Decentralised Exchanges (DEX) are playing a significant role in the financial services industry, presenting a fundamental shift in the way we conduct transactions and manage assets.

The recent collapse of cryptocurrency exchange FTX, resulting in the loss of at least $1 billion of customers’ funds, has brought the benefits of decentralised exchanges into the spotlight.

When putting crypto into a DEX, users maintain custody of their assets, making trades directly from their own wallet, as the exchanges use smart contracts based on blockchain technology.

The ability to have more control over their cryptocurrency is drawing more people to DEX platforms: Crypto exchange Kriptomat report revealed that DEXs handled $122 billion in transactions during the record-breaking April 2021 bull market, compared to just $1 billion in April 2020. 

However, the price of this more secure environment is ‘gas fees’, which must be paid to third parties, so-called miners, as compensation for validating transactions. Gas fees are paid by both traders and liquidity providers, with the latter facing these each time they want to add or remove liquidity from the exchange or to change their current position.

As the world becomes increasingly digitised, the role of DEX in financial services is set to revolutionise traditional trading and investment practices. In this editorial, we explore the impact of DEX on financial services and its potential to tokenise all types of assets, the rise of central bank-backed digital currencies, increased competition, and the need for enhanced technology to support this transformative shift.

Centralised vs. decentralised

Centralised exchanges have been the go-to platform for trading cryptocurrencies, offering ease of use and familiar limit order book structure, in which a trader submits a market order that is exercised against an outstanding limit order in the book.

However, they have inherent risks, mainly centred around custody and security. In a centralised exchange, users must trust the platform with their funds, leaving them vulnerable to potential hacks or mismanagement.

On the other hand, decentralised exchanges operate directly on the blockchain, granting users full control over their assets in their digital wallets. The settlement is also immediate, eliminating the need to wait for days for trades to clear, as is often the case with centralised exchanges. Decentralised exchanges are structured as liquidity pools, in which liquidity providers deposit a pair of cryptoassets into a pool. Traders then exchange, or swap, one cryptoasset for another in the pool. Price is determined by the current ratio of asset reserves in the pool.

Tokenisation of all financial assets

The future of DEX holds the potential to revolutionise the financial landscape by tokenising a wide range of assets, from stocks and bonds to real estate. This transformation will enable seamless and efficient trading of traditional assets, with potentially lower transaction costs for retail traders. Tokenisation would create an opportunity to bring traditional financial assets into the decentralised system, further bridging the gap between traditional and digital finance.

However, for this to happen, we first need to ensure the existence of stable means of payment on the blockchain. Currently, assets that are most often used for payments on the blockchain are stablecoins, for example, USDC. Stablecoins are supposed to be backed one-to-one with dollar reserves, but they are issued privately, i.e. not backed by any government. In contrast, a Digital Pound, backed by the central bank, could serve as the foundation of the UK's future decentralised finance system.

Increased competition and entry of big banks

The rise of DEX is expected to foster increased competition in the financial services industry. As DEX platforms prove their effectiveness and security, it is likely that big banks and traditional exchanges will enter this space to capture a broader customer base and diversify their offerings.

This competition can lead to more innovative financial products and services, ultimately benefiting consumers and investors alike.

Optimising the DEX experience

DEXs were first launched on Ethereum mainnet – the primary public Ethereum production blockchain – starting with Uniswap v2 in May 2020, which was upgraded to Uniswap v3 in May 2021. Recently, though, Uniswap v3 has also launched on the blockchain scaling solutions such as Polygon PoS, Optimism and Arbitrum raising the potential of a battle for supremacy between Ethereum mainnet and other blockchain scaling solutions.

Ethereum-based DEX platforms have gained popularity, but high gas fees and scalability challenges have hindered their usability.

In our recent research, we show that Polygon, a blockchain scaling solution, offers a promising alternative for smaller traders due to lower gas fees and quicker updates to liquidity positions. However, Polygon has fewer validators which raises concerns about security.

Striking the right balance between transaction speed and security is crucial for the sustainable growth of DEX platforms.

Enhanced technology for scalability

As DEX expands to accommodate a broader array of financial assets, it is vital that there are technological advancements to handle the increasing number of transactions.

Scalability, custody, and settlement are crucial components that must be addressed to ensure the sustainable growth of DEX. Larger technology infrastructure and innovative solutions are essential to support the influx of users and assets, thereby fostering a more robust and secure decentralised financial ecosystem.

Addressing trust issues

One of the key obstacles facing DEX, and more broadly DeFi adoption, is the lack of trust surrounding the backing of reserves. While major cryptocurrencies like Bitcoin and Ethereum are not backed by reserves, stablecoins like USDC provide transparency by disclosing their reserves. Still, stablecoins are issued privately.

Central Bank Digital Currencies (CBDCs) can potentially offer a solution to this issue by instilling greater trust through the backing of national reserves. As CBDCs gain traction, trust in decentralised finance systems can increase, leading to wider acceptance and adoption.

The road ahead

The future of DEX presents an exciting and transformative prospect for the financial services industry. The potential to tokenise all types of financial assets, coupled with the rise of central bank-backed digital currencies, is reshaping the way we trade and invest.

Furthermore, increased competition and the movement of traditional financial players into the DEX space will continue to drive innovation and better customer offerings.

Nevertheless, challenges such as scalability, trust, and security must be addressed with advanced technology to realise the full potential of DEX in revolutionising financial services. As we embrace this shift, we should strive for a balanced approach that combines the best of decentralised and centralised finance, ultimately creating a more inclusive and efficient financial system for all.