Evolution of Crypto-Exchanges From CEXs to DEXs: The Journey From Mt. Gox to Uniswap

Crypto exchanges evolution

A few years ago, I used to have an account on the „ancient“ crypto exchanges such as Mt.Gox, Cryptopia or Cryptsy. They were all hacked back then and none of them works anymore. Their user experience wasn’t great and as we know to this date, they had several security gaps that have been broken.

I also tried the first decentralized exchange IDEX. The user experience was horrible, the wrapping/unwrapping process was a tough one and lengthy loading was annoying. The crashes of the web interface were very frequent. IDEX worked on the order book principle, which turned out to be not ideal for a DEX because each bid and ask was updated into the blockchain and kept there.

After the bull run in 2017, the industry evolved by a huge step, but still, compared to human evolution, it moved from infancy into adolescence. But from the last two years, I can feel that the exchange business really matured. New and new features took place both for centralized and decentralized exchanges. And from a user perspective…that matters!

Centralized exchanges

Let’s take a look at centralized exchanges first. What is a centralized system in comparison to decentralized exchange? What are its advantages?

Centralized exchanges are trading platforms that function like traditional brokerage or stock markets. A CCE is owned and operated by a company that maintains total control over all transactions. Users of CCEs do not have access to the private keys of their exchange account’s wallets. This puts all of user’s trust in the hands of the exchange operators, as transactions can only be made through the mechanisms provided and approved by a central authority.

Source: https://hacken.io/education/decentralized-and-centralized-exchanges-advantages-vs-disadvantages-aa9a27da4584/

The way centralized exchanges handle trades is the orderbook system, where buyers meet sellers and the matching engine of CEX connects those two together.

Most of the well-known centralized exchanges improved their technology and added several functionalities. Simple exchanging of tokens is not enough to attract users nowadays. And it is good for the end-user and for the whole industry as well, because the newbie can be encouraged to use the exchange by its great UX and UI.

Usually, CEXes allow users staking of their PoS coins, savings opportunity, margin trading or some trading functionalities such as stop-limit orders or trailing stop-loss and trailing take-profit. Binance goes even further and offers their clients products such as Launchpool for receiving newly listed tokens or Launchpad, kind of IEO or listing of new coins. Crypto exchange KuCoin did for their clients a bidding simulation, similar to the upcoming Kusama parachain auctions with real crypto and real crowdloan rewards.

Free tokens, staking opportunities and lending are products that attract new users and they have their justification on the exchanges.

Decentralized exchanges

But let’s have a closer look at the comparison between decentralized exchange vs centralized exchange. DEXes went very popular last year, Uniswap even overtook Coinbase by the volume of trades, did you know that?!

DEX is an alternative to CEX without a central point of failure, no company is in charge of the assets. In comparison with traditional CEX, the transactions and trades are automated by using smart contracts and decentralized applications. This way is much more secure because there is no possibility of a security breach if the smart contract is well written of course.

Source https://www.soft-fx.com/blog/types-of-cryptocurrency-exchanges/ 

Two main ways to create a price on DEX are AMM (automated market-maker) and an orderbook. While the orderbook is mainly a tool of CEXes, because it matches buy and sell orders together, AMM serves DEXes very well, because it can manage huge financial volumes that fit into a relatively small number of transactions.

But there are also problems with present solutions. Let’s have a look at the biggest DEX of today by volume. Uniswap takes 2 coins and stocks them into one pool, while the price is automatically calculated. But when the liquidity of the 2 coins in the pool is low, there arises a slippage problem. Simply put, the large orders get filled at an inefficient rate.

One of the exchanges that prepares to run and solves the slippage problem is HydraDX, which is based on Substrate and will run in the Polkadot ecosystem.

Frontrunning and flash-loans

Two problems of today’s DEXes are frontrunning and flash-loans. Frontrunning can be made because of the mempool sorting of transactions on Ethereum. Because blockchain is open and transparent, some big transactions in mempool can be visible to sophisticated programmers or let’s say, speculators. They can frontrun the transaction/trade by using a higher network fee and enjoy the advantage of that kind of information.

