DEX Machina: An Introduction to Decentralized Exchanges
Michael Zhao
Last Updated: 10/17/2023 | 20 min. read
Uniswap Labs' new 0.15% fee has reignited debates on the sustainability of decentralized platforms like Decentralized Exchanges (DEXes), which are key to the DeFi ecosystem.
Our analysis shows that DEXes offer deeper liquidity at price levels farther from the midpoint compared to Centralized Exchanges (CEXes).
Liquidity Providers (LPs) capture the majority of trading fees, but also face the risk of Impermanent Loss.
Most DEX volume is driven by automated, sophisticated players rather than individual retail users.
We anticipate that DEXes will further solidify their importance, attracting more trading volume and an expanding user base as the overall DeFi ecosystem continues to grow.
For years, the traditional order book model has been synonymous with trading. It’s more than just a tool; it’s the heartbeat of exchanges, dictating price and liquidity for markets across the world. By matching orders between buyers and sellers based on certain rules, price discovery happens through the continuous interaction between buyers and sellers in the markets.
Order books have historically worked well, although not without faults. First, order books require a buyer and a seller to trade at a certain price; if there’s an illiquid asset, an order might take a while to get filled. Second, order books introduce centralization risk, since they require middleware infrastructure to host the order book and match orders, and also depend on market makers for liquidity. This often can lead to wide spreads and slippage for more illiquid markets.
Enter the world of Decentralized Exchanges (DEXes) — an innovative solution that addresses some of these challenges while reshaping our understanding of liquidity, pricing, and market participation. DEXes have also been central to some of crypto's most noteworthy events in recent years such as the Curve USDT depeg. If you've ever sought to purchase a token unavailable on centralized exchanges (CEXes), it's likely you've turned to a DEX like Uniswap. But how exactly do these platforms operate?
Zero to Hero
Imagine a schoolyard bustling with kids, where action figures and comic books are the currency of the realm. But trading these treasures is a chaotic mess—a jungle gym of missed opportunities and unfair swaps. You, the entrepreneurial genius of 5th grade, decide to set up the ultimate trading post: "The Liquidity Pool."
Establishing the Pool
You slap down 100 action figures and 100 comic books on the table (the “liquidity pool”). You are considered the “Liquidity Provider” (LP). Kids can now trade action figures for comic books and vice versa. The trading rate depends on a formula that you’ve conjured up:
Initially, this constant number is 100 x 100 = 10,000. The trade rate is a straightforward 1:1. One action figure gets you one comic book, and vice versa.
First up is Alice, a small-time trader known for her cautious yet clever swaps. She trades her two action figures for comic books via the liquidity pool. After her trade, you now have 102 action figures in the pool. Time to calculate how many comic books she receives:
102 Action Figures * X Comic Books = 10,000
Alice skips away with 1.96 comic books, nearly a one-for-one trade. For a small-time trader like her, it's like hitting the jackpot—a great haul for minimal risk! She’s just a few pages short from 2 comic books.
Next, the ground shakes as Bob, the "Whale Trader," saunters over. Known for his massive trades that can tip the balance, he wants to swap a whopping 10 action figures for comic books. Your table now holds 102 action figures and 98.04 comic books. Time for some math:
112 Action Figures * X Comic Books = 10,000
Bob lumbers away with 8.76 comic books for his 10 action figures. He's unfazed—after all, making waves is what whales do. However, his large trade has shifted the magic number, impacting the rate for everyone.
Your Incentive
So, what's in it for you, the mastermind behind this trading hub? Every time a trade is made—whether it's Alice's cautious swap or Bob's whale of a deal—a small trading fee is collected. This fee is your reward for providing the liquidity that makes all these trades possible. In the world of decentralized exchanges, these fees serve as the primary incentive for liquidity providers, making the ecosystem sustainable.
As you can see, while originally the pool was balanced, swaps were trading at a near 1:1 ratio. As the pools became more imbalanced, and as the trades became a larger amount of the pools, one asset gradually became more expensive, and trades became more imbalanced.
If we want to graph the price of Comic Books to Action Figures using the quantities of each in the pool, it would look something like this:
Figure 1: Price Depends on Asset Quantity in Liquidity Pool
As you can see from the chart, the larger the trade, the more the scales tip. In other words, the bigger the swap, the more you disturb the pool's balance, affecting the price for everyone. It's like a seesaw: the heavier the weight on one end, the faster the other end rises.
