DEX platforms are the heart and soul of the DeFi sector as they enable users to exchange digital assets. The main reason for their existence is to create a space where people can interact in a trustless environment without the need to ask intermediaries to settle disputes and conduct transactions fairly. This specific feature of the DeFi sector is the goal of cryptocurrencies that were conceived as an alternative to fiat money that is inherently centralized and can be easily manipulated by financial institutions.
The DeFI sector has over 1,400 different exchanges operating across over 30 chains. The number of independent blockchains that also have different financial services is much higher but we are talking about protocols tracked by various on-chain analytics platforms like DeFiLlama or De.Fi. The total value locked across these numerous platforms is over $16.4 billion as of September 2024.
Centralization is the reason why Bitcoin was born in 2008. The flames of the massive financial crisis were still scarring investors and regular folks all over the world when an anonymous developer under the nickname Satoshi Nakamoto published his magnum opus. Bitcoin’s whitepaper strongly implies that the creation of a decentralized monetary system is the only way of preventing financial institutions from causing another financial crisis or leading everyone to a situation where currencies completely lose value.
Blockchain technology allows users to operate in a trustless environment where the counterparty risk is completely nullified by the nature of the digital ledger that uses a consensus mechanism to validate transactions that are forever recorded and can be easily verified. It is an elegant solution that still has some rough edges but has been working as intended so far with a few hiccups along the way.
When the Bitcoin network was relatively small and the number of users did not create congestion, throughput was not an issue. However, it turned into one when the number of simultaneous transactions grew. The introduction of other networks that hoped to solve the scalability issue created a new ecosystem that needed more than just P2P marketplaces where users could exchange digital assets.
Centralized exchanges started popping up here and there offering services similar to those offered by brokers. However, many crypto enthusiasts who did not like the idea of centralization were dissatisfied. Decentralized exchanges have been around for a long time. However, their popularity exploded after the infamous FTX collapse, which exposed centralization issues.
A decentralized exchange is a protocol that allows users to trade assets directly from their wallets without contacting counterparties by interacting with smart contracts. The latter are tiny self-executing programs that are triggered when certain conditions are met. A trader does not have to search for someone to trade with like in the case of peer-to-peer trading or temporarily give up ownership of funds. Instead, they commit to a trade and it is processed automatically.
Exchanges can operate in a variety of ways, but there are three distinct categories that represent the overwhelming majority of protocols:
When someone wants to make a trade, there must be a sufficient quantity of the target asset in the pair to ensure a fast exchange. This is what is called liquidity — the capacity of an asset to be swapped for another asset. Since all smart contracts rely on sufficient liquidity to operate, decentralized exchanges are always competing for investor funds. In some cases, DEXes offer exorbitant interest rates or incentivize contributions to liquidity pools by giving sizeable rewards in native, governance, or layer-2 tokens.
Low liquidity leads to slippages when there are simply not enough assets in a pool and a trade is processed at unfavorable rates leading to financial losses. Since larger orders have a higher risk of slippage insufficient liquidity deters investors from using DEXes.
Some key differences between these two types of exchanges can be summarized thusly:
| Centralized Exchanges (CEX) | Decentralized Exchanges (DEXes) |
| Operated by a corporation | Operated by DAOs or corporations |
| Offer custodial services | Operate as non-custodial platforms |
| Use privately owned reserves for liquidity | Use liquidity pools |
| Have a single point of failure | Do not have single points of failure |
| May not disclose operational data | Operate transparently and can be independently audited |
One of the biggest issues with DEXes is the novelty of some risks on top of market volatility, liquidity shortages, and other known dangers. For example, smart contracts can have critical vulnerabilities that are easily exploited by crafty bad actors. Investors face risks like impermanent loss, unexpected gas fees, and other issues when trying to earn income by putting assets into pools.
However, these shortcomings have solutions that are being developed and implemented as you are reading this article. What really makes DEXes different from centralized exchanges is that users are in control of their assets at all times and take full responsibility for the safety of their holdings.
Difficult onboarding is the biggest issue for many DeFi protocols that try to attract users. Newcomers to the industry simply lack the necessary level of technical know-how or feel lost when encountering an interface that they have never seen before. Unfortunately, many DEXes do a poor job of teaching potential clients about their features and available instruments making it hard for new investors to join the DeFi sector.
However, interfaces have improved throughout the years and it just takes a couple of minutes to familiarize yourself with menus and controls. Getting started is even easier than in the case of centralized exchanges since many DeFi protocols require users to simply connect a wallet. For instance, all Ethereum-based protocols support MetaMask. Connect a wallet and you are good to go.
Many crypto enthusiasts believe that using DEXes is better in many ways. Investors who have stakes in liquidity pools have obvious reasons to keep this particular narrative alive and well. Many liquidity providers enjoy incredible benefits by simply holding tokens in pools. For instance, the sDAI-USDM pool on Curve DEX has a hefty 9.04% APY and 1.45% in CRV/CVX rewards with 30-day averages regularly outperforming expectations. Compare these yields to what an investor can earn by putting money into US treasury bonds (4.11% in 2024) and the reason why they like DEXes becomes quite clear.
Advantages enjoyed by liquidity providers are just one side of the coin. On the other side, traders also have their reasons for preferring DEXes over centralized platforms:
Some of the best DEX platforms in the sector offer versatile financial instruments to traders and investors. It is hard to ignore the benefits of yield farming opportunities for people who have capital that can be parked in liquidity pools. On the other hand, traders can work in a trustless environment and take care of their finances personally instead of giving up control over their assets and hoping that the intermediary is reliable and responsible. It was the biggest mistake of many investors who decided that trusting FTX was a good idea.
Choosing the right protocol for yield farming is very important. It is relatively easy to find a good protocol if you plan to trade assets. Looking at trading volumes, liquidity pool sizes, and fees is enough. However, reward structures can vary greatly making it hard for investors to identify good opportunities to part their capital.
We want to talk about some of the best protocols in the DeFi sector based on a variety of factors. Note that we do not endorse any of the projects that we are going to discuss below.
Finding the right destination for capital allocation is critical for an investor interested in the DeFi sector. Among the best platforms to choose from for both trading and investing are large protocols that have established themselves firmly and have a good track record:
Safety is hugely important for the long-term success of your investment operations. Identifying reliable projects is not that easy. We strongly recommend working with protocols that undergo external code audits and run expensive bug bounty programs. High TVL is also a good indicator of trustworthiness.
Here are some good choices:
Some of the best protocols to work with if you plan to trade actively are the ones that have low commissions usually achieved through using rollups and reducing gas fees. These often offer high APYs too. Note that the cost of transactions depends on a variety of factors including network usage and the type of blockchain they operate on. For instance, Ethereum transactions are more expensive than those on Base. Layer-2 solutions are usually cheaper than layer-1.
Centralization has its perks and can be useful to many retail traders who make lots of small-scale trades involving different types of assets. However, speculative trading is a small part of the overall investment operations in tradfi. Many institutional investors and individual capital holders will be interested in self-custody and trading large quantities of assets at a fraction of the cost they usually pay in CeFi.
The DeFi sector has a somewhat uncertain future with user activity going up and down while TVL numbers fluctuate dramatically. However, there is no denying that it is an ecosystem that must exist for the crypto market to continue growing. DEXes will continue playing a huge role in the development of the blockchain industry!
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