Mind keeps up the series of articles on the way the blockchain technology financial market works. This article is focused on the operation of decentralised exchanges.
Read also: Cryptocurrency into action: Opportunities and risks of an alternative to traditional investment markets
When writing about "ordinary" centralised cryptocurrency exchanges, the task was simplified by the ability to draw direct analogies with stock and commodity exchanges. Yes, there were many distinctions specific to the crypto sphere, yet in general, the system appeared clear and familiar.
A totally different picture emerges when analysing decentralised exchanges (DEX, Decentralised Exchanges). It is quite difficult to describe this phenomenon without delving into specific terminology and technical details, but we will try.
Decentralisation is much more in line with the cryptocurrency spirit than classic exchanges like Binance or Whitebit.
Bitcoin founder(s) were defining the task as follows: "There is a need for an electronic payment system based on cryptography that eliminates the trust factor and allows parties to send payments to each other directly, avoiding the use of intermediaries."
Intermediaries can include both banking institutions and traditional exchanges. The latter have access to clients' assets, and this implies the risk of losing them through fraud, external interference, or legal action.
A decentralised exchange is not a registered legal entity, but just a technology. The transaction is made directly from the client's wallet without the need to block assets or open an account.
The procedure is as simple as possible: you go to the website of a particular DEX, choose the pair of crypto assets (coins or tokens) you want to exchange, check the terms of the transaction, and, having connected your wallet, execute the transaction. No registration, no personal data, no identity checks, etc.
How does it all work?
Smart contract
Here we cannot do without using the new terminology that has emerged around blockchain technology. A smart contract, for example, is an algorithm that sets out the terms and conditions and the consequences of their fulfilment. This is a digital analogue of a regular written contract, where all important points are formalised in "computer language". It is actually a set of algorithms based on the "if event A happens, we do operation B" principle. In other words, everything is automated to the maximum extent possible.
Decentralised exchanges operate on the smart contract basis. The contracts stipulate all the essential terms of transactions, so there is no need to involve people to control or confirm transactions. Actually, people are involved, but passively – after signing the terms of the smart contract, their active intervention is no longer required.
Now some questions arise:
- Who writes these smart contracts and creates DEX and why?
- Who keeps the system running and why?
Understanding who the beneficiaries are is useful not only for the cryptocurrency world. But here, especially, when easy super-profits for traders are promised at every turn, it will be useful to understand who is really making a profit.
Whereas in a traditional exchange, the main beneficiaries and recipients of remuneration (primarily trading commissions) are the owners of the exchanges, here there is no legal entity in the traditional sense. But we're not here to refute Newton's laws, so we can't say that everything works "somehow".
DAO
DAO stands for decentralised autonomous organisation and can be considered an equivalent of a legal entity in the crypto world. Yes, it has no registration and no Unified State Register of Enterprises and Organizations of Ukraine code (or its equivalents in other countries), but it has collective decision-making and a common goal for participants (i.e., owners).
DAOs operation is also built on smart contracts that are designed to automate all processes as much as possible. DAO members can suggest changes to the contracts, which are then voted on, a procedure similar to traditional legal entities with more than one member.
Decentralised organisations can be of various types. One of them is crypto exchanges. You can check out the variety of DAOs on deepdao.io. At the time of writing, the first position is occupied by the decentralised exchange Uniswap.
More than 360,000 people own its UNI tokens (tokens can be treated as an analogue of shares in ordinary corporations). To understand the scale of the business, the total market capitalisation of Uniswap is approaching $5 billion.
So, we have answered the first question – the founders of the exchange (and other token holders) receive direct financial benefits from the growth in the market value of their assets. This is quite similar to traditional corporate stocks, with ups and downs depending on the economic situation and the state of the business:
Source: CoinGecko
Token holders can also participate in the management of the organisation, as is the case in traditional joint-stock companies. Thus, decentralisation takes on a more tangible form.
For instance, in Uniswap, in order to make proposals, you need to have a share of tokens of at least 0.25% of the total volume and enlist the support of 4% of the holders. Other DAOs may have their own terms and conditions, spelled out in the smart contract, as is the case with the charters of ordinary organisations. In other words, everything does not work "independently", there are certain people who are interested in the work of exchanges and are able to influence them.
An important advantage of DAOs over traditional organisations is the publicity of proposals and decision-making. All this is usually posted openly and is subject to discussion. That very same Uniswap has a page called Uniswap Governance. Among other things, you can see the organisation's monthly financial reports and more.
Sounds too good to be true, doesn't it? The picture would be incomplete without one more aspect: how are the governance tokens distributed in decentralised organisations and does the broader community of "minority shareholders" really have an impact?
Turn to last year's report by Chainanalyst with a title that sums up the problem: "DAO Analysis: Ownership is Surprisingly Concentrated". The study of the 10 largest DAOs revealed the following: less than 1% of owners have more than 90% of the votes.