Before we conclude, let's revisit some key terms:
Liquidity Provider: An individual or entity that supplies assets to a liquidity pool. In our schoolyard example, that's you with your action figures and comic books. You receive a fee based on the percentage of the volume traded.
Liquidity Pool: A collection of assets that traders can tap into. This pool is what makes trading possible in a decentralized exchange. Again, think of your table of action figures and comic books.
These are the fundamental mechanics of liquidity pools, distilled into a schoolyard trade of action figures and comic books. Just like in our example, decentralized exchanges rely on liquidity providers to keep the trading ecosystem balanced. Whether you're an Alice, cautiously stepping into the market, or a Bob, making waves with significant trades, your actions affect the liquidity pool and, by extension, the trading conditions for everyone else.
Liquidity Comparison to Centralized Exchanges
Now that you understand how liquidity pools operate in decentralized exchanges, you might be wondering how they measure up against the traditional, centralized platforms. So, how do decentralized exchanges, with their innovative liquidity mechanisms, stack up in terms of liquidity and market depth?
Let’s briefly discuss what liquidity means. One of the cornerstones of a robust trading environment is high liquidity: the ability to buy or sell assets without causing significant price fluctuations. Closely related to liquidity is the concept of market depth, which refers to the volume of orders at different price levels in an order book. For instance, if a market has $1 million of depth within a 2% price range around the current Bitcoin price, it means you could buy or sell up to $1 million worth of Bitcoin without affecting the price by more than 2%. However, if the market depth was only $500,000 within the same 2% price range, a $1 million purchase would likely cause a larger price swing. In general, deeper liquidity and market depth are advantageous as they tend to offer traders better prices, lower slippage, and increased order fulfillment speed.
Figure 2: An Order Book Shows the Cumulative Bids and Asks at Various Prices
To evaluate the efficacy of DEX liquidity, it's useful to turn to empirical data. A study by Kaiko in August 2023, a blockchain analytics firm, examined Uniswap's liquidity profile in various pools and compared them to the same trading pairs on centralized exchanges. The data reveals an interesting pattern: although Uniswap may offer lower market depth at price points close to the current trading price, it boasts greater depth at prices further from the midpoint. This suggests a more balanced distribution of liquidity. This could present a unique advantage over centralized exchanges, where liquidity often diminishes at extreme price points.
Figure 3: Liquidity Distribution More Balanced in WETH-USDT Uniswap v3 Pool vs. Binance
Kaiko also conducted a broader analysis comparing Uniswap to several top centralized exchanges. Remarkably, their findings indicate that Uniswap v3 outpaces all of the top 10 centralized exchanges in terms of liquidity within a +/- 6% price depth. This highlights the increasing competitiveness of DEXes in providing substantial liquidity.
Figure 4: Uniswap ETH-USDC Pool has Deeper Liquidity Compared to CEXes Within a +/- 6% Price Range
The share of trading volume on DEXes compared to CEXes has increased from 8% in October 2022 to 12% as of October 2023. This growth suggests a rising preference for DEXes likely driven by their liquidity benefits.
Figure 5: DEX to CEX Volume Ratio Has Been Growing Gradually
Despite their novelty, DEX platforms like Uniswap are carving out a distinctive and increasingly competitive position in the trading landscape. While they may not entirely supplant centralized exchanges, we believe their innovative approaches to liquidity and market depth make them an increasingly viable alternative for various trading scenarios.
A Look into Liquidity Provider Returns
While decentralized exchanges may offer compelling alternatives to their centralized counterparts, what are the implications for individual participants, particularly liquidity providers? After all, these are the actors who fuel the liquidity pools that make decentralized trading possible.
Every liquidity pool charges a fee for trades conducted on its platform. For instance, a “0.03% fee USDC-WETH pool” means that the protocol takes 0.03% of each trade's value and distributes it to the Liquidity Providers (LPs) that are providing those assets (USDC and WETH). It's worth noting that historically the lion's share of these trading fees—typically between 80% to 90%—goes to the LPs, leaving only around 10% for the protocol itself.
The Uniswap Anomaly
One reason for this skewed distribution is the unique fee structure of Uniswap, the largest DEX by historical volume. Prior to October 16, 2023, Uniswap did not levy a fee, which meant that 100% of trading fees were distributed to LPs. When Uniswap is excluded from the analysis, protocol fees claim a significantly larger portion, averaging around 35% of the total trading fees generated (Figure 6).
