Non-custodial exchange volumes are trending higher, but challenges remain for the ecosystem's long-term growth

More than 99% of cryptocurrency trading happens through centralized exchanges (CEXs) today. But this trend is shifting to decentralized or non-custodial exchanges at a faster pace, according to The Block's research findings.

CEXs are, in a sense, simpler to use. They offer easy fiat-to-crypto on-ramps, users don't have to set up wallets or worry about storing their private keys. CEXs also offer better liquidity than their decentralized counterparts.

But users have to trust centralized platforms to keep their funds safe, especially in the case of a hack or security event. More than $1.44 billion worth of crypto has been stolen in exchange hacks to date. There have also been exit scams and other fraudulent events worth millions of dollars across the crypto industry. These developments have occurred because users do not self-custody their funds when transacting with CEXs.

In the case of non-custodial or decentralized exchanges (DEXs), users are in control of their own funds. This is one of the most significant features of these platforms. They also offer privacy protection, since DEXs do not require any personal data when used. Yet, less than 1% of crypto trading happens through these exchanges compared to CEXs.

Nevertheless, DEX volumes are growing at a faster rate than CEX volumes. In January 2019, DEX volumes were only 0.12% of CEX volumes — now that figure has grown to 0.66%. This represents growth of 450% in over a year, according to The Block's research.

Growth factors at play

There are several factors at play that have led to this growth, according to DEX protocol operators.

"Decentralized trading protocols are getting better both in terms of UX [user experience] and liquidity...Also, more interesting, higher quality projects on Ethereum are being developed, which leads to more usage and demand for tokens," Hayden Adams, the founder of Uniswap, told The Block.

Antonio Juliano, founder of dYdX, shared similar thoughts. "DeFi [decentralized finance] UX and liquidity have been rapidly improving," he said, adding that in the past six months, dYdX liquidity has improved by more than 500%.

Other factors include the growth of the DeFi or Open Finance space itself, including demand for stablecoins, borrowing/lending and derivatives products, according to Linda Xie, co-founder and managing director of crypto investment firm Scalar Capital and an advisor to the 0x decentralized exchange protocol.

"This demand will only increase as there are more features/options added such as perpetual contracts and tokenized versions of bitcoin," she said.

Sunny Jain, KyberSwap's head of product, told The Block that many traders are exchanging ether (ETH) and altcoins for stablecoins like DAI — another factor for recent DEX volumes growth.

The challenges

While DEX protocols have improved recently, there is still a long way to go for them to even come close to CEXs in terms of user activity.

Last month, for instance, about $88.5 billion worth of trading volume took place on The Block's legitimate volume centralized exchanges. Meanwhile, on decentralized exchanges, that figure was only about $528 million, i.e. less than 1%.

To improve volumes further, there are many challenges that DEXs need to tackle.

First is liquidity. Though it is getting better, it's still a challenge, dYdX's Juliano told The Block. Adams, however, said that Uniswap's exchange protocol removes the need for professional market making by replacing it with passive, automated, pooled liquidity provision, and therefore, "anyone can use it to guarantee there will be liquidity for any token, accessible trustlessly on-chain. This makes it a very useful 'money lego' for other projects to build on."

KyberSwap's Jain, however, argued that automated market-makers "do not provide sufficient" liquidity and that more professional market-makers are needed to operate on-chain.

Another DEX challenge is scalability. It is "not a huge problem" right now because there isn't much demand at this time, but it will become "a much bigger issue in the next year or two" as some of the first DEXs start to scale users, said Juliano.

Ethereum gas prices or transaction costs also pose a problem. It can be "pretty bad for users,” said Adams. Scalar Capital's Xie concurred. "Sometimes for a small trade, the gas cost can be prohibitively expensive," she said.

Indeed, since the beginning of the year, average gas prices have seen significant growth, rising from around 10 Gwei (one ETH equals one billion Gwei) in January to 36.5 Gwei currently, according to market data provided by Etherscan. In March, especially, due to the violent market swings and unusually high transaction demands, the gas prices surged to over 100 Gwei at one point before settling down around the current level, as The Block reported.

DEXs also need to get "100 times faster" than their current speed to compete with CEXs, Sergej Kunz, co-founder and CEO of DEX aggregator 1inch.exchange, told The Block. More generally accepted security audit principles also need to be put in place to prevent the next DAO hack, he added.

However, the real challenge for DEX operators is to convert CEX users, FTX CEO Sam Bankman-Fried told The Block. He said that today, many large ETH holders are generating most of the activity in DeFi products, which are "pretty easy pickings."

Looking ahead

Many of the challenges mentioned are solvable, say the DEX operators.

Once taken care of, the market could see a shift toward greater DEX dominance sometime next year, according to 1inch's Kunz.

KyberSwap's Jain said the potential market is "definitely big enough" for both DEX and CEX to co-exist, but DEXs will indeed "capture a much larger market share compared to what it is like today."

Scalar Capital's Xie said she believes that CEXs will continue to dominate DEXs for most popular cryptocurrencies like bitcoin and ether due to their liquidity and ease of use. For other assets, such as digital collectibles and in-game items, DEXs will gain "significant" traction.

Indeed, Uniswap's Adams said the DEX protocol already outperforms most CEXs on "many" ETH/ERC20 pairs, adding that when more fiat is tokenized and there is more interest in trading between on-chain assets, that's when "DEXs would crush CEXs."

Crypto venture firms also remain bullish on the overall DeFi space. Polychain Capital's founder and CEO Olaf Carlson-Wee told The Block that in the long term, "every type of asset will 'live' on a blockchain, and all payments and financial services will be automated with trust-minimized software using blockchains."

"This automation includes cryptocurrency trading platforms — in fact it is likely one of the first categories to be automated and replaced by smart contracts," said Carlson-Wee.

Andreessen Horowitz (a16z) also looks to invest more in the DeFi space with its recently launched second crypto fund worth $515 million. Notably, Coinbase also believes that the DEX revolution is coming, although it is still a few years away. FTX's Bankman-Fried said it will take about four years, while dYdX's Juliano said it'll probably take at least three to five years.

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