With a fast-growing market and impressive innovations, decentralized exchanges (DEXs) are undoubtedly one of the most interesting segments of DeFi to watch.

Where do they come from?

Since its first application in the financial sector, blockchain technology has opened doors to rethinking many traditional financial services in a new, decentralized way. In recent years, a growing number of projects have been developing financial services based on blockchain, from peer-to-peer payment systems to borrowing platforms. This sector is usually called DeFi for decentralized finance. Exchanges play an important role in enabling financial markets, so it does not come as a surprise that the idea of creating a decentralized exchange (DEX) as an alternative to traditional centrally-managed exchange emerged in the crypto space.

In 2016, Vitalik Buterin (the founder of Ethereum) first introduced the concept of an Automated Market Maker (AMM) as a tool to organize a DEX. AMM provides liquidity to the market by incentivizing users to supply their assets for creating liquidity, the lack of which was a commonly perceived challenge for DEXs. The price on the market is determined by the automatic adjustment algorithms in response to supply and demand. Since this first proposal, AMMs have been commonly deployed by DEXs, and their number has grown significantly in the last couple of years.

An AMM is not the only option to organize a decentralized exchange. A number of projects have been introducing some degree of decentralization to the traditional setup of a centralized exchange based on an order book. One possibility for a DEX is to run all the orders and alterations on-chain, while another option is to keep the order book management centralized. However, plugging conventional centralized infrastructure into DeFi has its limitations and challenges, with lack of scalability being one of the most significant ones. AMMs are arguably better suited for decentralized infrastructure which explains their currently dominant position on the DEX market.

How are DEXs different from centralized exchanges?

The main function of an exchange is to match buyers and sellers of currencies (or other assets), so that the law of demand and supply could be realized at a certain price. Traditional and most cryptocurrency exchanges to date are centralized. This means that a trusted intermediary manages orders and transactions on an exchange.

Centralized exchanges are also custodial: in order to buy or sell something, users need to transfer their assets to the exchange, giving the exchange control over the assets. In contrast, decentralized exchanges do not have a central authority, and all transactions are managed by self-executing smart contracts under a set of pre-coded rules. DEXs are usually non-custodial, which means that the clients keep their assets by remaining in control of their private keys.

In addition to very low counterparty risk (with some elements of centralization and flawed design, the risk is non-zero as shown by some recent hacks), DEXs usually offer a high level of transparency as all transactions are recorded and stored on a blockchain. At the same time, decentralized exchanges typically do not use any KYC (Know Your Customer) or AML (Anti-Money Laundering) procedures, and users can be completely anonymous. This might also pose certain legal challenges for further developments.

DEXs can offer more diversity in traded coins. Centralized exchanges usually handpick their traded assets based on their trading activity, prevalence, and security standards. Many altcoins that do not satisfy some of the requirements, especially at the beginning of their life cycle, can be traded on DEXs which are permissionless and anyone can create trading pairs. In addition to higher diversity, DEXs are often able to offer competitive rates and fees, in part due to the decreased cost without centralization.

While first generation DEXs faced some significant challenges with liquidity, as well as with the user experience, application of AMMs, sophisticated incentive schemes for liquidity providers, and general development of the technology practically eliminated these problems for current decentralized exchanges. As a result, the ratio between trade volumes on DEX and CEX has increased significantly within the last year, and is estimated at 10,08% for July 2021. With all these advantages, DEXs still face some challenges including regulatory uncertainty and in some cases a steep learning curve for investors accustomed to using the services of centralized exchanges or traditional finance institutions.

What are the major DEXs?

Over the past year, DEXs have experienced explosive growth. The trade volume on DEXs has increased from $1,87B in June 2020 to $87B in the same month of 2021. The number of market players has also increased, though only a few bigger ones make up the majority of the market.

One of the most established players on the DEX market is Uniswap, an AMM-based exchange launched in 2018 on the Ethereum blockchain. It is an open source project, where users are allowed to list tokens paying only the corresponding blockchain fees. Liquidity is created by liquidity providers who are rewarded by fees paid by users for their transactions with liquidity pools. This financial incentive is needed to attract sufficient liquidity to the markets in the absence of the possibility for liquidity providers to receive bid-ask spread, which is a typical incentive mechanism for market makers in centralized exchanges.

In 2020, SushiSwap was created as a fork of Uniswap (by copying all of the latters’s original code and introducing a native token, SUSHI). It also included additional features, such as the possibility of yield farming. SushiSwap users can earn SUSHI as a reward for providing liquidity to the markets. They can further maximize their yield by depositing liquidity tokens (SLP) into a yield farm, by staking their SUSHI for additional reward, or by participating in a lending market to earn interest.

PancakeSwap is another big DEX project similar to Uniswap in design, but built on Binance Smart Chain and compatible with its BEP-20 tokens. PancakeSwap recently got a dynamic competitor – MDEX, a project built on the Huobi Eco-Chain and Ethereum which expanded to Binance Smart Chain in April 2021. MDEX offers a “dual mining mechanism” of liquidity mining and trade mining and is closely competing with PancakeSwap in trade volume.

Governance tokens from DEX protocols

To attract sufficient liquidity to the market, decentralized exchanges need to incentivize users to submit their assets to liquidity pools. Many platforms have come up with creative ways to reward liquidity providers and traders on DEXs, and introducing their own tokens is one of the ways to do it. The tokens can be used to distribute rewards among participants, and as a means of reward itself.

DEX tokens are often tied to governance functions. As any decentralized project, a DEX needs to find a way to evolve and develop in the interest of its community. Native tokens in this case are used to enable governance functions for holders, such as voting on protocol parameters.

In 2020, Uniswap introduced its token UNI which was allocated at genesis among community members, investors and employees. UNIs enable holders to submit and vote on proposals. Projects like Sushiswap and Pancakeswap also have their native tokens, SUSHI and CAKE respectively. These coins can also be staked and used in yield farming for additional reward.

Recent developments

Decentralized exchanges represent a relatively new segment of DeFi with an impressive rate of growth and innovation. In May 2021, Uniswap introduced its new version Uniswap 3.0 with some changes to improve its attractiveness to liquidity providers and improve capital efficiency. Uniswap 3.0 enables so-called concentrated liquidity positions that are represented by NFTs. Concentrated liquidity allows liquidity providers to choose the price ranges where they are willing to provide liquidity, thus giving them more flexibility with the amount of capital at stake and corresponding risks. Uniswap 3.0 also introduces multiple fee tiers that give liquidity providers more room to optimize their returns.

Another interesting development on the market is Layer 2 DEXs. Layer 2 in blockchain refers to a network that operates on top of a base chain (such as Ethereum) and can perform some portion of transactions independently, while at the same time inheriting trust guarantees and security of the base chain. Layer 2 technology allows better scaling opportunities and faster transactions, which in the context of DEXs can enable financial instruments with higher complexity and lower transaction costs. Some of the most promising Layer 2 solutions for DEX development include Arbitrum and Optimism for the Ethereum. Also, the Polkadot project has launched a testnet for its Layer 2 DEX – Polkadex which is an orderbook-based exchange.