Exchanges are the biggest business in crypto. If you are a crypto user, you probably have traded on some crypto exchanges. Most crypto trading volume today happens on centralized exchanges (CEXs), where exchanges hold your assets so you don’t need to manage your wallet’s private key. Trading on CEXs is a really fast, cheap and user-friendly experience. Why do we need decentralized exchanges (DEXs) at all?
One popular answer is DEXs offer more safety because you can hold custody of your own funds. Sure, there were CEXs that bail and run. But DEXs have more hacks (the code is open-sourced) and DEX owners can write malicious code anyway. The truth is, most people think Binance and FTX are safe enough for them.
Another popular answer is DEXs offer more transparency than CEXs. It is nice to know if your assets are being misused by the exchange. But transparency is not a killer feature that will make most traders switch from CEXs to DEXs.
Don’t get me wrong — self custody and transparency are important. But in order to go mainstream, DEXs need to offer some value adds that will make mainstream traders and liquidity providers (LPs) switch from CEXs to DEXs. Self custody and transparency alone won’t make the cut.
The case for LPs
Uniswap democratized LPs for all. It reduced complex market making on CEXs to a simple x*y=k curve, so that an average Joe can provide liquidity with a click of mouse. Today on most (AMM based) DEXs, any retail investor can be an LP and earn transaction fees. With retail liquidity, traders can trade more volatile assets that most market makers on CEXs don’t want to risk market making for. Also, traders can get less slippage with abundance of retail liquidity.
With such unique benefits, the demand for retail LP on DEXs is clear. According to a recent report, Uniswap has ~2x more liquidity than both Binance and Coinbase for ETH/USD market, and ~3x more liquidity than any major CEXs for ETH/mid-cap markets. This is without the subsidy of UNI token.
To better serve the need of retail LPs, DEXs today still need to figure out how to make LP earn profits reliably. LPs in AMM style DEXs have impermanent loss. LPs in oracle style DEXs have unpredictable earnings because they have to accept all orders with a predetermined oracle price whether that trade is favorable or not. Phezzan Protocol will solve LP profibility issue by using the orderbook model. Meanwhile, it will also allow retail investors to provide liquidity with a click of mouse. There will be future articles on how Phezzan Protocol make this happen.
DEXs have a clear edge over CEXs for retail LPs, as they can’t even market make on CEXs. Most DEXs support retail LP with simple strategies (e.g. x*y=k market making) from launch. Many startups are providing more complex LP strategies on behalf of retail LPs. We are seeing the rise of on-chain algorithmic LP platform, such as Atrix. There are even emerging decentralized hedge fund, such as RobOtter, that will allow retail investors use advanced machine learning based strategies.
Thought earning money via market making is something only Wall Street elites can do? Not any more if you use DEXs!
The case for traders
DEXs offer many unique trading pairs not available on CEXs. This is because coin listing and market making on most DEXs are permissionless and dead simple. Listing a new market on CEXs typically takes weeks of communication, costs expensive listing fee and has complicated listing requirements. However, on DEXs you can create any new market and bootstrap liquidity within minutes. In fact, Uniswap initally got traction during Defi Summer because you can only buy certain popular coins on Uniswap. Up until today, a lot of coins are still only available to trade on DEXs.
DEXs are also more convenient to trade than CEXs for crypto natives. If your coin is on-chain, then trading on DEXs only take 1 transaction. If a DEX’s slippage is not too far off from that of major CEXs, most traders won’t bother transfering coins back to CEXs just to trade. Wallets can integrate with DEXs and make trades dead simple. Today, users are willing to pay crazy high 0.875% transaction fee to trade inside Metamask’s built-in swap to save some time. That is why owning user frontend is crucial for the long term success of DEXs. Phezzan Protocol will launch its mobile app and eventually its own wallet in the future.
Now here is the real crazy part: even for bluechip coins, sometimes (~20–30% of time?) you can get a better deal on DEXs than on CEXs. How is that even possible? Aren’t AMM DEXs super capital inefficient, so trading on DEXs should have a higher slippage than CEXs? The secret lies in the composability of DEXs. Because smart contracts are permissionless, DEX aggregators can split your order across different DEXs to get the best possible price. The liquidity of 1 DEX alone can’t compete against leading CEXs, but the combined liquidity from all DEXs can compete well against leading CEXs. This edge will only grow as the liquidty of DEXs keep improving. It is likely 5 years from now, you can get the best deal on DEXs instead of CEXs most of time.
You can sometimes get a better deal on 1inch than on FTX
Aggregators for spot DEXs are working very well today. In the future, aggregators will get popular for perp DEXs as well, once there are more solid perp DEXs. Crypto native prime brokeages can extend margin to clients across different perp DEXs, and then a cross-venue clearing house can bookkeep and manage users’ positions across different perp DEXs. This is a very challenging but doable undertaking. Once it is accomplished, traders can trade any perpetual contracts as long as it exists on any perp DEXs. The resulting price will most likely be better than CEXs as well, as the order is splitted across multiple DEXs.
Five or ten years from now, there should be a protocol that allows you to cross margin to trade any spot and derivative market, aggregating the liquidity across the entire DEX space. This will beat out CEXs trading experience by a light year. Leading spot and perp DEXs will have an advantage building that vision out as they have a large TVL that can be used for extending margin and risk management .
As there are so many unique advantages of DEXs, why most traders are still trading on CEXs?
One plausible answer is for large cap coins, you still get the best deal on CEXs most of time. It will take another few years for the liquidity of DEXs to build up to provide better pricing than CEXs. But that is a weak argument. People are trading at places with non-optimal price all day.
The real answer is most people are just lazy. As long as their orders are filled with reasonable price, they will trade at wherever most convenient for them. Right now for most people, the most convenient place for crypto trading is at CEXs. Fiat on/off-ramp is super easy, and there is no need to setup a wallet to manage private key. Most crypto traders today don’t even have their own wallets.
But this is going to change in the next few years. With the explosion of DeFi, NFT, GameFi and SocialFi dApps, more and more people are starting to put their assets on chain. The magic DEX flippening CEX moment will happen when most assets are on-chain. That could be five or ten years from now. Like mentioned above, trading on DEXs is cheaper and faster for on-chain assets. If you are bullish on blockchain dApps space in general, you should be bullish on DEXs.
Five or ten years from now, most people will trade on DEX. Because just like me, most people are lazy.