P2P or peer-to-peer trading refers to trading on decentralized exchange markets, allowing users to trade in cryptocurrencies directly with one another.
P2P was the core principle behind creating the original cryptocurrency, Bitcoin. It aimed at allowing people within the network to transact freely without any intervention from third parties. For this system to work, it had to stay true to the ethos of decentralization.
With the global (crypto) financial industry facing unprecedented challenges in recent times, namely inflation, rising interest rates, not forgetting the latest crypto crash due to the 2022 blow-up of Terra (LUNA), Celsius and FTX, many believe Decentralized Finance (DeFi) and its innovative byproduct — the Decentralized Exchange (DEX) can offer alternative solutions to the crisis. The system not only eliminates intermediaries that cost money but also has the potential to democratize access to financial systems for billions of citizens around the globe. Research shows that the DeFi market could reach approximately half a trillion dollars by 2028.
But Decentralized Exchanges have the following challenges that need addressing before they can be adopted for large-scale institutional trading.
The Challenges to Institutional Adoption
Despite a tremendous growth rate, DEX engagement is yet to reach a level of adoption that can match its centralized counterparts. Here are the top challenges DEXs currently face:
DEXs currently tend to focus on simple buy/sell orders, and have limited functionality for advanced trading- for example margin trading or stop loss orders.
DEXs are also too expensive and too slow to use at scale unless they’re built on scalable L1s or high-performant L2s. Defective L1s further give rise to challenges such as miner frontrunning, MEV and Sandwich attacks.
Incompatibility with traditional financial frameworks is one of the biggest challenges to the institutional adoption of DEXs. Traditional/ Centralized Exchanges (CEXs) are governed by regulations, which is in direct conflict with the core principles of decentralization — no central authority or owner. Regulators in the DeFi ecosystem could also find it challenging to maintain certain levels of control within the space.
User experience is another significant roadblock to the mass adoption of DEXs. DEXs are prone to human errors due to their lack of intuitiveness, and can be difficult to use for the less tech-savvy. For example, in November 2020, a trader confused the ‘gas limit’ and ‘gas price’ input boxes and ended up paying $9,500 in fees to execute a $120 trade.
For DeFi to be widely adopted, the process must be made simpler, easier, and user-friendly, especially for regular people. This is currently not the case. For example, in order to use a DeFi application, users need a noncustodial wallet (a wallet where they control the private keys). Interacting with a Decentralized application (DApp) requires connecting the wallet, which can quickly become complicated, especially when using a mobile wallet.
Hacks in recent years have led to losses of billions of dollars, making security another major concern in the DeFi space and a primary impediment to its institutional adoption. DApps, in particular, are vulnerable due to their bridging protocols. In fact, approximately $1.6 billion worth of funds have been estimated to be stolen from DeFi protocols in the past year alone.
Another point that highlights the security challenge is that approximately 99% of tokens traded on DEXs are either scams or have huge insider allocations. This encourages ‘rug pulling’ by the founders — running away with user funds if the capitalization is high enough.
Fraudulent behavior is quite high in the space due to a lack of checks and balances in token issuance.
How Can These Challenges Be Addressed
- DEX’s could offer more cross-chain and customizable functionalities. These could potentially solve the scalability challenge brought about by the underlying L1, and improve liquidity
- DeFi platforms can build protocols that comply with regulatory requirements. Phree is an excellent example of this. The platform builds decentralized protocols keeping in mind regulatory requirements wherever possible. Phree actively works with traditional financial institutions to adapt processes such as KYC and anti-laundering checks for the DeFi space
- Collaborating with traditional financial institutions to build DeFi protocols that address standard regulatory requirements such as KYC and anti-money laundering checks
- There must be a strong emphasis on vetting protocols to detect any vulnerabilities. While platforms like CertiK do carry out audits by checking out smart contract codes, their efforts are less than satisfactory in detecting scams and protecting users
- Increased auditing of DApps before they go live
- Building user-friendly wallets and DApps for non-technical users
Challenges notwithstanding, the future is bright for P2P crypto trading. By taking the necessary preemptive steps, peer-to-peer trading has tremendous scaling potential.
Let’s briefly look at the workings of P2P exchanges.
How Does P2P Crypto Trading Work?
The DeFi system uses Automated Market Makers (AMMs) to facilitate the automatic, permissionless trading of digital assets using liquidity provisions or pools. Simply put, orders on a P2P exchange are matched with pending orders from other users, and you are only charged a network fee.
P2P platforms generally only serve as a medium for connecting buyers and sellers. Instead of a single server run by a central authority, they feature several servers run by the same software.
This process is enabled by the use of smart contracts. A smart contract is a collection or set of instructions programmed to automatically execute when certain conditions are met.
All participants in P2P trading have equal rights and obligations, negating third-party involvement. The system relies on consensus algorithms to verify all transactions and fend off double-spending.
Key Advantages of DEX Trading
Decentralized Exchanges have grown exponentially since their inception in 2014, handling over USD 1 trillion in trading volume in the past year alone. Some of the key pillars underlying this growth are user autonomy, increased control over assets, and greater security. Other advantages include:
DEXs do not require or implement KYC (Know Your Customer) procedures. Everything from transactions to wallets is anonymous, ensuring pseudonymity, although not utmost privacy.
Self-Custody of Assets
‘Not your keys, not your crypto’ is the thumb rule for DeFi. This simply means that on a DEX, users retain control of their private keys, which translates into genuine ownership of assets.
Lower Transaction Fees
As mentioned before, DEXs negate the need for intermediaries, resulting in overall cheaper transactions. However, most DEXs currently run on Ethereum, sometimes leading to high gas fees. That said, blockchains are already innovating solutions that ensure minimal fees. For example, a transaction worth $100,000 on the Polygon Network may cost only a few dollars.
DEXs are less likely to face issues of suspended or stopped services. The very nature of such exchanges provides greater security as they have no single point of failure.
The technology around DeFi and decentralized exchange is already witnessing fundamental changes, especially in terms of regulations and security — factors that could positively affect institutional adoption in the near future.
Challenges such as low liquidity are being addressed through the use of liquidity providers and Automated Market Makers (AMMs) — these pool the liquidity from users and price assets within the pool using algorithms. Such innovations have enabled users to swap tokens almost instantaneously.
User-friendliness is also improving, as evidenced by the large number of crypto investors in low market cap coins in 2021.
2nd generation CEX’s like dydx massively increase trade throughput by using L2s like Starkware. This allows for trades to be executed almost instantly.
What is needed at the end of the day is a fine balance between the two ecosystems — centralized and decentralized — to bring the best of both worlds to the forefront.