Decentralized Exchanges Are Building a Life Raft but Need a Bridge

Recently, crypto traders have shown a lot of enthusiasm for decentralized exchanges, or DEXs. The enthusiasm is warranted. We’re starting to see the fruits of many years of hard work pay off with DEX trading volume and use increasing every day. 

In spite of this growth, the vast majority of crypto trading still takes place on centralized exchanges. DEXs offer a clear set of benefits in terms of fund security, flexible custody and transparency, so why is it that the majority of the market still shuns them in favor of centralized alternatives? We think we know the answer, and we’ve spent the last year and a half working to build a next-generation DEX that can go head-to-head with centralized exchanges. We continue to make progress, and we want to share some reflections, insights and observations that have shaped our innovations.

It’s all about the market makers

Market makers drive the crypto market. They bring much-needed liquidity to platforms, without which it’s impossible to attract traders and end users. Market makers are the linchpin of the exchange flywheel. Additional liquidity brings more traders, which brings more market makers, which brings more liquidity — and so on.

We’ve spent countless hours talking with the most influential traders and market makers in the industry, and two things are clear:

1. (Almost) none of them are market making on DEXs today

2. All of them are interested in market making on DEXs in the future.

So, what’s the problem? The glaring issue is that market makers have spent millions of dollars and working hours to build technology and human capital that interface with existing exchanges. These systems are built with certain assumptions around performance and features — assumptions that are broken by all existing DEXs. We can’t expect market makers to rebuild their systems from the ground up for a tiny slice of the overall market. If we want to tackle centralized exchanges with any level of success, we have to meet these important participants where they are today.

What’s missing from DEXs?

You may be thinking you already know the answer. Everyone has heard the criticism that the current generation of DEXs doesn’t scale. Multiple teams are seeking to address this by implementing layer-two systems that can lower transaction costs for trade settlement.

These new developments are great and bring much-needed room for growth — provided anyone uses the product in the first place. Layer-two systems only remove limitations on growth; they don’t do anything to make the exchange an attractive product in the first place. Any serious trading product must first meet the bar set by existing alternatives before it is able to compete on a unique selling proposition, which in the case of DEXs is custody flexibility and transparent fund security.

So, what’s really going on? If we take a deeper look at the current landscape for decentralized trading products, we can conclude that three primary issues are plaguing DEXs and preventing wider adoption and use:

    1. High latency and low performance

These items lead to a whole host of issues. Front-running and trade collisions break “price-time priority” and lead to unfair trade execution. Delays in execution of trades or cancels make it impossible for market makers to quote deep, tight spreads, lest they risk getting arbitraged due to price changes on other venues.

To address this, an exchange must have a high-performance, in-memory trading engine. It must also be able to handle bursts of traffic and hundreds of thousands of orders per second with low millisecond latency. A simple layer-two system is not sufficient to provide the performance and execution guarantees that the market demands.

    2. Lack of features and non-standard formats

Market makers and algorithmic traders have a large number of venues to choose from. These players assess new opportunities not only by the potential revenue and income they will generate but also by the upfront integration and ongoing maintenance costs. This ratio of opportunity to cost is the most important determining factor, as it’s a representation of the efficiency of their development work and capital.

DEXs need to be 100% plug-and-play in order for new participants to join and provide liquidity with minimal effort. After all, if you’ve already designed a winning strategy, why take the time to redo it to suit a market share of less than 2%? This includes offering the same advanced order types as other top tier exchanges, and an API format and documentation that adheres to the unofficial standards that have emerged.

    3. Lack of compliance

Know Your Customer and Anti-Money Laundering policies are a reality for all participants with significant amounts of capital. We’ve had multiple conversations with market makers that declined to engage with us under the assumption that, as a DEX, we weren’t compliant. Whether we like it or not, it’s impossible for high net worth individuals and institutional players to trade on platforms that don’t meet their basic compliance needs.

Where are we now?

Analyzing current products through this lens, we can see why DEX adoption is still limited. We used off-chain execution to eliminate on-chain front-running and trade collisions, but it did not have the matching engine necessary to provide the execution guarantees that top participants demanded. The API did not adhere to industry standards, which led to unnecessary complexity and stifled development efforts.

Automated market makers, or AMMs, are a clever solution to circumvent some of the latency and performance issues that make it impossible to host a liquid order book on-chain (pricing in AMMs is only updated when someone takes an order). However, these pricing curves are, by definition, a less flexible option than order books and far from ideal for professional market makers who have the capacity to make markets more efficiently. Additionally, due to the use of on-chain execution, these platforms suffer from front-running and manipulation.

Existing layer-two DEXs have a similar set of issues. The lack of a proper matching engine leads to inefficient pricing and robs market makers of necessary execution guarantees. User friction such as the need to register separate keys, asset quanta and other factors makes it time-consuming for developers to adapt their operations to support layer-two DEXs. In addition, market makers still need to contend with the security implications of using relatively immature cryptography to secure valuable crypto assets.

Ultimately, scalability still matters, but only if you have something worth scaling. The issue at the moment for central limit order book DEXs is not so much that we can’t fit enough transactions on-chain but that the process for creating these settlement transactions is clunky and unintuitive. This said, we believe the upcoming release of layer two will address current DEX performance needs and accelerate the adoption of decentralized trading.

By offering the industry an innovative approach to DEX development, DEXs will be able to compete with centralized exchanges where it matters most: at the user experience level. 

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

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