Originally published in the NOWNodes blog.
There are two types of crypto exchanges, and these are centralized and decentralized crypto exchanges. Currently, centralized exchanges maintain a significant dominance in the crypto exchange market. Yet, one cannot ignore the growth of decentralized exchanges, popularly known as DEX. In July, the total crypto trading volume became equal to almost 4% of the trading volume on centralized crypto exchanges.
The month of July was the best month for decentralized exchanges. They were able to touch a record-breaking trading volume in July. They surpassed a trading volume of $4 billion in July. It is an all-time high trading volume for DEX.
The month of July was quite special for decentralized exchanges. There was a considerable increase in the ratio of trading volume on DEX to trading volume on centralized exchanges in July. The jump in the ratio was quite dramatic as the ratio stood at 2.1% in June. In July, the ratio of trading volume on DEX to trading volume on centralized exchanges reached 3.95%. It is a considerable rise as before June, this ratio was never more than 1%.
Types of Decentralized Exchanges
There are two types of DEX. The first of which is the order book P2P exchanges, and it uses a bidding model to fulfil the trades. The second DEX type is an exchange that is based on liquidity pools. It means that they leverage automated market makers to fulfil the trades.
Order Book Decentralized Exchanges
In an order book DEX, the buying order from a trader is matched with the selling order of another trader to complete a trade. The core concept of the order book exchanges is far more suitable for centralized exchanges. A high trading volume and the centralized structure of exchanges indicate that there is high liquidity on the platform. It ensures that there is a tight spread. Hence, the crypto traders face minimal slippage while placing large orders.
An order book DEX allows a trader to submit two types of orders on its platform. These are a limit order and a market order. A user can buy a crypto token at the best available price by submitting a market order. The trade is completed on order book DEX by pairing the open orders of both the buyers and sellers. On the other hand, the open order DEX sets a specified price for a trader to purchase a set number of tokens. The most popular open book DEXs include EthFinex, IDEX, and EtherDelta.
Why DeFi Tokens are not Compatible With Order Book Decentralized Exchanges?
The DeFi space and order book exchange model does not work well with each other. It is because the DeFi sector is still at a nascent stage. Most of the DeFi protocols are new and are in the early stages. Thus, their DeFi tokens do not yet have a following to ensure a higher number of traders in the market for them.
As there is a lack of liquidity in the DeFi token space, their prices are more likely to fluctuate because of the large number of transactions. Such price fluctuations can cause a wide spread. It is a vicious cycle as the tokens with high price fluctuations are unlikely to be accepted by the order book exchanges.
The automated market maker model is perfectly suitable for the DeFi tokens. They leverage deterministic algorithms for their operations, and they pool liquidity from both the market makers and the traders. The algorithms set parameters to complete the trades on the platform. Every automated market maker exchanges store both buyer and seller funds in an off-chain liquidity pool.
Liquidity Pool-Based Decentralized Exchanges
The algorithm behind the liquidity-pool-based DEX is known as automated market makers. It’s not a new concept as automated market makers have been known among the mechanism design and academic game theory circles. They have known about it for more than a decade. Yet, it became popular in the crypto world pretty recently.
The automated market maker DEX is different from the open book decentralized exchanges. It does not specify the prices at which the seller wants to sell a digital asset. Neither does it specify the amount at which the buyer wants to buy a digital asset. Instead, the automated market maker exchange pools crypto assets in a liquidity pool. Then, it leverages deterministic algorithms to make markets. The algorithm uses some predefined criteria to quote prices to the buyers. But each automated market maker exchange has its own algorithm.
Currently, Uniswap is the market leader in the DEX segment. Uniswap uses the automated market maker model in its operations. It allows everyone to earn fees from the Uniswap by providing liquidity to the exchange. The fees that a user earns by providing liquidity on Uniswap is their share of earning from the trading activities on Uniswap.
So what’s the most attractive feature of an automated market maker model? It is the ability of any user within the crypto community to become a liquidity provider. This way, the users providing liquidity can also benefit from the success of a DEX. There are other successful players in the DEX space like Bancor and Balancer.
The compatibility between the decentralized exchanges and the DeFi space has set DEXs at a path of hyper-growth. Both June and July were phenomenal months for DEX. The ratio of trading volume on DEX to that in the centralized exchanges reached 2.1% in June. In July, the ratio became almost 3.95%. The trading volume on DEXs stood at $4 billion, an all-time high figure.
Some experts believe that the decentralized exchanges must become more user-friendly to support the DeFi space. The growth of DEXs may also be interconnected somehow with the growth of DeFi space. As of now, CEXs has a clear lead over the DEXs. Yet, we expect that DEXs will maintain its growth and will keep on growing.