What decentralized exchanges can — and can't — do about market manipulation

While high-profile hacks get all the headlines, decentralized exchanges are facing a longer-term challenge: market manipulation.

With the promise of transparent on-chain trading, DEXs are, to advocates, an alternative to opaque and at times corrupt traditional markets.

At the same time, the novelty of decentralized exchanges has opened up new means of market manipulation. Researchers at the University of Luxembourg identified a total of 199,725 attacks and 1,580 attacker accounts using frontrunning across five years of the Ethereum blockchain, most of which were novel forms of manipulation enabled by the way DEXs interact with the blockchain.

And as The Block Research has noted, DEXs like Uniswap and SushiSwap have featured many trading pairs whose volume has been dominated by individual traders — a strong indicator of a manipulation technique called wash trading, which is especially prevalent among smaller tokens.

Extensive legal terminologies define negative behavior in traditional markets — spoofing, frontrunning, and wash trading are major examples. But these terminologies are still in legal flux when it comes to DeFi.

However, DEXs face serious questions from regulators who are skeptical about whether they live up to the promise of reducing malicious behavior. And those legal definitions behind manipulation are constantly in development, meaning that future court decisions can very well incorporate novel types of market manipulation.

DEXs — or, more accurately, the developers who write the code behind them — are, at the same time, building up their own responses.

DEX ecosystem at a glance

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The Ethereum-based Uniswap, which launched in 2020, is by far the largest decentralized exchange in the world, followed by the Binance Smart Chain-based PancakeSwap and DODO, a multi-chain platform. There is also an ecosystem of DEX aggregators, of which 1inch is the largest.

At the moment, none of these entities bars wallet addresses suspected of market manipulation. Most also lack kill switches for markets — especially the most popular DEXs, which use automated market makers.

Take the example of Uniswap Labs, a company that develops the code behind the protocol and front-end exchange application. That code is, then, available freely to anyone. Uniswap Labs argues that this separation means they are not responsible for trading on Uniswap in the same way as, say, Coinbase is for trading on its platform.

Nonetheless, Uniswap Labs is locked in conversation with regulators — namely,  the Securities and Exchange Commission (SEC) as well as the Commodity Futures Trading Commission (CFTC) — over what that distinction between their company and the protocol means exactly. Anne Termine, a former enforcement attorney with the CFTC, told The Block of DEXs, “From the CFTC and SEC’s perspective it’s still their duty to maintain adequate controls to detect, prevent and stop any market manipulation.” 

Uniswap Labs wrote in a statement to The Block, "This is an issue that Uniswap Labs spends a lot of time thinking about and researching. Uniswap Labs is the primary contributor to the most popular and innovative automated market maker (AMM) and decentralized exchange protocol, and the challenges here are very different from those facing a central limit order book on a centralized exchange – but so are the potential solutions when you think about AMM technology and the transparency presented by blockchain"

Uniswap Labs is not unique in distinguishing its business from the protocol it developed, but it is fairly unique among DEXs in allocating resources to making this case to the public and government. PancakeSwap, for comparison, features a development team that is entirely anonymous and could not be reached for comment for this article. 1inch, a DEX aggregator, has geoblocked US users from its platform since September as a means of avoiding the need comply with US regulations.

Resistances and vulnerabilities to manipulation

DEXs, at their core, aim to solve the vulnerabilities identified in traditional markets.

For example, frontrunning in commodities markets is a function of inside information on a pending trade — often, information that a broker knows in advance. Importantly, buying up commodities in advance of a large trade is not illegal as long as knowledge of that trade is public.

On a DEX, trades reach the blockchain and are publicly visible at more or less the same time. One of Uniswap’s core innovations is the automated market maker, a technology that was theorized prior to the advent of cryptocurrencies. Traditional market makers are a key vector for problematic trading or even manipulation in mainstream markets. The prospect of frontrunning on insider information is, at the very least, out of the hands of the DEX.

At the same time, researchers at the University College London said in non-peer-reviewed research that they were able to use a method they called “sandwich trades” to generate several thousand dollars daily in 2020, when Uniswap was seeing daily volume of $5 million. For comparison, that number is more like $1.5 billion today.

Features such as gas fees — which can result in certain transactions receiving preferential treatment by Ethereum miners — could be construed as a mechanism for other forms of manipulation. Miners aim for maximum extractable value, which the Ethereum Foundation defines as the “maximum value that can be extracted from block production in excess of the standard block reward and gas fees by including, excluding, and changing the order of transactions in a block.”

While miners are themselves not necessarily trading on this information, changing the transaction order would raise questions about best execution in a traditional market. Similarly, while DEXs don’t feature internal brokers who collect non-public information that they could use to frontrun big trades, crypto miners do gain some visibility into proposed transactions before they are validated, potentially constituting a  vector for frontrunning.

Something like spoofing — making trades that the trader never intends to follow through with — is already very difficult to prosecute in traditional markets, as it’s hard to demonstrate the intention of canceling a trade. Identifying those sorts of intentions behind wallet addresses interacting with a protocol like Uniswap becomes inconceivably complex.

Current and prospective solutions from DEXs

On some level, these are a function of trade-offs, especially in the core value of decentralization.

As mentioned before, most DEXs do not directly prohibit wallets suspected of manipulating markets from interacting with them. But some may be willing to sacrifice decentralization for more control over potential manipulation.

For example, HashFlow is a “DEX” that returns to traditional market makers rather than AMMs like those that Uniswap revolutionized. The exchange advertises this as “Hashflow market makers have full control over their pricing strategies, so they can quote tighter while being capital efficient.”

Other solutions are under development to facilitate more fully decentralized platforms. Solidus provides one such solution. Solidus is a blockchain analytics firm that, unlike more forensic-oriented companies like Chainalysis, specializes in identifying market manipulation, recently expanding from centralized exchanges to DEXs.

“If it’s a fully permissionless decentralized protocol, you can’t block anyone from using it, you can’t use a killswitch,” Solidus COO Chen Arad told The Block. If you’re willing to sacrifice decentralizing, he says, “you could potentially have a degree of permission. Or you could start preventing usage based on red-flagged wallets.”

Arad pointed out that there are more decentralized options within DeFi than full blocks on accounts, however. One is simply highlighting risky trading practices as they emerge using social media, broadcasting such issues to the community. Others include modifying code in such a way that it blocks trading practices that emerge as problematic.

Critically, there is no doubt that regulators are examining both potentially manipulative practices on DEXs and the ways in which those DEXs are responding.

But there is also some curiosity as to how these practices develop. A major area of interest is the ways that DeFi operators interact with regulators, particularly in the US, to establish definitions for manipulation that will form baseline expectations moving forward.