Crypto exchanges come in various types, but centralized exchanges (CEXs) and decentralized exchanges (DEXs) are the most widely known and used. These platforms serve as the go-to avenues for buying and selling digital assets, offering straightforward solutions for novice investors.
A centralized crypto exchange is a platform that acts as a middleman between buyers and sellers of crypto assets (and some act as market makers too). Some of the leading CEXs in the market are Coinbase, Binance, and Kraken. They are regulated entities that provide security, liquidity, and convenience for their users, matching their orders and executing trades at a fee. Vitally, CEXs are one of the only ways to trade fiat currencies like the USD or EUR for cryptocurrencies. However, they also have some drawbacks.
Investors trust CEXs to handle their assets safely and fairly, while this is often the case, there are a multitude of instances of the exact opposite happening, such as the collapse of FTX in November 2022, which resulted in the losses of billions of customer funds.
On the other hand, decentralized exchanges are platforms that let users trade crypto assets without intermediaries or custodians. Furthermore, they don’t take custody of your funds when you trade (unless you stake them in liquidity pools), completely avoiding the problem of bad actors losing or stealing your funds. Unlike CEXs, which hold and manage users’ funds and identities, DEXs give users full control and security over their transactions.
DEXs use smart contracts and blockchain technology to execute trades directly between users (and pools of users), with a lower risk of hacking, censorship, or manipulation (assuming it is fully audited). Decentralized exchanges are a key component of decentralized finance, or DeFi, which aims to create a more open and accessible financial system.
Some of the leading DEXs in the market are Uniswap, dYdX, Kine Protocol, and PancakeSwap.
The Future of Crypto Exchanges
Some centralized exchanges, although convenient, have been faulted by many for abusing the trust of their users. Most must take custody of your funds for you to trade. Most reputable top exchanges like Coinbase don’t steal or misuse your funds, but even some of the most popular exchanges have been caught doing this, such as FTX. The SEC has also accused Binance and its founder of illegally diverting and commingling customer funds, but they are innocent until proven guilty.
Due to the requirement to comply with regulations, especially those touching on money laundering and other criminal behavior, most CEXs have made it mandatory for users to go through a Know Your Customer (KYC) process. This requires users to provide extensive personal information, which helps in verifying identities to restrict illegal activities such as money laundering and terrorist financing. All exchanges that are legally available in the U.S. require KYC, and many other countries have similar requirements.
Lack of user control over their cryptocurrencies is a major drawback that has been pushing investors to decentralized exchanges like Uniswap. This situation is made worse by the rampant security issues, with centralized exchanges becoming targets of high-profile hacks.
One of the main benefits of decentralized exchanges is in the name: decentralization. According to a report on cryptocurrency theft statistics of 2023 by Persona, these crypto platforms function “on a distributed network of computers with no single owner, as opposed to traditional banks, which are managed by a central authority and its intermediaries.” No central authority can refuse your business, nor can it take your funds (assuming the contracts are safe and secure).
Challenges Faced By Decentralized Crypto Exchanges
Despite DEXs being the obvious alternative to CEXs, they also face numerous issues that make the platforms less efficient in real life – at times standing out as more costly compared to centralized exchanges.
Scalability is one of the critical challenges synonymous with DEXes, as they rely on different blockchain protocols to process and record transactions. Blockchains like Ethereum are prone to network congestion, high gas fees, and long confirmation times.
Limited liquidity is one of the biggest issues DEXs grapple with. DEXes are usually built on liquidity pools, which are simply smart contracts with usually 2 (but can be more). This allows investors to make trades immediately, without the need for another investor (or a market maker) on the other end of the trade, like normal order books.
Low liquidity means that there isn’t enough of one or both cryptocurrencies in a liquidity pool. This leads to premiums on trades for tokens with low liquidity, giving traders worse prices than they might get on CEXs.
Some DEX users only use them to swap between cryptocurrencies, but others deposit their tokens into liquidity pools to earn fees on each trade. This is what enables DEXs to exist, and the practice can be quite profitable.
However, these pools have their own set of challenges, including the risk of impermanent loss, which arises when your share of the liquidity pool is worth less than the present value of the deposit. This happens when the prices of tokens fluctuate compared to each other.
Security is another challenge DEXs continue to struggle with despite not having custody of the crypto assets traded on their platforms. This custodial benefit is only true to a certain extent, especially since decentralized exchanges are not immune to exploitation or hacking.
Smart contracts are often seen as cold, calculating, and precise, but even these programs are susceptible to attacks due to various vulnerabilities. Several DeFi protocols and DEXes lost millions of dollars in 2020 due to manipulated smart contracts.
Lastly, DEXs operate in a grey area with little to no regulation. This implies that they are not compliant with the same standards and guidelines required of CEXs.
The absence of regulation in the DeFi space acts as a double-edged sword. On one hand, certain users favor unregulated platforms for the sake of ease of use, privacy, and anonymity. However, the downside is that these users won’t benefit from the regulatory safeguards and protections available to customers on regulated platforms.
That brings us to a new platform, a new permissionless, open-source (GPL), and auction-based protocol Uniswap launched on 17 July, for trading automated market makers (AMMs) and other liquidity sources and might just be the missing piece in the puzzle for the future of crypto exchanges.
Uniswap Unveils UniswapX: Finding The Best Deals From AMM DEXs
AMMs refer to decentralized exchanges that incorporate algorithm “money robots’ to make the process of buying and selling digital assets seamless for individual traders. In other words, “Instead of trading directly with other people as with a traditional order book, users trade directly through the AMM,” the Chainlink education hub explains.
It is important to understand AMMs as liquidity providers for decentralized exchanges like Uniswap.
