Given the hazy regulatory landscape, DEXs ought to have gained greater traction than CEXs because they allow the end user more control. Customers’ preference to use CEXs has not changed despite their collapse. DEXs have had to overcome obstacles of their own to create viable business plans. Even though the AMM decentralized exchange was one of the most creative concepts that started the DeFi movement, it seems unsustainable and difficult for liquidity providers to run without financial support from speculative investors in the form of incentive schemes and rewarded tokens. In recent years, billions of dollars have been invested in DeFi protocols and DEXs, but the bootstrapping attempts have either failed or been short-lived.
Lack of Incentives
For many DEXs, trading fees were insufficient motivation to remain in the pools once the liquidity incentive programs ended. High slippages have resulted from the depletion of liquidity and the low capital efficiency of AMM DEXs. As a result, the cost of trading on-chain is now comparatively higher than that of dealing on centralised exchanges.
Considerable effort is being made to reinvent DeFi for lower slippage costs and improved capital efficiency to provide deeper liquidity, to assist DEXs compete with CEXs. These strategies range from adding order-book matching to DeFi to enhancing AMM models even further.
Order-book matching is part of dYdX’s hybrid infrastructure. Because of this innovative approach, customers can buy/sell cryptocurrency assets with fair trading costs and great liquidity without having to rely on unreliable exchanges around the globe. However, by concentrating on enhancing the AMM model, Uniswap V3 maintains its dominant position in the DeFi market, with a market share of over 60%. Every week, over $5 billion worth of transactions are facilitated by Uniswap and dYdX, both of which are making progress towards closing the gap between DEXs and CEXs.
A look at CEXs and why these platforms are still popular
Centralised Exchanges are a great option only if backed legally by local regulatory laws. Users can deposit fiat or cryptocurrency assets into centralised exchanges, which act as depository financial institutions, to purchase or sell cryptocurrency within their trading accounts.
Every trade is settled off-chain, and customers only move their cryptocurrency holdings back to their public blockchain addresses when they want to withdraw them. These accounts are KYC insured but there is no guarantee of protection such as adequate insurance in case of bankruptcy. Customers often mistake CEXs for stock exchanges but the same laws do not apply here. FTX bankruptcy left many depositors hanging without any recourse. Legal route is too complex and refunds take years such as Mt. Gox.
With the use of smart contracts, users can trade cryptocurrency assets on decentralised exchanges without requiring permission. All trades and transactions are settled instantly on public ledgers.
Trading Fees Dilemma?
Fees on centralised exchanges typically range from 0.1% to 0.6%. Decentralised exchanges, charge anywhere from 0.04% to 0.3% but the overall trading expenses (including exchange fees and slippages) on decentralised exchanges are more than CEXs. This is because of slippage fees brought on by lower liquidity levels on DEXs.
Slippage, which is frequently regarded as a hidden cost in trading, is the difference between the expected price of an order and the price at which it is executed. Increased liquidity lowers slippage, which increases user appeal for the trading cost.
Trader’s Dilemma: Users have to decide whether to trade on DEXs with greater trading expenses (which include slippage and exchange fees) or tolerate the exchange’s solvency risk.
Market makers make money on exchanges by keeping capital in stock and matching higher bids with lower offers to profit from spreads in exchanges that use order-book matching procedures. By raising trade volume, market makers’ presence on exchanges greatly improves liquidity. Exchanges frequently work with market makers to arrange agreements for reduced trading fees to encourage them to deploy their capital.
Liquidity providers—as opposed to merely liquidity enhancers—must be present in AMM pools as the main source of liquidity. To encourage liquidity providers to retain their cash in the liquidity pools, DeFi incentive programmes in the form of awarded tokens need a sizable amount of funding. But as finance has become scarcer and interest rates have increased, incentive programmes have been less prevalent throughout chains, which has led to a substantial decentralised liquidity drain. This has made supporters wonder if DeFi’s existing conventional growth strategy can last.
The danger of receiving returns that perform worse than merely hodling the tokens is represented by impermanent loss.
To encourage liquidity providers to maintain their funds in the pools, DeFi protocols are required to offer rewarded tokens in addition to shared swap fees. Because these awarded tokens were easily exchanged and saw steady price growth during the bull market, AMM (Automated Market Maker) pools seemed like such a fantastic “free lunch.”
However, liquidity providers encountered growing difficulties in continuing to be profitable as trade volumes started to drop and the subsidies dried up. This was made worse by the mounting risk of cyber security exploitation. As a result, a large number of them decided to leave the pools.
Way Forward?
Every strategy, including AMM, decentralised liquidity books, and hybrid structures like dYdX, has supporters and detractors in equal measure. Which strategy becomes more popular over the coming years will only become clear with time, particularly if the cryptocurrency market continues to rise.
With more regulatory clarity expected in the coming years, CEXs could become more popular and DEXs still have the chance to improve their products before CEXs may be able to reclaim their advantage. A hybrid model that incorporates order books of CEXs while retaining the decentralisation of DEXs could serve as the best mechanism. Best of both worlds situation could propel the growth of DeFi with the customer benefitting in the long run.
Disclaimer: This article was created for informational purposes only and should not be taken as investment advice. An asset’s past performance does not predict its future returns. Before making an investment, please conduct your own research, as digital assets like cryptocurrencies are highly risky and volatile financial instruments.
