With more than $2 billion in crypto assets stolen to date through fraud or hacks on CEXs, DEXs are gaining attention. DEXs offer a peer-to-peer or order book-based, non-custodial, trustless exchange solution; they conduct trades on-blockchain, so parties exchange assets directly, eliminating the need for a central party to hold client funds. A fully on-chain order book can be slow and lacks privacy, however, due to the inherent constraints of a public blockchain. While original DEXs were entirely “on-chain,” so-called hybrid DEX entrants are introducing innovative twists, combining central and decentralized components, or introducing the use of layered or side chains, to offer “best of both worlds” solutions.
Established CEXs are taking note. For example, Binance, a leading CEX that regularly reports more than $1 billion in daily turnover (although there are questions about this figure), recently announced plans to build its own DEX. Other CEXs are launching institutional-focused custody or block trading services.
Recent technological advances to the underlying blockchain architecture also support the resurgence of the DEX. In pure form, however, DEXs have yet to attract significant liquidity.
Financial institutions interested in investing or trading cryptocurrencies have a huge technology learning curve already, and TABB is aware of several banks that have formed teams to help the company keep tabs on the space. With the DEX model gaining traction, institutions have yet another option as to how to potentially interact with clients. Hybrid DEXs are being architected to provide low latency; secure, private transaction handling off-chain; and decentralized, non-custodial settlement on-chain. The latter makes theft of client assets, through fraud or hacking, much less likely. These new entrants are not theoretical; as our latest research report details, numerous full and hybrid DEXs are operating today.
Some of the main challenges of any trading venue are in the areas of price discovery and liquidity – it is the same “chicken and egg” problem familiar to anyone interest in launching a new and improved marketplace. Volumes on current DEXs can be way below those on leading CEXs.
To address some of these issues, a raft of new open protocols is emerging to make creating DEX networks easier. These “third-generation blockchains” are designed to address bottlenecks around scalability, interoperability and governance largely through new smart-contract functionality and support for multi-asset trading. A potential advantage for crypto traders is that DEXs built on common protocols can “see” each other, thereby creating accessible, shared pools of liquidity across a common network.
With some of the most ambitious DEX projects and protocols relying on further blockchain upgrades, the success of DEX in capturing market share from CEXs is far from assured. Further, CEXs themselves have time to adapt.
Introducing centralized components back into a decentralized framework also risks introducing similar issues with latency found in any centralized exchange model, as a key determinant of latency is the physical distance between the traders’ and the exchange’s servers. Traders employing high turnover strategies invest heavily to ensure their technologies minimize latency, or the time elapsed between when a transaction event (e.g., price, order, cancel, etc.) is sent, acted upon and confirmation received. Depending on exchange architecture, CEX or DEX, and how the market data and price discovery process is implemented, latency-reducing strategies could play a significant role in traditional investors’/traders’ trading experiences and cost of trading.
TABB Group research has confirmed financial institutions are actively considering investing and/or trading cryptocurrencies, with significant funds sitting on the sidelines. For these institutions, the emergence of more technically mature, institutionally oriented DEXs is certainly of interest, as they propose to solve some issues inherent to CEX and OTC models. The DEX market landscape is building and shifting rapidly, and it deserves to be watched closely.