Liquidity pool depositors play a crucial role in the DeFi ecosystem, as they are responsible for ensuring liquidity is available on exchanges for tradable assets that might otherwise suffer from illiquidity. These depositors flock to DEXs and tokens that are the most profitable (and secure), leading to liquidity drying up in other pools. The growing number of DEXs also spreads liquidity out into more and more pools, lowering the liquidity of each individual pool.
In light of the obvious liquidity problems often faced by traders on DEXs, Uniswap launched UniswapX – “a non-custodial Dutch auction-based trading protocol implemented for the Ethereum Virtual Machine (EVM),” the whitepaper states.
UniswapX integrates a blend of on-chain and off-chain liquidity sources, taps maximal extractable value (MEV) as a method to enhance pricing, proposes swaps at zero gas fees, and extends the platform’s scope to enable cross-chain trading.
How UniswapX Pushes the DEX Innovation To The Next Level
Uniswap, as one of the most popular and largest decentralized exchanges, is well aware that liquidity pools are the only reason (along with AMM contracts) that DEXes can exist without active market makers. Since these pools are susceptible to dry spells, UniswapX has been fronted as the ultimate solution.
The new platform, although still in beta, finds the best prices for swaps from around the internet and mixes liquidity from both off-chain with on-chain liquidity. It does this by outsourcing transaction routing to third-party fillers who take over the process of filling swaps either directly or would be obliged to direct traders to selected AMM pools with appropriate liquidity.
These fillers have to compete with each other for fees because orders are set as Dutch auctions, which are simply auctions that descend in price until someone bids.
In addition, fillers would be required to settle gas fees on behalf of traders carrying out the swaps. Instead, the gas fee that the filler undertakes would be included in the Dutch auction value that they bid on. This eliminates the need for users to hold tokens native to the respective blockchain utilized, for example, Ethereum or Polygon to complete orders. This also means that swappers won’t have to pay for unsuccessful transactions.
How Swappers Trade on UniswapX
When traders utilize the Uniswap Protocol (v1, v2, v3, and v4) for their trades, they initiate and authenticate transactions. These transactions define crucial details such as the input token, the desired output token, the specific execution route, and a minimum output amount.
Once the swappers finalize their transactions, they submit them to the blockchain’s mempool, which can be either public or private. In the mempool, these transactions await miners to pick them up and validate them.
UniswapX harnesses the power of Permit2, a token approval contract that facilitates signature-based approval and transfer actions for any ERC20 token. Furthermore, UniswapX utilizes an on-chain Reactor Contract for settlement. This contract plays a key role in verifying whether the execution of each trade aligns with the user’s expectations, while it also reverts trades that fall short of pre-set criteria.
Prior to the initiation of any trade, swappers are required to approve the Permit2 contract. Consequently, instead of formulating and posting transactions independently, swappers who use the UniswapX protocol sign orders which then specify the following:
- Input token
- Output token
- Specific input (or output) amount
- Initial output (or input) amount
- The minimum required output (or input) amount
- A chosen decay function
- A designated claim deadline
- Authorization for the UniswapX reactor contract to conduct token transactions on the user’s behalf.
The whitepaper states that fillers have the freedom to combine gas fees with the total cost of swaps, however, they may choose to bundle numerous orders to reduce the overall transaction costs. Uniswap said that with way, fillers nurture a competitive environment for offering the best prices for swaps.
Fillers then fill the order with whatever liquidity they want to, off-chain, on-chain, or both.
Unlike traditional AMMs, UniswapX cleverly incorporates MEV into its architectural framework. MEV is currently used by bots to abuse slippage and force traders to pay more for token swaps while they profit. UniswapX uses this in the traders’ favor by improving prices.
UniswapX plans to integrate cross-chain trading later this year, which will support the seamless swapping of “trade assets on an origin chain for desired assets on a destination chain.” For instance, trading BNB for ETH on the Binance Smart Chain and receiving MATIC on Polygon.
The Drawbacks of Centralized DEX Interfaces Like UniswapX
DEX interfaces and aggregators like UniswapX are game changers in the DeFi sector, with traders emerging as the biggest winners. With liquidity available from numerous AMMs and off-chain sources, user experience on DEXs will likely be enhanced significantly. For a long time, CEXs such as Binance and Coinbase have been preferred because of their liquidity advantage, but users who care for having complete control over their assets may turn to UniswapX-like products to take advantage of the best prices, brought by competition among fillers.
Nevertheless, these interfaces and aggregators for DEXes themselves are somewhat centralized. For example, some exchanges can remove certain tokens from the user interface, which some investors may consider a form of ‘delisting.’ In such a case, investors are required to trade the tokens manually using smart contracts – a rather complex and risky procedure.
In 2021, Uniswap delisted 100 tokens from its interface, citing regulatory pressure. At the time, the DEX said that “these changes pertain to the interface at app.uniswap.org – the Protocol remains entirely autonomous, immutable, and permissionless.”
Furthermore, the Uniswap team will likely be able to ban certain wallets from the UniswapX interface, making them a centralized entity with control over the app. The reason this is possible, at least according to Uniswap, is to ban suspected criminals. This could be important because if fillers are using off-chain stolen, sanctioned, or similarly illegal funds to fill trades, UniswapX users will be the ones hurt.
That said, the benefits likely to come out of having centralized DEXes like UniswapX may outweigh the drawbacks. While investors must carry out their own due diligence before trading crypto assets on any platform, centralized DEX interfaces and aggregators like UniswapX could shape the future of digital asset trading.
Centralized exchanges have continued to triumph over decentralized exchanges due to limited liquidity, the complexity of the trading process, and the high transaction cost of the latter. UniswapX solves all these challenges by offering lost cost swap and zero cost on unsuccessful on-chain transactions, making the process seamless even for novice traders eyeing the DeFi space.