How Capital Efficiency Determines a Top-Tier DEX

By Stan Peterson
Published November 2, 2021 Updated November 2, 2021
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How Capital Efficiency Determines a Top-Tier DEX

By Stan Peterson
Published November 2, 2021 Updated November 2, 2021

When looking for a platform on which to lay down roots and invest, there can be an overwhelming amount of information to digest.  It seems that each week there is a new set of acronyms, terms, and potential schemes that sound amazing—and maybe aren’t.

What is a potential investor to do?  While there is no way to give absolute guidelines, at least without reviewing every single platform’s founding team, value proposition, pros/cons, and risks, there are some general guidelines that will at least separate out platforms with higher embedded risk.  

When trading on a DEX (decentralized exchange), the key difference from a centralized exchange is that the transactions occur peer-to-peer.  In a sense, this is an incredible achievement as one of the visions for crypto was a market independent from banks or other go-between institutes.  When done well, the market can run very smoothly, but the processes used in this type of market can also create risks to those who don’t know what to watch out for.  Trading on some DEX’s might help you to become very familiar with terms like slippage—in the form of an expensive lesson learned.

So what are some of the key things to look for in a DEX?  What guiding principles should potential traders follow?  We address the biggest factor needed for a DEX to serve its customers well, along with some of the more common risks and how to avoid them.  We also show how several of the top DEXs have addressed these risks for their customers and what we can learn from these innovations.

Capital Efficiency

Simply put, the key to a top-tier DEX is capital efficiency.  This is the ability for the market to smoothly match up supply with demand.  Specifically for a DEX, it is the ability to provide the best swap prices and largest/deepest liquidity pools.  This lowers risk of failed transactions, risk of delays, and other risks caused by the combination of volatile price swings and the transaction processing time.

How do DEX’s create capital efficient markets?  Through liquidity.  Players in the market called liquidity providers essentially lend their money, usually by purchasing the DEX tokens and staking them in exchange for a share of transaction fees.  This creates a liquidity pool, and the more pools a DEX has access to, the more efficiently traders can swap tokens on the network—and the more trust created for all parties, since the DEX has the liquidity to process all trades quickly and without running out of capital.  One of the top platforms for liquidity depth is MakerDAO, with nearly $10 Billion locked into their protocol.  Their rise to fame with such a massive TVL caused DAOs as a whole to increase in popularity, taking a more proactive role in governance, even focusing more on financing projects as a VC-like entity.

No DEX is worth much if someone can’t trade easily and safely.  For a DEX to have any chance at becoming top-tier, they must hold a wide variety (in addition to depth) of liquidity pools so that users have a long list of tokens they can swap.  In terms of safety, DEXs are more protected from platform-wide hacks because the funds are in traders’ wallets, but it’s important to research what audits have been completed and approved by a top crypto audit company.  These audits should be conducted on the protocol as a whole, but also on the smart contract structure used by the trading parties.

If these are the key elements, then why is there such a mixed bag in terms of DEX quality?  That’s because in addition to capital efficiency, breadth of pools, and audited code, there are other elements that can make the difference between profit and loss for a DeFi trader.

Photo by Justus Menke on Unsplash

Slippage 

Slippage occurs when a trader executes an order, but due to price changes during the time the order is requested and completed, this can result in the trader earning less money.  This is a factor of both time and volatility:  The longer a transaction takes to be filled, and the more volatility the assets experience, the higher the chance for slippage.  While some DEXs have tools allowing traders to set their “slippage tolerance”, essentially noting the amount of acceptable loss, the better solution is to minimize transaction times to avoid slippage altogether.  A focused example of this is Ardana’s Danaswap toolkit.  Danaswap is in development and is referred to as an Automated Market Maker (AMM), which will use deep liquidity and a wide range of coins—including stablecoins, crypto tokens, and wrapped/synthetic tokens—to match up trade orders quickly.  Ardana operates on the Cardano ecosystem, meaning that transaction speeds are significantly higher than Bitcoin or Ethereum, and the profit-killing gas fees that plague Ethereum are not an issue.  Danaswap’s capabilities will prevent nearly all slippage, and at the same time offer traders different ways to earn interest or rewards for depositing the platform’s Ardana stablecoins.

Photo by Piret Ilver on Unsplash

Fees and Returns

The difference in the money that traders—and liquidity providers—can make varies widely, with a lot of variables adding and removing profits.  In terms of fees, the most talked about case of “fee anxiety” is the increasing Ethereum gas fees, which can swing wildly but have increased significantly over the last few years.  Traders have lost any profits made once they swap out their tokens on Ethereum, leading to the mass development of solutions that avoid these gas fees altogether.  On the other side of the equation, the returns offered by liquidity providers can vary as well, and yield farmers may hop continuously from platform to platform chasing deals and promotions offering attractive returns (hopefully steering clear of high gas fees).  Curve Finance has gained a reputation on both fronts, offering consistently high returns for liquidity providers as they lend out liquidity to other DeFi protocols, and using tightly executed transactions that minimize slippage and reduce fees.  A major example of this is the $USDT to $USDC swap executed on Curve Finance’s platform:  $192 Million was swapped, resulting in fees of under $100—almost unheard of in DeFi (and impossible using central exchanges).

Putting it Together

Becoming a trader or liquidity provider on a DEX doesn’t have to be as complicated or intimidating as it might seem at first.  While there are a lot of platforms to choose, and mistakes can cost real money, searching for key elements including capital efficiency, an audited platform, tools that minimize slippage, and a strong return/fee ratio can set you on the right path to success.

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Disclaimer
The presented content may include the personal opinion of the author and is subject to market condition. Do your market research before investing in cryptocurrencies. The author or the publication does not hold any responsibility for your personal financial loss.
About Author
Stan Peterson
756 Articles
Being an active participant in the Blockchain world, I always look forward to engage with opportunities where I could share my love towards digital transformation.