Digital exchanges like Binance and Coinbase, have long been the on-ramp to onboard newbies into the crypto space. It was the compliant way for customers to gain access to cryptocurrency in a safe and user-friendly environment. These digital exchanges served as the stepping stone for millions of users to purchase their first digital assets. Their success led to the availability of non-traditional financial instruments that allow customers to trade without any form of accreditation and with no restrictions.
These digital exchanges are also highly centralized, in terms of operation and architecture. They require new customers to provide documents in compliance with laws required for KYC (Know Your Customer), AML (Anti-Money Laundering), and ATF (Anti-Terrorist Financing). This is counter to the philosophy of cryptocurrency and the blockchain, where decentralization is necessary to make the system a truly trustless and permissionless environment to facilitate direct peer-to-peer transactions. The blockchain, the underlying network used in most cryptocurrency, is designed for an independent system architecture that is decentralized.
Unfortunately, digital exchanges can still block transactions and even reject applications from users who do not meet the requirements. They also function much like middlemen and collect high fees per transaction, which they can dictate. While cryptocurrency’s roots are for financial inclusion, the digital exchanges are in line with traditional financial systems to meet regulatory compliance that meets the rules set forth by government agencies like the SEC (Securities And Exchange Commission) in the United States.
The worst problem a centralized system can encounter is hacking incidents. A breach into the digital exchange system can wipe out digital wallets. There have already been several high profile incidents, most notably Mt. Gox and BitGrail. In 2019 alone, hacked exchanges lost $292 Million worth of cryptocurrency. Many customers, instead of withdrawing their digital assets to a personal wallet, keep their cryptocurrency in the custody of digital exchanges. This leaves customers prone to losing their digital assets if the digital exchange gets hacked.
Decentralized exchanges or DEX have emerged in the shadows of the big digital exchanges. 2019 saw DEXes slowly ascend and perhaps the covid pandemic accelerated their significance in 2020. DEX offers various cryptocurrency trading services, notably swaps (exchange of cryptocurrency) and liquidity. This forms part of the DeFi (Decentralized Finance) space which is becoming a huge platform for cryptocurrency trading. One good thing about a DEX is that technically, since it is decentralized, it cannot be hacked. That is only if the operation were truly decentralized, meaning they don’t take custody of digital assets or hold a user’s private key. That is more of something that centralized exchanges do.
Some DEXes are also an AMM (Automated Market Maker), introducing a new concept that makes use of on-chain data using the Ethereum blockchain. AMM does away with order book services and replaced it with automated smart contracts. The main market for AMM like Uniswap and Curve is the trading of ERC-20 tokens to provide liquidity. This type of liquidity is a new form of financing that is a part of the DeFi space. It applies traditional financing techniques to the blockchain, allowing users to collateralize loans while liquidity providers earn from lending money. There are other services that use a protocol in DeFi that include exchanges, derivatives, payments, and digital assets.
The DeFi space has taken off in 2020. Since the first week of August (2020), the total value locked in DeFi jumped over 85% in 27 days from $4.2 billion to $7.88 billion on August 30 (Source: bitcoin.com). The Total Value Locked (TVL) in DeFi smart contracts is worth over $11.29 Billion (as of 10/19/20).
TVL in DeFi is valued at $11.29 Billion (10/19/20) (Source DeFi Pulse)
To break it down by protocol:
DEXes — $4.38 Billion
Lending — $4.13 Billion
Digital Assets — $2.1 Billion
Derivatives — $690.6 Million
Payments — $156.7 Million
DEXes are leading in the DeFi space through token swaps that involve ERC-20 tokens and ETH (Ether). The trading volume on some DEXes like Uniswap has also started to outperform established digital exchanges like Coinbase. During the period between September 28 and October 4 in 2020, Uniswap’s volume hit $811 Million versus Coinbase’s $322 Million. DEXes may even replace centralized exchanges for most trading. Coinbase, while it remains centralized, is facilitating the on-ramps to DEXes which still makes them a significant part of the DeFi space.
Binance is helping in DeFi as a CeDeFi (Centralized Finance/Decentralized Finance) provider for DEXes to somehow become legitimate for offering financial services. Binance’s CEO Changpeng Zhao sees CeDeFi as a complement and not a competitor to DeFi. It is like offering DEX-as-a-Service from a centralized exchange, which takes care of compliance issues. This makes the platform a more user-friendly environment for those who are new investors in cryptocurrency. At the same time, they are offered DeFi features like providing liquidity and crypto-collateralized lending.
Overall, this should be good for Ethereum. It is providing a real world use case for smart contracts in the DeFi space, bringing more capital into the system. It is fair to say that it is only getting started, and $11 Billion may look like a small amount in the days ahead. Ethereum may not be undervalued for long if these DeFi protocols prove it can work in bringing financial services to new markets. The trading is generating transactions on the Ethereum blockchain which benefits miners and soon stakers. Perhaps it still has to prove that it can maintain the volume of trading, an indication that it is actually being used and not just hype.
The momentum is there, but the cryptocurrency market is highly volatile and unpredictable. There is still the issue of regulatory compliance to deal with, but DEXes have an advantage over centralized exchanges. They can circumvent compliance because DEXes don’t have any actual organization. It is basically free software that user’s install to transfer value and not an actual business entity. While government agencies are beginning to increase scrutiny into established exchanges like Coinbase, it won’t be surprising when they start to look deeper into DEXes. After all, the DEXes are making plenty of money that government agencies (e.g. IRS) may want more share of for taxation purposes and tracking. This will likely shape the future of DEXes and the rest of the DeFi space.