Decentralized Exchange (DEX) is one of the major driving forces of decentralized money (DFI), thus generating considerable interest from institutional investors. But since DEXs are strongly different from conventional trading venues, financial institutions need to be aware of the opportunities and risks involved.
Decentralized Finance (DFI) Digital Asset Space’s biggest success story, blockchain technology has enabled other platforms to move closer to inter-operability and scalability, after finding an initial home in Ethereum, all but refraining from a “problem-solving solution”. $ 175 billion In the lock-in fund, which was below 10 10 billion a year ago. In addition, Defy is drawing now Significant amount In venture capital.
Although virtually every new venture claims to offer something different, Defie’s majority is governed by two main divisions – the nding pool and the decentralized exchange (DEX). There have been several iterations in the following years, but the embedded model is largely based on ideas driven by exchanges like Uniswap and Banker.
What exactly is a DEX?
In short, a DEX connects sellers and buyers and automatically calculates exchange rates and fees based on supply and demand. Instead of matching buyers and sellers through order books like centralized exchanges, smart contracts perform all the business. DEXs like Uniswap typically work through a liquidity pool with one pair of tokens. Liquidity pools may contain Bitcoin (BTC) and US-dollar stablecoins such as Tether (USDT), for example.
In exchange for providing liquidity to the pool by “locking in” assets, users are often referred to as “yield farmers,” who earn a portion of the transaction fees paid by traders who use them to exchange tokens. Yield is adjusted according to the relative lack of resources in the pond. Returning to the previous pair, for example, if the volume of USDT was running low, the yield would automatically increase to encourage users to provide more liquidity. The goal is to create a decentralized and automated trading system. Other exchanges, such as Balancer, operate multi-token pools, where Curve Finance focuses on stable coin arbitrage.
Although most of the growth in DEX use has been driven by the retail sector, there is growing evidence of institutional interest in space. Recent reports From Chainalysis. However, DEXs offer a different offer from their centralized counterparts and a unique set of opportunities and challenges for institutional players.
The advantage of DEX over centralized exchanges
First, their open and unauthorized nature means that DEXs can list a remarkably large tray track, as anyone can launch their own liquidity pool. At one point in 2020, Kondesk Report That Uniswap has added more than a thousand new token pairs a week. Therefore, DEXs give early investors the ability to start trading with sufficient liquidity before being listed on a token-centric exchange. Moreover, since all the activities of a DEX are governed by the underlying smart contract, traders do not have to leave the custody of their funds in the hands of third parties.
In addition, DEXs may provide higher execution reliability during times of higher volatility due to the cascading liquidation of derivative positions on centralized exchanges. Although CEXs may not be responsive for a short time due to API overload, DEX trading is effective and orders can be executed reliably, although the fees required to complete a transaction can increase significantly in the short term (especially in Ethereum-based transactions).
Risk of using a DEX
Unfortunately, many of the advantages of using a DEX are a double-edged sword, and institutional users in particular face certain risks. For one, most DFIs are currently unregulated and participants do not typically use KYC. Anyone can download a wallet like Metamask and start token trading immediately.
The lack of control serves as a honeypot for scam token operators to launch their own pools and DEXs are also involved in money laundering. For example, after the centralized exchange KuCoin was the victim of a major hack in late 2020, criminals used the decentralized exchange to sell About মিল 20 million Stolen tokens. The lack of a regulatory compliant legal framework creates an entry barrier for organizations forced to operate within the limits of licensed secondary markets.
Similarly, slippage and front-running are also common risks in DEX. Blockchain transactions are not instantaneous, and in volatile cryptocurrency markets, it can take time to execute an order as a confirmed transaction. On-chain trading networks are also subject to congestion which can lead to much higher execution fees than the central exchange.
Also, due to the open nature of the public blockchain, anyone can see the pool of transactions waiting to be confirmed. Front runners set up bots to scan the pool for potentially lucrative arbitration business, and when they find one, they immediately make the same transaction, but for a higher fee, it makes picking from the queue for a mine more interesting. Many DEX and platforms have taken steps to address this risk, but it remains a permanent problem.
In addition, the clarity of the smart contract code underlying the DFI protocol allows anyone to view it, but it also means that anyone can detect and exploit code bugs and vulnerabilities. For example, smart contract risk is a persistent problem for the DFI sector, leading to the proliferation of dedicated DFI insurance pools, such as Nexus Mutual or Opium Insurance, which provide coverage for smart contract risk. Using code auditing services from established cybersecurity consulting firms such as Cartic or Kaspersky, as well as providing generous bug bounties to white-hat developers is becoming more common for projects.
A challenging, but improving user experience
In addition to the risk factor, organizations may also find that DEX lacks a number of user experiences.
While it is theoretically possible to trade any token, only the largest pool has sufficient liquidity for large trades. DFI exists completely differently from the conventional financial system, so there is no way to start a DEX using Fiat currency. Instead, the user must first obtain crypto using a centralized service before participating in Defy.
DEX also requires self-custody, where many organizations may choose to use a custody provider for digital assets. At the beginning of the DFI wave, user interfaces often became a thought for developers who were more focused on smart contract code. This is evidenced by the user interface of services such as Curve Finance which still has the look and feel of a DOS computer program from the 1980s.
In addition, DEXs tend not to provide a range of order types, charting tools, or technical indicators found in their centralized counterparts. However, this is changing rapidly. More recent developments in DEX such as DYdX and Perp offer decentralized, self-protection spots and derivatives trading together with a CEX-like user interface. This shows that decentralization does not necessarily come at the expense of features and user experience.
Decentralized exchange has made huge strides in recent years, growing from a niche concept to accumulating billions of dollars in lock-in assets. While organizations are reasonably interested in concepts and are interested in capitalizing on the transformative potential of some DEXs, they should be aware of the regulatory and operational challenges involved.