The image shows that in most of the DAOs studied, key decisions are made by an extremely small group of owners. With coordination between them, small investors, even if they vote in a consolidated manner, will not be able to influence anything. This concentration is much higher than in traditional joint-stock companies. For example, the ten largest shareholders of Apple (NASDAQ: AAPL) control less than 30% of the votes.
It is clear that even there, a small shareholder will not have a significant impact. But traditional joint-stock companies have never been about freedom and decentralisation.
We are not emphasising this issue for intimidation or attempting to defame the DAO sector. On the contrary, we see a serious prospect for this area. However, in order to fully realise the opportunities, it is necessary to take a realistic view of the situation.
Thus, under unfavourable conditions, the holders of key volumes of DAO tokens may make decisions that will not be beneficial to small investors. And you should understand this when buying tokens. However, if you are using a decentralised exchange only as a tool for transactions, this issue should not be a major concern.
Instead, the following matters:
Who keeps the exchanges running? And here we need to understand the mechanism of DEX operation.
How does it all work?
Let's recall how transactions are made on centralised exchanges. Buyers and sellers place their orders, forming exchange cups, and then execute transactions at the current prices or wait for the quotes to change. There are also market makers who usually trade in both directions, providing liquidity and making money on the difference.
On DEX, everything is radically different. Currently, the most popular is the AMM mechanism – an automatic market maker. The transaction takes place between the client and the liquidity pool formed on the exchange.
Mind's Reference:
A liquidity pool is a set of assets locked in a DEX smart contract to support trading and other functions of decentralised exchanges.
This means you don't wait for another exchange client to make a counter offer, or look for a price in the "glass" – you can make a trade at any time: The "other side" in the form of a liquidity pool is always ready and waiting for you. This is, in fact, an automatic market maker.
Where does it come from? From other market participants who have decided to contribute their assets to provide liquidity on the exchange. In effect, they became co-organisers of trading. In simple terms, other participants block their assets in accordance with the terms of the exchange's smart contract, which guarantees that these assets are available for trading without additional confirmation by the owner.
Decentralisation as it is – anyone can become a member of the liquidity pool, ensuring the operation of the exchange. Of course, the more people who join this process, the more opportunities for trading will arise.
And this is done not just for fun, but to receive a commission fee, which is distributed among the participants who have contributed their assets to the exchange's liquidity pools. Therefore, DEX gives everyone the opportunity to feel like a trade organiser and market maker, receiving a stable commission rather than a volatile profit from trading.
So, a brief summary. A decentralised exchange operates thanks to automated mechanisms that involve a wide range of people. This allows you not to have a centralised counterparty that "locks up" liquidity. In fact, trading takes place between any person and a pool of liquidity that was previously formed by other persons.
Advantages of DEX
Among the advantages are the following.
Crypto assets remain on your wallets – you don't need to transfer them to exchange accounts or give anyone access. This means that you retain control and responsibility. Even if something happens to the exchange, you are not at risk, because your wallets will not be affected.
Your interaction with the exchange begins and ends at the moment of the transaction. The only significant risk here is a mistaken access to a phishing site that pretends to be real.
It is no coincidence that, for example, the pages of DODO and PancakeSwap exchanges contain such warnings:
There is no need to register, provide documents or confirm your identity.
Of course, a number of centralised exchanges also have a rather lax approach to such issues. But as Mind has already written, this "advantage" is deceptive. If anonymity of trading is important to you, use DEX.
However, don't forget that the history of your crypto wallet is still public, although it is not directly linked to your identity. We have serious doubts about the future prospects of complete anonymity in the world of crypto assets.
Tax evasion, money laundering, and terrorist financing are key issues for most governments today. Therefore, they will focus on solving them, including in the field of crypto assets.
You can find out what information Uniswap collects about you on the privacy policy page. Among other things, it states: "We may share information we collect as requested by regulators, government agencies, and law enforcement to comply with applicable laws and regulations."
The history of individual wallets is not any secret either.
The opportunity to be on the "other side of the deal" by becoming a member of a liquidity pool. This activity also involves certain risks that are not obvious at first glance, and they are worth writing about separately. In any case, this, as well as the management of the exchange's activities through tokens, is not related to trading as such. Therefore, the first two points should be considered the real advantages.
Disadvantages of DEX
Slippage (relevant for large transactions or low-liquid pairs). Also, in the face of strong market dynamics, your trade may simply not be executed in time at the stated price. But this situation is also typical for market orders on centralised exchanges.
High commissions that may depend on the current situation. The price of the "gas" (the fee for transactions in the Ethereum network) depends on the activity of transactions – the "hotter" the market is, the higher the prices rise. You can check them here or here.
The second link also lists technologies for reducing transaction prices. At the same time, the market also offers commission-free options. However, in this case, the commission will be integrted into the transaction price.
Slower transaction speed and inability to actively trade during the day.
Limited trading within a single blockchain. However, this is solved by bridge technology).
Price manipulation – if someone gets information about your transaction just before it is executed and manages to "play" on it.
Which exchange to choose?
