Are decentralized exchanges the future of trading?

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Hayden Adams launched decentralized crypto exchange Uniswap on November 2, 2018 by tweeting to his 200 followers and handing out printed t-shirts at home at an industry event. Three years later, spot trading on the new platform had reached the equivalent of $86 billion per day.

Decentralized exchanges such as Uniswap and the oddly named Sushiswap and Pancakeswap allow buyers and sellers of crypto to trade at a price dictated by a written protocol on blockchain-based smart contracts.

They rely on automated market maker algorithms to calculate prices based on the relative weight of buyers and sellers in a single pool. This is a different approach to the limit order book as used on centralized exchanges, where traders record bids and offers in a laddered hierarchy and wait to be matched.

Uniswap et al – part of the decentralized finance (aka “DeFi”) trend sweeping crypto – have grown rapidly to go after centralized competitors such as Binance, Coinbase Exchange and FTX.

At one point, around a quarter of spot crypto transactions were done through the new sites, data from The block shows.

Could the upstarts, who operate without central depositories, ever dominate? Recent to research says they can – and probably will. Some even believe that the decentralized model will also become the norm in traditional asset classes.

The all-in transaction costs of decentralized exchanges compared to centralized crypto exchanges are roughly equal, academics from the University of St. Gallen and the Swiss Finance Institute have found. And Uniswap’s bid/ask spreads are similar to or better, and more stable, than major centralized competitors.

Centralized sites – “CeFi” – are less vulnerable to price disruptions, it seems. Arbitrage trades are expensive on decentralized exchanges, as gas fees apply to each of the multiple trading steps often required. These fees do not apply on a centralized hub, which operates off-chain.

However, reductions in gas fees, coupled with a modest increase in trading volumes, would tip the scales in favor of decentralized exchanges, the researchers believe. And gas fees are expected to drop after the Ethereum blockchain’s recent shift to a proof-of-stake model.

“It’s going to be increasingly difficult for centralized exchanges to be profitable,” says Andrea Barbon, assistant professor of finance at the University of St. Gallen. In the realm of crypto, decentralized exchanges could “take control of a huge market share,” he thinks.

Of course, market participants have reasons other than cost savings for trading on more conventional platforms: technical issues can take time to resolve on a decentralized protocol, for example (the process occurs when participants vote for updates).

Regulators may seek to ensure that exchanges remain on centralized exchanges where they can exercise control or conduct oversight more easily.

But crypto traders are quickly adopting new practices, as already shown by the rapid advance of decentralized sites so far. “We are always looking for liquidity and [on that metric]decentralized exchanges are coming,” said Hugo Langeen, CEO and co-founder of Valid Alpha, a crypto hedge fund, speaking at Risk.net‘s Cryptocurrency Trading Forum in September. If this continues, he said, his fund would change more of its trades.

Crypto’s credit crunch in recent months, in which several big players in the space collapsed, leading to cascading losses for others, could even spur the process. Truly decentralized parts of the infrastructure “worked perfectly” during the shake-up, claims Magnus Holm, CIO at Hilbert Capital, a systematic crypto fund.

Carol Alexander, a professor at the University of Sussex, told conference delegates that DeFi could potentially lead nine to one in crypto in as little as two or three years.

And it might not end there. Niclas Sandstrom, Hilbert’s CEO, says gasoline fee volatility, rejected transactions, and latency remain DeFi’s weaknesses, for now. But all that will change. “We’re not there yet,” he said. “But decentralized exchanges will take over in the future.”

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