Decentralized Exchanges (DEXs) have become a popular trading avenue for crypto natives since the launch of Uniswap in the summer of 2020. As of writing, there is over $21.4 billion locked in various DEXs, which is still a fraction of the 2021 highs when the DeFi bull market caused DEXs TVL to surge up to $78 billion.
However, despite this remarkable growth, DEXs are still struggling with some pertinent issues that have been a major hindrance in adoption. For context, DEXs only account for around 7% of the daily trading while Centralized Exchanges (CEXs) led by the likes of Binance and Coinbase make up the rest of the market share.
This lag in adoption can be attributed to several factors, most notably, the fragmented nature of DeFi ecosystems. Technically, Layer 1 smart contract networks such as Ethereum, Solana, and Avalanche operate in isolation. The process of moving digital assets between these DeFi environments is not only cumbersome for newbies but also for crypto veterans.
A Fragmented DEX Ecosystem is Bad for Business
DeFi’s main ethos is to decentralize the traditional financial ecosystem by making it more accessible and ultimately bridging the global liquidity gap. Unfortunately, the DEX ecosystem is yet to achieve this level of efficiency.
Most of the exchanges that exist today operate on an average of two chains, save for a few like Uniswap, Sushiswap, and upcoming DEX environments such as ENCORE. So, why is a siloed DEX ecosystem bad for business?
Similar to the challenges of conducting business on a global scale, DEXs, which are limited, present a significant hurdle in chasing yields beyond one DeFi chain. This is particularly evident looking at Ethereum’s Layer 2 networks such as Optimism and Arbitrum; the former enjoys a TVL of $7 billion and the latter $18 billion.
What’s pressing is that these ecosystems continue to operate as rivals given the shortcomings in bridging liquidity. Instead, DeFi users are in most cases forced to prioritize the yields from one chain over the other as it is usually costly or too technical to transfer tokens.
Additionally, the fragmentation of DEXs is detrimental to the market’s efficiency when it comes to pricing and user experience. There have been several instances where DeFi users trading on DEXs experienced mispricings due to low liquidity within a particular DEX. As for the user experience, it is not surprising that DeFi products have consistently been criticized for having a poor UX.
Imagine having to switch between multiple DEXs on different chains; it is not enough that one has to wrap the tokens but also perform other steps such as bridging to make the digital asset tradeable on a different DEX. Some of these processes are definitely technical even for the average crypto Joe and are one of the main reasons why DEXs are yet to challenge CEXs in a fundamental way.
Bridging the Liquidity Gap in DEX Trading
The ingenuity of crypto innovators is one of the factors that has kept the industry thriving for the past decade and a half. Of course, with DEXs now clocking around four years of notable activity, several solutions have come up to solve the fragmentation issue.
On one hand, some DEXs have resulted in pooling more internal liquidity from the community. This is why incentive programs are still a thing in DeFi; for instance, Arbitrum’s DEX Camelot last year launched an incentive program, featuring 3 million ARB tokens that were to be distributed to over 60 liquidity pools.
But more intriguing are DEXs that are going beyond the community setup to tap into the existing liquidity across other DeFi trading platforms. One such DEX is Encore, which is currently working on a multi-chain ecosystem that will provide seamless interoperability across several blockchains without the need for raising internal liquidity. The project is also tapping into AI integrations designed to improve the platform’s user experience.
This list wouldn’t be complete without the mention of interoperability-focused blockchains such as Cosmos and Polkadot, which are both building infrastructures to enhance protocol communication. Recently, the Cosmos ecosystem has witnessed significant traction with more DeFi-oriented chains now using the Inter-Blockchain Communication Protocol (IBC).
The challenge, however, remains in creating technology that will facilitate seamless interactions between Layer 1 chains. As it stands, Bitcoin and Ethereum, which are the two pioneer chains, still cannot communicate directly. This is, of course, a speed bump for traders looking to capitalize on both chains.
Conclusion
DEXs have proven to be a key part of DeFi’s future as a novel financial ecosystem. However, as highlighted through this article, fragmented liquidity, if not solved, will continue to be a challenge in onboarding more users or improving market depth. Luckily, the debut of cross-chain DEXs solves more than half the problem. As the market evolves, DeFi users will likely experience better ecosystems, both in terms of liquidity and UX.