As we did in the review of centralised exchanges (CEX), it is worth starting with public ratings. CoinGecko has a separate page for DEX ratings. Don't let the relatively low trading volume make you suspicious. Firstly, DEX is not used for active intraday trading, scalping, etc. And secondly, it is irrational to cheat on fake trades here, as it happens on many CEX.
The top 10 on CoinMarketCap looks somewhat different:
The second position here is notably occupied by an exchange that operates using the order book method (as is the case on centralised exchanges), and not through the liquidity pool mechanism, which we described above. However, this is rather an exception today.
Since you don't have to go through the registration and asset warehousing process when choosing a decentralised exchange, there is no need to be tied to one exchange. Your interaction with any DEX is a one-time transaction. There can be many of them, but this does not require you to be tied to any one.
So, first of all, it's important to check what transaction conditions a particular exchange offers for the particular instrument you plan to trade.
You should remember that liquidity pools do not contain everything that can be traded. In fact, each pool consists of specific assets. Just like in currency exchange offices, we see EUR/UAH, and here we have something like USD Coin/Tether.
When forming pools, a certain amount of asset A (in our example, USD Coin) and a certain amount of asset B (for example, Tether) are added to the pool, and then the pool content is balanced. This mechanism will be described in more detail below, but it is important to understand that pools may differ significantly in price and volume. These are, so to speak, separate mini-markets with different prices.
You may have noticed that there were no traditional currencies in the example. And this is an important feature of crypto exchanges – you work with crypto assets that should be in your wallet. While you can deposit funds to your account on a centralised exchange in dollars or hryvnias, here you are dealing with cryptocurrencies (including in the form of stablecoins).
Mind's Reference:
Stablecoin is a cryptocurrency whose exchange rate is being stabilised, usually by pegging quotes to conventional currencies or commodities. There are different pegging mechanisms.
A standard transaction is the exchange of a stablecoin and a certain cryptocurrency or token. Most DEXs currently operate on the Etherium blockchain, and this also affects the availability of certain asset pairs.
It is important to research the trading activity in a particular pair beforehand in order to lose less during the transaction. This can be done on CoinGecko (DEX page), which collects information on trading volumes in different asset pairs for each exchange. You can see assets, spreads, and trading volumes. The trust score is also provided separately.
Figure: information on trading on the PancakeSwap exchange (v2)
For illiquid pairs or small liquidity pools, slippage can be excessive.
For example:
An attempt to buy Merit Circle tokens for approximately $1500 worth of ethereum could result in a 30% price drop. And this is standard practice for illiquid instruments. So you should not trade them without a clear understanding of what you are doing and why.
However, there is another solution than choosing from an infinite number of DEXs (by the way, some centralisation through the unification of exchanges and their liquidity pools would be to the benefit of the market). There is a number of liquidity aggregator services that collect information from many exchanges and offer optimal opportunities for transactions. In effect, they eliminate the need for clients to check prices manually.
Such services include 1inch, CyberSwap, and others. They are also implemented as DAOs, so in addition to using the services, it is possible to purchase the organisation's tokens.
The full list of functions and features requires a separate survey.
When we try to make the same ETH/MC transaction on CyberSwap, we receive a warning:
And after agreeing, we can see the minimum number of tokens we will buy, the estimated gas fee, and the impact on the price. Let's learn more about this below.
How does a DEX transaction work and what you should pay attention to?
Most decentralised exchanges (or should we say "exchangers" here) has as simple as possible interface, and yet there are some additional features. Let's take Uniswap as an example. We want to buy 100 units of Polygon (MATIC) for Ethereum. We simply enter the desired number of units in the lower field and see the price:
If we do not trust the exchange, we can check the current prices on other resources: CoinMarketCapor Coingecko. It's identical. In general, it is a good practice when working with crypto assets to look at different information sources. The market is still very far from efficient, and the DEX niche is very scattered.
You can specify the "slippage tolerance" parameter (drawback No. 1, mentioned above). In a liquid pair, of course, this is not so critical, but for some assets, the execution price of a trade can differ significantly from the expected one.
Thus, according to the conditions we have specified, the transaction will be cancelled if the price changes by more than half a percent in your favour. Here, you can also specify the transaction waiting time (which is again important for low-liquid pairs).
If we expand the menu, we will also see some approximate properties of the transaction, so our influence on the price in the liquidity pool will be insignificant (0.01%). The maximum amount of expenditure in ethereum is also indicated, given the set slippage of 0.5%.
Those who are curious can also see the transaction path – the algorithm tries to optimise costs by using several liquidity pools.
Having made sure that we are satisfied with the conditions, we click the "Connect the Wallet" button
and wait for the trade to be executed. As we said, direct interaction with our wallet occurs only during the transaction, which is the main advantage of decentralised exchanges – we retain control over the assets. However, if we make a mistake – we exchange the wrong assets, check the price inattentively, etc. – the support team will not help us cancel the transaction.
Full decentralisation goes hand-in-hand with full responsibility, so it is definitely a desirable option if you are really ready to take control.
In other cases, the help of professional intermediaries will do more good than harm.
