Starting in the summer of 2020, the Ethereum network has been overloaded with heavy use of DeFi smart contracts that allow users to transact directly with each other, without relying on centralized exchanges (CEX).
One of the most common cases is that of an exchange between ERC-20 tokens using decentralized exchanges (DEX), an idea that dates back to the beginnings of Ethereum but which until this year had not yet had a full spread, until the boom of DeFi.
What is a DEX?
DEXs are exchange markets available in various forms, united by a fundamental point: they do not hold the crypto assets of customers. DEXs use smart contracts to manage funds on-chain, so users never have to trust third parties with their money. How DEX trades take place can vary greatly from one implementation to another.
Initially, the DEX used a central limit order book, similar to what the CEX did, but later the developers saw that this mode is not suitable for a blockchain, because the placing and cancellation of orders by market makers, and the trader’s interactions with the on-chain order book are expensive and error-prone, due to the high costs and latency of on-chain transactions.
The DEXs then introduced the off-chain order book, which eliminated the cost of order creation and reduced the cost latency to place an order.
AMM
In 2020 we have seen the rise of automated market makers (AMMs), which partially solved the problem of the limits of having an on-chain order book.
In this sense DEX like Uniswap has completely removed the order book, replacing it with a simple on-chain formula through a smart contract. This architecture has allowed the new DEX DeFi to achieve very rapid growth.
The always-on and permissionless liquidity makes them a good solution to build other applications. The liquidity pool structure makes it easy for users to tie up capital and earn a passive reward from trading fees and cash extraction.
Limitations of DEX
Despite the aforementioned advantages, there is doubt about the long-term viability of AMMs, and these products also provide a less flexible and effective version of market-making than CEXs.
DEXs will always lag behind CEXs substantially in markets requiring sophisticated analysis and human intervention.
Correspondence and trade execution is a consensus issue to determine who arrived first, which trades should be executed and in what order.
A decentralized network, which by design and underlying structure must reach consensus on a number of different nodes, will never be able to compete at the same level with the speed and efficiency achieved by the CEXs.
In addition, potential bugs present in the smart contracts for the execution of DEXs, make it possible to lose or hack funds when transactions are made, or even their destruction as in the recent case of a user who has mistakenly burned 28,050 AAVE (worth over $ 1M) when he sent the tokens to AAVE’s contract address instead of an actual recipient.
Advantages of CEXs
The concerns related to the regulatory framework accentuate the growing need for traders, especially institutional ones, to comply with regulations, and in this context, the CEXs offer compliance with the requirements established by the competent authorities, while the DEXs are currently in a gray area.
In the CEX the volume of transactions is greater, as well as faster the trading speed and greater the liquidity.
In particular, regarding the user experience, the CEX usually offers very intuitive and easy to use dashboards compared to the complexity of using DEX DeFi.
CEXs offer a wide variety of options because they support all types of blockchains and tokens, while DEXs are mainly focused on Ethereum and not even on all tokens.
The technical development of the CEXs is faster due to their entrepreneurial and clearly commissioned nature, while the DEXs are more opaque and it is not clear to whom they can be traced.
Fees are much more efficient and reduced in a CEX than in DEX, because in the latter it is also necessary to pay the network. Considering what has recently been seen on Ethereum, the costs can be so high as to make it uneconomical to trade on small sums: this problem will never exist for CEXs who optimize and stabilize fees, without any surprise for users.
