Sector Report: Decentralized Exchanges (DEXs)

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The Decentralized Exchange (DEX) industry is a rapidly growing sector in the world of cryptocurrencies. Unlike centralized exchanges like Coinbase and Binance, DEXs enables users to buy and sell digital assets directly between themselves in a decentralized environment. The top five DEXs have a combined market capitalization of over $6 billion, making them a favored investment in the cryptocurrency world.

This article examines the burgeoning decentralized exchange sector to determine its sustainability and probable expansion in the upcoming years.

Market Overview

One of the defining characteristics of a DEX is the Automated Market Maker (AMM) model it utilizes, powered by smart contract-based pools for each trading pair. The prices of each pair are based on algorithms centered on supply and demand dynamics in the pool, providing a more efficient trading experience.

Additionally, DEXs are non-custodial, unlike CEXs like CoinBase, meaning they do not hold user funds, making them accessible for new users without the need for KYC verification.
While trading volumes on DEXs remain considerably smaller compared to CEXs, they’ve gained traction during the DeFi boom that started in 2020. DEX trading currently accounts for about 15% of all trading volume.

Investment Thesis

There are two ways for investors to gain exposure to DEXs: either by buying the tokens or by participating in liquidity mining by providing liquidity to pools.

• Buying the token: DEXs is based on native tokens. Purchasing the token is an option for investors looking to benefit from DEXs, as they are impacted by trading volume. These tokens may have other use cases like governance, staking, and payments. It is akin to buying “stock” in the DEX with high trading volumes and potentially better returns in the future.

• Liquidity mining: Alternatively, stakeholders may participate in the ecosystem by providing liquidity to one or more pools. It involves locking both tokens of a pair (e.g., ETH and UNI), with liquidity miners getting a percentage of the DEX trading fees as a reward.

Who Is Funding: Institutional Foundations

The DeFi boom has attracted institutional investors who have shown a growing interest in DEXs, with several projects generating hundreds of millions of dollars in funding. Many DEXs implement the decentralized autonomous organization (DAO) governance model, while some are backed by centralized entities that maintain the protocol.

Uniswap Labs, which secured $165 million in October 2022, is Uniswap’s backbone. Polychain Capital is leading the charge, with investors like A16Z Crypto, Paradigm, SV Angel, and Variant joining in. Uniswap Labs is worth $1.66 billion. 0x raised $70 million in a Series B financing headed by private equity firm Greylock Partners in the same year. Pantera, Sound Ventures, OpenSea, Coinbase, and A. Capital also participated.

Amber Group invested $175 million in 1 inch in a Series B deal towards the end of 2021. Around 50 investors participated, including VanEck, Fenbushi Capital, and Jane Street. According to a Chainalysis analysis, institutional investors boosted transfers from CEXs to DEXs during market instability, like the crash of FTX.

Top DEX Projects

Uniswap, a decentralized exchange (DEX) founded in 2018 that focuses on Ethereum-based tokens, has seen great success in recent years. The exchange boasts an annual trading volume of nearly $400 billion and has attracted over 45,000 daily active users. The exchange also has a total market cap of almost $5 billion, making it the 18th largest cryptocurrency.

Uniswap has over $4 billion in total value locked, making it the sixth-largest DeFi protocol by TVL and the second-largest DEX by TVL after Curve. With its success, Uniswap raised over $160 million at the end of 2022. It is anticipated to grow as the crypto market recovers, with the UNI token possibly among the first to profit from it.

Synthetix Network

Synthetix Network is an Ethereum-based protocol that allows users to gain on-chain exposure to real-world assets like fiat currencies, commodities, stocks, and indices. By using SNX tokens as collateral, users can create synthetic tokens (Synths) that track the value of their primary assets. The protocol has an annual trading volume of over $4.4 billion and generates annual charges of over $13 million. Currently, more than $400 million worth of crypto is locked on Synthetix, making it among the top 30 DeFi protocols by TVL. The platform also hosts over 2,000 daily active users. At its peak in 2021, Synthetix was one of the major DeFi projects by TVL and trading volume. Despite its recent decline, the exchange still offers a unique business model, making it worth considering.

SushiSwap (SUSHI)

SushiSwap (SUSHI) is an Ethereum-based exchange that started in 2020. It was created from the open-source code of Uniswap, making it very similar in functionality. SushiSwap has a native token (SUSHI) that functions as a governance token, allowing users more control. Although it attained much popularity at the start, SushiSwap has since lost substantial ground and is now smaller than Uniswap in terms of trading volume ($6.5 billion annually) and trading fees ($20 million annually). Additionally, the average daily active user count of SushiSwap is less than 4,000. SUSHI has been the worst-performing token among DEXs during the crypto winter, and its future remains uncertain.

Investor Takeaway

Despite the decline in trading volumes in DEXs since the beginning of 2022 due to the “crypto winter” season, the sector is still relatively new and has potential for growth in the future due to its promise of non-custodial trading at low costs. The collapse of FTX has also worked in favor of DEXs, as many investors do not trust centralized exchanges with their assets any longer.

Certain popular DEXs that were popular in the early days of the DeFi boom, such as sushi, may not recover. Some exchanges with billions of TVL that may continue to dominate are still thriving (Uniswap, Balancer, Curve, and PancakeSwap).

It is also important to note that although DEXs are not at risk of hacking attacks, there may still be loopholes in the smart contracts that could present attack points, particularly in the bridges connecting different blockchains.

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