One of the newly built projects within the Polkadot ecosystem is Mangata Finance, a DEX that will, later on, connect not just Polkadot world, but also Ethereum with all the ERC-based tokens. Mangata will have no network fees so there will be no user’s competition. And no-overtaking as well, that on Ethereum leads into absurd increases of gas fees. And because only DEX will run on Mangata Finance and no other kind of smart contracts, there won’t be possible to get attacked via flash-loans as well.

Mangata will be connected to the Polkadot network as a Parachain, so it will take advantage of its interoperability.

Slippage

Large orders can heavily affect the price of the asset being bought. Imagine you want to buy 100 ETH for 100,000 DAI — while the order executes, the price of ETH goes higher and higher and you can actually end up with only 80 ETH (or less) for your 100,000 DAI. This is simply how the algorithm works and it can easily cause a slippage even with small orders if the liquidity is low.

Source: https://polkadotters.medium.com/hydradx-the-uniswap-killer-450da81dca5c

Uniswap is having dual pools (pools with 2 cryptocurrencies), so the slippage could be a big problem when the liquidity of those pairs is low. Kind of a solution is to have multiple pools, for example, Balancer uses up to 8 cryptocurrencies in the pool.

HydraDX will solve the slippage problem in an innovative way that goes even further beyond the solution of Balancer. There will be just one single pool called the Omnipol, but this pool will serve all the assets in the exchange! Omnipol will have two sides. The first half will be filled by liquidity providers and various assets including DOT, KSM, DAI and others. The second half represents their base asset HDX and the 1:1 ratio will be kept algorithmically. More assets will be added during the time, the more HDX tokens will be minted and burned in the other way when the asset will be removed from the Omnipol.

Omnipol solves the slippage problem, because it will have enormous liquidity even for the huge orders.

HydraDX has one more tool to prevent slippage and that is order matching by the oracle. Because of that feature, asks and bids can be matched within the same block.

A new trend in crypto

According to Glassnode's on-chain analysis, the new trend is obviously moving crypto from centralized exchanges such as Binance or Huobi to DeFi protocols, where the crypto-assets can be used for lending or providing liquidity. Thus, they make a passive income or an additional profit to their cryptocurrencies.

Source https://insights.glassnode.com/content/images/size/w1600/2021/03/03_exchbal.png

This trend of wrapping Bitcoin into smart contracts and using it in DeFi is obvious also from this chart from DeFi Llama, which indicates the increasing number of wrapped BTC into WBTC. In the last 50 days or so, the number of WBTC almost doubled!

Source: https://defillama.com/protocol/wbtc

Conclusion

Centralized crypto exchanges aren’t unhackable. Handling decentralized protocols can’t be done without the possibility of human error leading to loss of funds or a bug in the smart contract. But still, the crypto exchange business evolved a lot since the Wild West of the last decade.

Even when some funds might be stolen from a crypto exchange, the majority of them are well prepared for those kinds of unpredictable events and have some extra funds to cover the losses. CZ would tell you that “Funds are SAFU”.

The application and features of both DEXes and CEXes make this field more attractive than it was before. And surely it is even more for those, who recently realized, that their dollar or euro isn’t preserved enough in the bank for 1% sitting on the savings account, while the inflation rate could reach 3%-10% with all those stimulus checks and liquidity injections.

Improvements in user experience and interface both in centralized platforms and decentralized exchanges make me think that this is a good way for mass adoption in the near future. And I am glad to say that I see the exchange business finally matured.

Used photos: Pixabay.com

References:

- https://hacken.io/education/decentralized-and-centralized-exchanges-advantages-vs-disadvantages-aa9a27da4584/
- https://www.soft-fx.com/blog/types-of-cryptocurrency-exchanges/
- https://polkadotters.medium.com/hydradx-the-uniswap-killer-450da81dca5c
- https://insights.glassnode.com/content/images/size/w1600/2021/03/03_exchbal.png
- https://defillama.com/protocol/wbtc