Figure 6: Weekly Average of Protocol Revenue Share Excluding Uniswap Hovers Around 35-40%
Let’s consider an example.
Imagine you become an LP on a decentralized exchange. You deposit an equal value of two cryptocurrencies into a liquidity pool: 1 ETH and 1,700 USDC, assuming 1 ETH is worth 1,700 USDC at that time. Let's also assume that the total liquidity in the pool is 10 ETH and 17,000 USDC, making your contribution 1/10th of the total pool.
Now, let's say the price of ETH rises to 2,000 DAI in external markets. In the AMM, the asset prices adjust according to the ratio of ETH to DAI in the pool. As people buy the cheaper ETH from the pool, the amount of ETH decreases, and the amount of DAI increases, causing the price to adjust.
Let's say after several trades, and XY = K math, the pool now has 9.22 ETH and 18,439 USDC. Given that you are 1/10 of the pool, your holding value currently is 3,687.82. If you decide to withdraw your share from the pool now, you will have made 3,687.82 - 3,400 = $287.82.
But what if you held the two amounts? You would have had 1,700 USDC and 1 ETH, or 1,700 + 2,000 = 3,700. The difference between this amount and your liquidity position – 3,700 - 3,687.82 = 12.18 — is your impermanent loss. We can graph impermanent losses as so:
Figure 7: Impermanent Loss Increases With Larger % Change in Price
It's important to note that the graph does not account for fees generated from trading activity, which may impact the analysis. As an LP, you're essentially making two key assumptions:
Price Stability: You hope that the prices of the assets in the pool will remain relatively stable, minimizing any impermanent loss.
Fee Compensation: You expect that trading fees and any additional incentives provided by the protocol will offset any impermanent loss you might incur.
Despite the challenges, there are ways for LPs to try to remain profitable:
Sideways Markets: LPs generally profit from fee generation, especially in stable or "sideways" markets where asset prices don't fluctuate wildly.
Stablecoin Pairs: Platforms like Curve Finance offer stablecoin pairs with high trading volumes and low price divergence, making them potentially profitable for LPs.
Dollar-Cost Averaging: The constant rebalancing inherent in LP positions can also serve as a form of dollar-cost averaging, allowing LPs to build positions in assets over time.
By understanding these factors, you can better gauge the risks and rewards of becoming an LP. Let’s take a look at who the major DEX users are currently.
Current Cohort Analysis
Cohort analysis reveals that the majority of trading volume comes from sophisticated users and automated trading systems, rather than casual or individual traders. This trend is particularly pronounced in the largest liquidity pools, as measured by Total Value Locked (TVL). Automated trading participants account for over 60% of the total trading volume in these pools.
Figure 8: Automated Participants Tend to Dominate Volume on DEXes
The prevalence of automated traders on DEXes, facilitated by Ethereum's mempool, brings both opportunities and challenges. While they contribute to market efficiency, they also pose risks to passive LPs. Understanding this landscape is essential for anyone looking to participate effectively in decentralized markets.
Decentralized exchanges have begun carving out a vital role in modern trading, offering unique advantages over their centralized counterparts. Through various mechanisms, they have democratized liquidity and presented novel opportunities for asset exchange.
However, this innovation comes with its own complexities, including the risks associated with impermanent loss and the competitive dynamics introduced by automated traders. As the sector continues to mature, both casual traders and sophisticated liquidity providers may wish to equip themselves with a comprehensive understanding of these nuances to navigate this evolving trading landscape effectively.
[1] Example provided for educational purposes only and based on a common type of DEX pricing calculation called a Constant Function Market Maker.
[2] Synthetic asset refers to a tokenized version of other assets. For example, USDC is a crypto asset that is a synthetic asset that tokenizes the US dollar.
[3] Based on total volume, Uniswap has the highest amount of cumulative volume - around $1.7T as of October 17, 2023. Uniswap v3 is Uniswap’s most utilized DEX as of October 17, 2023.
[4] This assumes price discovery happens in external markets. If all of the trading happens within the liquidity pool then there technically would be no impermanent loss, since the liquidity pool prices reflect the actual prices.
[5] Maximal extractable value (MEV) refers to the maximum value that can be extracted from block production in excess of the standard block reward and gas fees by including, excluding, and changing the order of transactions in a block.
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