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Decentralized exchanges (DEX) continue to haunt centralized exchanges (CEX) this year by absorbing a major part of their liquidity.
In August, leading DEX Uniswap managed to overthrow Coinbase Pro in daily trading volume by a significant margin. Currently, data from Coingecko shows that Uniswap hosts $389 in daily trading volume while Coinbase Pro only has $303 million.
As a result of the rise of decentralized finance (DeFi), more traders and investors migrated to DEXs.
Since most projects within the $10 billion DeFi sector cannot be found on CEXs, most of the liquidity left and transferred to places like Uniswap.
Obviously, this creates a huge problem for the ‘old guard.’ With lower liquidity rates, there is also a lower trading activity.
Therefore, less people will be interested in trading on the platform.
Additionally, it will prevent CEXs from further developing their exchange, supporting new tokens, and introducing many other new features.
Did CEXs introduce any new cool feature to bring back liquidity?
Most experienced traders already know all the pros and cons of both types of exchanges. However, they also know that the pros of CEXs do not make up for the lack of liquidity.
As we mentioned before, decentralized exchanges took a significant portion of liquidity from CEXs. In the end, traders of all sizes rely deeply on an exchange’s liquidity to trade. The question is, how do CEXs plan to improve the situation?
Centralized exchanges plan to combat this issue by introducing negative fees. To understand this better, we have to take a look at how maker and taker trading fees work.
For every trade, the exchange will charge both makers and takers a certain percentage in fees.
Makers, known as market makers, represent a user who places a trade on an order book. They are called market makers because they provide liquidity to the exchange’s order book and the overall market.
Takers, known as market takers, represent a user that fills a trade already existing in the order book. The result? They take liquidity off the market.
Essentially, makers and takers represent different sides of the same coin. While one provides liquidity to an exchange, the other takes away from it.
It now becomes clear that to improve liquidity, exchanges must motivate makers to bring more liquidity. How do they do that? They offer lower fees or better yet, negative fees.
Solving the liquidity problem with negative fees
To combat the flow of liquidity towards decentralized exchanges, CEXs introduced negative fees. With negative fees, CEXs will pay liquidity providers to participate in their platform.
Traditionally, both makers and takers had to pay fees to create or fill orders. Today, exchanges will incentivize makers by providing them with so-called negative fees.
As an example of how this works in the real world, we will use Coinuma. Coinuma is a new CEX based in Europe which primarily aims to create a strong community of crypto traders for Spanish-speaking countries.
Arriving at the time when the DeFi sector stood in the spotlight of trading, the exchange quickly realized that it would need to incentivize users to provide liquidity on their platform. To do this, they introduced inverse fees.
To attract liquidity, Coinuma charges takers with 0.3% fees for each order while rewarding makers with 0.1% in fees. To better explain the financial incentive, we can calculate how much makers would receive and how much takers would pay in a BTC/USDT contract.
Let’s say that a Maker creates a 10 BTC limit order and a Taker creates a 10 BTC market order. If the execution price of these orders is at 10000 USDT per BTC, we can deduce the following fees:
Taker fee: 10 x 10000 x 0.3% = 300 USDT
Maker fee: 10 x 10000 * -0.1% = -100 USDT
Once the order is executed, the taker will pay 300 USDT and the Maker will receive 100 USDT. Therefore, makers can receive $100 every day for simply providing liquidity to the exchange.
This can be compared to the way DEXs reward liquidity providers (LPs) by supplying them with liquidity. If CEXs offer the same concept for existing customers, they can bring back the liquidity DEXs took during 2020’s DeFi boom.
What DEXs lack
While DEXs are sought for their strong fundamentals, anonymity, safety, and decentralization, most investors went to DEXs for only one reason.
They listed more new speculative DeFi projects.
The reality is that, apart from the ongoing DeFi hype, DEXs are not viable long-term. Why? They lack most of the trading tools and capabilities that centralized exchanges offer.
Here are some of the most important features that cannot be found on DEXs:
Limited trading tools
On DEXs, trading is conducted through the process of token swapping. This makes trading very limited as users have no access to advanced trading tools. There are no options for margin trading or stop loss.
Advanced traders cannot even utilize trading algorithm bots.
Another limiting factor is the lack of a centralized order book that provides faster trading.
Token swapping can sometimes only take minutes, but when the Ethereum network faces high activity, it takes hours for a single transaction to go through.
This makes real trading practically ineffective.
In fact, experts see DEXs only as a way for speculators to invest in new projects, without any ability to actually trade.
Moreover, if DEX traders are lucky enough to encounter a fast transaction, they will still deal with high fees. In the last couple of months, traders on platforms such as Uniswap had to pay up to $40 for a single transaction.
Therefore, high fees make it impossible for anyone to actively trade without spending a fortune in fees. An environment like this is more suited for whales and other individuals with sizeable portfolios.
Risk of losing access to funds
DEXs are for the most part praised for their decentralized design. With a decentralized platform, users have full control over their funds. Assets are stored not on the exchange itself but in the wallets of users.
Sounds great, right? While having full control over your money might sound good, there still remains a few risks.
Most users are unaware that it is relatively easy to lose access to all of their funds. And in the chance that they do, there is literally no way to recover them.
Users who lost their login data or sent assets to the wrong addresses will lose their assets forever if they trade on DEXs. Since the platform has no control over your wallet, there is no way for them to return your assets.
On CEXs, all you have to do to recover your money is to contact technical support. On most exchanges, it will only take a few minutes to file a request and solve your problem.
If you make a mistake and send a few thousand dollars to the wrong address of an asset’s wallet, the exchange will always seek to help you.
Furthermore, it is easy to retrieve access to your account even if you lost all of your login data. By confirming your identity and showing the exchange that you are the real owner of a wallet, you will be able to retrieve it.
On the other hand, this is impossible to do on a DEX. If you forgot your login information or seed phrases, you are most likely doomed.
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My name is Per Englund and I’m a long-term fan and investor and trader of Bitcoin and other cryptocurrencies. I caught the attention of Bitcoin like many other several years ago, but it was first around 2016/2017 that I truly got into cryptocurrencies and blockchain technology.
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