In recent years, Decentralized exchanges (DEXs) are winning market share from centralized exchanges (CEXs), a phenomenon that is quite telling for the future of decentralized finance (DeFi). In this blog post, we take a data-driven approach to understand the likelihood that DEXs will continue to prevail, and where improvements need to be made for a more decentralized future.
The exchange of digital assets is one of the largest applications of cryptocurrency since its inception. Currently, DEXs are capturing a larger share of the market compared to their centralized counterparts. In the 2020–2022 bull cycle, DEXs surpassed CEXs in terms of volume of on-chain transactions. One of the leading forces for this movement was the development of applications in DeFi that allowed users to do more with their cryptocurrencies, such as staking, lending, borrowing, and purchasing NFTs. DEXs provided a convenient place for users to exchange assets without their funds needing to leave a self-custodied DeFi wallet. As the industry moves towards a trustless, decentralized future, users will become increasingly reliant on DEXs as the primary source of liquidity for digital assets.
When analyzing exchanges, volume is the key indicator used to define the dominance of a venue. Volume is expressed as the number of shares traded in a particular asset over a specified time period, typically denoted in USD. Currently, Uniswap V3 on Ethereum leads the market, conquering 44.8% of all volume on DEXs [CoinGecko]. Other versions of Uniswap (V2 liquidity and Layer 2 deployments) make up an additional 12.3% of total volume. Even on faster chains, such as Polygon, Uniswap’s deployment is able to consistently hold its share of volume, as observed in the figure below.
Besides the dominance of Uniswap, other players have entered the market by introducing new venues (alternative chains such as Binance, Solana, and THORChain) and new types of exchanges (Stableswap and Request for Quote). There has not been sufficient evidence that any of these new venues satisfy the three prongs of a successful DEX: competitive pricing, profitable LP’ing, and battle-tested code.
We first observe that the pairs constituting the majority of volume for most DEX’s are those involving popular stablecoins (USDC, USDT, BUSD, DAI) as well as the blue-chip L1/L2 tokens (WETH, SOL, MATIC, stSOL).
Since most of these tokens have little use case in the real world, the primary driver of volume is speculative trading. In periods of high volatility — which is frequent in crypto — volumes can be 6–10x their average, reaching over $5B for Uniswap V3 on Ethereum. In chains, or specific pools, where volume is low, some DEXs offer liquidity mining incentives (usually in the form of governance tokens) to attract LP’s, which can improve APYs enough to bootstrap the flywheel of attracting natural swap volume from traders.
The invention of the Concentrated Liquidity Market Maker (CLMM) has further disrupted the need for large amounts of TVL to attract volume. For instance, Orca, an AMM deployed on Solana, attracted 37M of volume on Dec. 31, 2021 on its V2 product while having over 700M in TVL, and now with its adoption of concentrated liquidity, has achieved 50M of volume on Nov. 17, 2022 with 40M of TVL. Due to the difficulty of adoption of active management strategies and rewards associated with newer pools, the profits of LP’s on these DEX’s are much higher in the short-term, but we speculate that the TVL/Volume ratio will correct in the long-run based on the efficient market hypothesis. The deep liquidity created by CLMMs have also allowed it to maintain market share, even when compared against cutting-edge technologies such as Request For Quote (RFQ) systems.
The big question is “where is the volume coming from on Uniswap?”. CeFi-to-DeFi flows have increased, but surprisingly they are not the driving force behind DEX transaction volume growth, as shown in the figure below.
As of November 12, the biggest source of volume is MEV bots. Overall, the data suggests that the DEX trading spike isn’t primarily driven by inflows from CEX users looking to self-custody and exchange between assets. Rather, it’s driven by MEV bots updating the price of the AMM based on knowing more information about the specific market. While volume may be an attractive metric for LPs, trades coming from MEV bots are known as toxic flow, since those bots often have more information than the LP. Oftentimes, the LP is quoting a stale price, and then MEV is able to profit risk-free from arbitraging that liquidity with another market. This is a major avenue of open research in the DEX design space, which we cover in more detail in a future blog post.
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