Decentralised exchanges: Solving the scaling problem

ETH 2.0 is coming, but not soon enough. In the meantime, leading DeFi protocols are scrambling to implement layer 2 to ease the burden of high gas fees

Copper Team

Cryptocurrency, at its core, was designed as the ultimate financial disruption – requiring no centralised authority.

And yet, there is a kind of paradox in the majority of crypto trading volume occuring on exchanges that are centralised.

However, we are now seeing the beginnings of a shift towards decentralised exchanges (DEXs) such as Uniswap, Balancer, and Curve. The growth these DEXs have recorded in the months from June till present have been nothing short of phenomenal.

New data from Dune Analytics reveals the trading volumes of Uniswap, the leading decentralised exchange, exceeded $15.4 billion during the course of September. By comparison, the centralised behemoth, Coinbase reported $13.6 billion in monthly trade volume that month.

Part of Uniswap’s remarkable growth can be ascribed to the lack of security and transparency that centralised exchanges have demonstrated in recent weeks. However, yield farming, otherwise known as liquidity mining, has been the undisputed main driver for DEXs boom.

The yield farming craze was sparked by Compound’s governance token, COMP, back in June and massively boosted the number of transactions conducted on the Ethereum blockchain. This led to the congestion of the Ethereum network and participants paying higher gas fees to execute their transactions. At the height of the phenomenon, gas fees skyrocketed to the point of pricing out anyone transacting with smaller amounts.

The hash rate for the Ethereum network hit its all-time high of more than 250 terahashes per second on 6 October – an 80% increase since January 2020.

With the DeFi ecosystem continuing to grow unabated, so does the urgency for scaling solutions that reduce congestion on the Ethereum network.

The layer two scaling solution that will be brought by Ethereum’s highly-anticipated upgrade, colloquially known as ETH 2.0, is regarded as the long-term solution to bring stability to the network. Layer two scaling solutions are technologies that erase some of the computation that’s on-chain (layer one) and take it off-chain, so that the network can run faster.

But with ETH 2.0 unlikely to come anytime soon, a handful of DeFi protocols are experimenting with layer-two solutions, and many of them have already come to fruition. OMG, Loopring, and ZKsync are just some of the more popular iterations, While these projects work with the same premise, they use the concept in different ways.

The OMG Network is one of the leading contenders for layer two adoption, enabling up to 4,000 Transactions per Second (TPS) while maintaining the security of the Ethereum blockchain through smart-contract technology. OMG recently saw the migration of Tether to allow for cheaper USDT transfers. Bitfinex is also in the process of integrating with OMG’s off-chain scaling solution.

The Loopring protocol, on the other hand, focuses on enhancing the throughput of Ethereum through zkSNARKs, ensuring as much work as possible is securely done off-chain, with verification reserved as an on-chain activity.

Meanwhile, Matter Labs launched zkSync in June 2020 as a scalable, low-cost enabler for trustless payments. This protocol leverages zkRollup technology that implements zero-knowledge proofs and constant on-chain data connection.

The latest development in Ethereum scaling news is last week’s announcement that Coinbase Wallet is integrating with Optimism’s Optimistic Rollup testnet. Coinbase is only the second major centralised exchange after Bitfinex to announce plans to take part of their transactions off the Ethereum main chain.

The future looks bright for DEXs

DEXs may still be a long way from achieving the scalability and liquidity needed for mass adoption, yet new data from CoinGecko illustrates that decentralised exchanges are growing and evolving faster than centralised exchanges.

Thanks to inherent advantages in terms of security and privacy, it’s not hard to see why DEXs are suddenly more attractive to retail traders at a time when trust in centralised exchanges is faltering.

After all, this month alone saw the indictment of the four BitMEX co-founders for AML and KYC negligence, and Kucoin drained of approximately $150 million in cryptoassets. Users of decentralised exchanges would also never be confronted with a scenario where an exchange suddenly suspends withdrawals from the platform, as was the case with OKex also earlier this month.

Institutional investors, on the other hand, have long been wary of trusting exchanges to look after their trading capital and increasingly leverage solutions such as Copper’s ClearLoop. Independent custody could too soon become an important element of the retail ecosystem as DEXs continue to challenge centralised exchanges on the importance of separating custody and exchange.

This article was originally published in Crypto AM: Technically Speaking on Tuesday 27 October 2020.

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