The Final Frontier of Crypto Decentralization: DEXs and The Liquidity Problem

Circumstantial evidence of insider trading and fabricated volume on major crypto exchanges has catalyzed renewed focus on decentralized exchanges — or DEXs — as the future of crypto trading platforms. However, can the present issues within the current market paradigm be solved?

The crypto community has recently been rocked by a series of accusations leveled at cryptocurrency exchanges. Now, some of the largest trading platforms in the market revealed charging higher listing fees than the NYSE or Nasdaq.

Cryptos May Be Decentralized, But Markets Aren’t

Decentralization is the core concept that drives cryptocurrencies and blockchain technology. The force behind the success of new blockchain platforms — the cryptocurrency market — is, however, not decentralized. The top 10 cryptocurrency exchanges handle a vast amount of trade volume via opaque, centralized structures with no governance or oversight outside of loose regulatory frameworks.

These centralized exchanges determine which tokens are listed and, in most cases, provide limited exchange data, creating an ecosystem with the possibility to fabricate trade volume information.

Recent data published by trader and investor Sylvain Ribes provides compelling evidence that fake volume is a very real issue within the crypto market, stating that major exchanges fake volume “in a laughingly obvious and artificial way.”

Does artificial trade volume affect traders, though?  The US CFTC believes so — taking wash trading and artificial volume seriously enough to launch an investigation into the manipulation present within the cryptocurrency market, with “illegal practices that can influence prices such as spoofing or flooding the market with fake orders” cited as the primary issue.

University of Texas professor John Griffin recently captured headlines for publishing an in-depth study into potential manipulation of crypto markets via Tether. In a Bloomberg interview he stated that manipulation is rife within the crypto market ecosystem:

“There’s very little monitoring of manipulative trading, spoofing and wash trading. It would be easy to spoof this market.”

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Ultimately, there are two ways to halt potential exchange manipulation within the current cryptocurrency market model — regulation, or decentralization. Regulation, while operating with the perceived best interests of traders as a primary goal, is executed by a centralized third party, and is thus susceptible to the same risks as centralized exchanges. Regulation can also become reactionary and stifling, preventing innovation from occurring within the blockchain industry.

Decentralization, however, offers the promise of a transparent exchange ecosystem completely immune to the manipulation currently damaging the cryptocurrency market. A decentralized exchange entirely separated from a third party appeals to many blockchain evangelists as the best solution to the centralization issue — but will exchange decentralization be beneficial for the crypto market?

Volume Generation is Present Within Traditional Markets

The libertarian vision of a holistic blockchain-driven economy needing no centralized governance may not leave room for the artificial reinforcement of trade volume. But volume generation is a very real — and widely accepted — element of traditional securities markets.

The UK Government Office for Science, for example, published a study demonstrating the role of market makers within traditional securities markets, explaining they’ve existed for as long as securities have been traded.

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Data within the study reveals that across 30 stock markets in 29 countries, only the Tokyo Stock Exchange relies completely on public order flow for liquidity. The remaining 29 markets rely on market makers to provide liquidity beyond that supplied by the public. The practice of liquidity management even extends beyond the exchanges themselves — listed companies are now beginning to purchase market maker services to improve the secondary market liquidity of their listed shares.

Without market makers intentionally creating orders and generating volume on traditional exchanges, many stocks would possess virtually no liquidity. It’s not entirely unreasonable to expect that a decentralized exchange would establish an incentive to add liquidity, creating a market maker mechanism to ensure high volumes.

Liquidity Management Won’t Go Away

Many of the centralized cryptocurrency exchanges present in the market today already implement honest, upfront methods of adding liquidity to the market, offering maker/taker fee models that don’t charge market makers commission. Less reputable exchanges, however, are resorting to wash trading and artificial volume inflation.

Ultimately, liquidity management is an emergent factor of any complex market. The manner in which it is handled — especially by centralized exchanges with virtually no oversight — is disrupting trust and transparency within the cryptocurrency ecosystem. DEXs, however, hold the potential to create truly distributed market ecosystems in which participants are incentivized to add liquidity to order books in a transparent, provable manner.

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