with minimal code changes.
However, some have found that optimistic rollups could make the front running problem worse by allowing operators to see the transactions ahead of time. This would fundamentally defeat the goal of minimizing the need to trust the operators. This is the basic prerogative of ubiquitous Layer 2 solutions.
There are currently few solutions to address the supply problems described by Matuszewski, although increased liquidity and specialized tools can help make these exchanges more cost-effective and deterministic. However, the lack of real pricing is likely to persist. Melnik offered a possible solution:
“There may be some MMA designs that oracles use for these purposes [de descubrimiento de precios], but in my opinion the use of oracles […] it greatly exacerbates problems with the front barrel. “
However, this would not remove the reliance on traditional exchange mechanisms.
Non-custody as the next iteration
According to Ardoino, “the solution always lies in the hybrids.” In his view, the future of the decentralized exchange will be shaped by custody and full remuneration in the chain, that is, by updating bipartite accounts after an exchange. However, processing or order reconciliation will not happen in the chain, he added:
“You can use open source comparison engines that are not in the chain, but run on thousands of different nodes and have their own little books. Aggregates can make a bigger book.”
This approach would maintain custody in the chain and keep customization engines out of the chain – albeit peer-to-peer – to solve performance issues without losing decentralization. “”This is the kind of resilience we should be heading towards instead of trying to build everything on a single blockchain“Ardoino closed. Although adaptive engines are not peer-to-peer engines, such solutions are already provided by platforms like Loopring and DeversiFi.
Loopring is based on zkRollups, a second-tier technology that offsets the compute workload to an operator who must provide unbiased evidence that their changes are valid. In Loopring’s dedicated solution, data is sent to the main network in compressed batches. Finestone claimed this was “a centralized exchange that simply can’t go wrong or abuse user funds”..
Related: Yield Farming adds to the noise about DeFi, but the basics lag behind
However, this limits the performance of the exchange as, according to Finestone, Loopring can process 2,100 trades per second. While this is much higher than DEXs in the chain, it is still significantly undercut by a fully centralized exchange. DeversiFi has a higher performance with 9,000 transactions, but stores the data out of the chain in a “data availability committee” (in the Spanish data availability committee). Both exchanges are not deposited, although in the case of DeversiFi, users would have to rely on the committee instead of locking on-chain data to get their money back.
Anton Bukov, CTO at 1 inch, pointed to similar solutions as zkSync to combat latency and poor performance. All Layer Two systems are still largely in their infancy and performance will likely improve in the future. The matchmaking engine isn’t a bottleneck in this case, as Finestone found that Loopring uses traditional cloud computing providers like Amazon Web Services and Google Cloud Platform. Some proposed DEXs like Serum and Vega still implement chain matching, but use more powerful blockchains.
Can decentralized exchange become the norm?
Given the basic pricing restriction of MMAs, they cannot become the top cryptocurrency trading venues. On-chain liquidation is a major bottleneck right now, but even massive upgrades may not be enough for all traders.
Not custody but centrally operated exchanges fix many of the problems with existing DEXs, but right now they do not seem to be achieving the level of performance required to replace their centralized counterparts. In theory, they could also be one step ahead of their users, which is similar to centralized venues in that respect, as Finestone pointed out. However, when compared to optimistic rollups, the operators tend to be the exchanges themselves, which encourages them not to foul.
Finestone also believes central exchanges will always be useful. “mainly [para] those who want the convenience of “traditional” style property ownership and wherever they interact heavily with Fiat“In their view, a final state of DEXs would cause them to process two-thirds of the total volume. Hence, it is possible that the various types of centralized and decentralized exchanges could fill their own niches as the sector evolves.