Decentralized Exchanges: The Future or a Flawed Trading Solution?
I. The DeFi Reposition after the Contagion
The collapse of FTX has wreaked havoc across crypto, tanking markets, wiping out businesses and damaging trust in the industry. It is important to recognize the gravity of this situation - one of the worst events to have occurred in the history of cryptocurrency. However, there are still reasons to remain positive as the industry recovers and moves forwards.
DeFi has the reputation of being the playground for investors with high-risk appetites. However, in recent years, we've seen the industry shift to accommodate average everyday investors. One silver lining from the FTX implosion and the contagion is that it may encourage the adoption of decentralized finance (DeFi), as the risks associated with conducting transactions through opaque, custodial entities have once again become apparent. A vertical of DeFi that is well-positioned to capture this newfound demand for transparent, decentralized, and non-custodial solutions in the wake of this event are decentralized perpetual exchanges.
Centralized exchanges are the go-to venues to trade perps. However, a growing number of DeFi protocols have emerged as viable alternatives and are positioned to attract more users in the aftermath of the Contagion. Despite the fact that on-chain decentralized exchanges (DEXs) currently hold only a small share of futures open-interest, their potential market is significant in the short and long term.
Perpetuals have gained immense popularity due to their design and ease of managing positions, and they have become a critical element of the cryptocurrency market structure. Perpetuals volumes exceed those of spot trading, making them the primary way for traders to open leveraged long or short positions. Furthermore, unlike CEXs, investors may have the opportunity to capture the upside of this trend, as the leading perps DEXs all have tokens, many of which have been outperforming the broader market. They are not just a crypto retail investor favorite but also gaining ground among a more considerable number of professional and institutional traders who are shifting away from traditional calendar futures.
II. But Not Exactly Problem Free
When it comes to trading perpetual contracts, decentralized protocols are the future. They are far superior to traditional centralized exchanges in terms of improved security, lower fees and more control for the individual traders. However, it’s crucial to note that decentralized protocols for perpetual contract trading are not without their challenges, despite their resistance to hacking and fraud due to the absence of a central point of failure.
Crypto investors have shown keen interest in perpetual trading. But apart from that, the major issues like lack of liquidity, too complicated UI/UX and incomplete incentive design plague the DeFi industry.
Despite the most recent explosion of on-chain activity, early DEX adopters still suffer from vulnerable DEX backstops and fragmented liquidity across protocols and chains. These exchanges are decentralized, there is no central order book, and liquidity is distributed across multiple liquidity pools. As a result, traders may find it more difficult to execute trades at their desired price points, particularly during periods of high volatility or low liquidity.
Moreover, because decentralized perpetual exchanges typically lack the depth of liquidity that centralized exchanges offer, they may be more vulnerable to price slippage, where orders are executed at prices different from those requested by the trader. This can result in losses for traders and reduce confidence in the platform. Small-cap altcoins have issues with liquidity, it becomes almost impossible to trade perpetuals without slippage.
This issue further exacerbates the issue of slippage and makes it more difficult for traders to execute trades profitably. This can in turn limit the appeal of decentralized perpetual exchanges to a broader audience of traders, particularly those with larger trading volumes who may require deeper liquidity to execute their orders effectively.
These exchanges typically require users to interact with smart contracts and manage their own private keys, which can be a daunting task for less experienced traders. Crypto UX/UI is slowly getting better but it has a long way to go.
There are several challenges related to UI/UX design in DeFi applications that need to be addressed. One of the main issues is the complexity of these applications. DeFi platforms can be complex, which can make it challenging for users to navigate and understand how the platform works. This complexity can also create a steep learning curve for users, which may discourage them from using the platform.
One example is the complexity of DeFi platforms such as Uniswap, a popular DEX platform. It has a steep learning curve, especially for new users who may be unfamiliar with concepts like liquidity pools, gas fees and slippage. The platform’s interface can be overwhelming and confusing for users who are not familiar with the swapping process, which requires several steps and an understanding of the platform’s mechanics.
Another issue related to UI/UX design in DeFi is the lack of standardization. There is currently no standardization in the design of DeFi applications, which means that users may encounter different interfaces and workflows when using different platforms. This lack of standardization can create confusion and frustration for users. Different platforms may have different interfaces and workflows, making it challenging for users to switch between platforms. While GMX or ApeX has a relatively simple interface, other platforms like Kwenta may have more complex interfaces with additional features that may be overwhelming for some users.
Technical jargon is another challenge related to UI/UX design in DeFi. DeFi applications often use technical jargon that may be unfamiliar to non-technical users. This can make it difficult for users to understand how the platform works and what they need to do to achieve their goals. Some exchanges call “Funding rate”, others call “Borrow Fee” to indicate the interest rate paid, or “Position” vs “Purchasing Power” to indicate the size of the trade, or “Collateral In” vs “Margin” to show the required capital to execute trade. It may be a barrier for users who are not familiar with perpetual trading.
Limited feedback and transparency are another challenge in DeFi UI/UX design. DeFi applications may not provide users with enough feedback on their actions or the state of the platform. This lack of transparency can make it difficult for users to understand what is happening on the platform, which can lead to uncertainty and confusion.
Many DeFi applications are not optimized for mobile devices. This can be a barrier for users who prefer to use their mobile devices to access the platform.
Particularly, most Decentralized Perpetual Exchanges often lack certain user-friendly features that centralized exchanges offer (Market Order, Stop-Loss Order, or Advanced Charting Tools, etc.). It can limit their appeal to a broader audience of traders. Many traders may be deterred by the steep learning curve and the potential risks associated with managing their own private keys and interacting with smart contracts. This could result in a smaller user base and lower liquidity, which could in turn exacerbate the problem of wider bid-ask spreads and higher volatility, as discussed earlier.
Lack of Incentives
When it comes to incentives and privileges for users, DEXs have some distinct differences from CEXs, particularly in the affiliate model. In a traditional affiliate model, CEXs offer financial incentives to users who refer a certain number of new traders to the platform. This can create a powerful network effect, where crypto community leaders and content creators are incentivized to invite their audience or connections to join the platforms, which in turn can lead to greater liquidity, trading volume, and profits for everyone involved.
In contrast, DEXs generally do not have an affiliate program, and instead rely on other incentives to attract and retain users and liquidity providers. For example, many DEXs offer reduced trading fees or other rewards to users who hold a certain amount of the platform’s native token. This can encourage users to hold onto their tokens, which can help stabilize the platform and create a more vibrant ecosystem but cannot encourage the platform growth in liquidity, trading volume and number of users.
Taking two leaders of perpetual exchanges into comparison, Binance vs GMX, we clearly see that Binance has a higher commission rate compared to the competitor. Based on the fact, it is true that Binance offers affiliates a higher base referral bonus of up to 40%, while GMX only offers a maximum of 15% as the highest referral tier, of course with a trading volume requirement.
This means that Binance gives up 40% of its revenue from the Futures product. However, GMX only pays 15% of the maximum is also understandable since they have other parties that need to be compensated, such as token holders and liquidity providers. From this point, we can see that, despite the platform’s profit-sharing offers to the participants, honest speaking, GMX in particular and decentralized perpetual exchanges in general are not able to compete to replace the CEX ones.
Furthermore, the fact that there are some frequent users participating in using the platform, like GMX, making a significant contribution to trading volume and liquidity, almost does not receive any rewards at all, no VIP portal, no privileges.
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