A Market Maker’s Dilemma: Decentralised Exchanges (DEXs) vs. Centralised Exchanges (CEXs)

A Market Maker’s Dilemma: Decentralised Exchanges (DEXs) vs. Centralised Exchanges (CEXs)

Liquidity provision is a tricky business. Market makers play a pivotal role in crypto markets, especially in terms of liquidity provision for both decentralised (DEXs) and centralised exchanges (CEXs). Each type of exchange environment has its own set of challenges and opportunities for both clients and market makers. We want to look at the pros and cons of DEXs and CEXs and how we, as market makers, walk a fine line between both to achieve the best outcomes for our clients.

DEXs: Decentralisation at the cost of Liquidity

For market makers, liquidity is our bread and butter. It is necessary for us to do our job in order to help our clients achieve their objectives.  DEXs present the following risks in our experience:

  • Smart Contract: The reliance on smart contracts by DEXs exposes market makers (and clients) to risks of bugs or exploits, which can lead to financial losses.
  • Front-Running: Transparency on-chain of transactions can be visible before the transactions are confirmed, leading to potential front-running or MEV exposure.
  • Impermanent Loss: In liquidity pools, market makers face the risk of impermanent loss, particularly in volatile market conditions.
  • Limited Order Types: DEXs typically offer fewer order types and trading features, limiting market makers' strategies and manoeuvrability.
  • Limited Liquidity: DEXs typically have less liquidity than CEXs, making it a challenge to execute large orders without significantly impacting pricing or moving the market.

Yet DEXs often experiment with new financial products and protocols, offering market makers early access to these innovations.  They also offer a level of autonomy and anonymity not typically available from CEXs.  This can be invaluable when it comes to providing liquidity without impacting the market. In addition to trading fees, participating in DEX liquidity pools can offer additional rewards to both market makers and their clients, like yield farming tokens and other financial incentives.

For clients, DEXs offer increased transparency and potentially lower fees due to the peer-to-peer nature of DEXs.  However this P2P framework has higher risks due to being outside of regulatory structures. It is important for clients to understand the risk/reward tradeoff when using DEXs.

CEXs: The Liquidity Dilemma

We have learned the hard way that centralisation also comes with tradeoffs.  For Market Makers, CEXs present the following challenges:

  • Regulatory Compliance: regardless of jurisdictions, most CEXs operate under stricter regulatory frameworks, requiring market makers to comply with various laws and regulations. Although this gives clients a perceived sense of security due to regulatory oversight, it is a trade-off in terms of privacy and autonomy.
  • Counterparty Risk: Crypto was meant to move away from reliance on a central intermediary or point of failure. CEXs have increased risk associated with the solvency and integrity of the exchange and are open to manipulation by the exchange itself or large players that dominate the market.
  • Intense Competition:  CEXs in many ways speed up the race to the bottom (in trading fees) and create huge competition between market makers to ‘compete’. This can be both positive and negative for clients as CEXs tend to be dominated by large players either in the form of the exchange itself or large market makers that dominate liquidity provision and listing terms.

However, this exchange environment also offers huge opportunities for both market makers and clients through:

  • Higher Liquidity: CEXs generally offer higher liquidity, enabling market makers to execute larger orders with minimal price impact or market movements.
  • Advanced Trading Tools: CEXs provide sophisticated trading tools and features, which allow for more complex strategies (such as leverage, futures, derivatives, etc. and various order types) to be created and executed efficiently.
  • Stable Environment: The regulated environment of CEXs offers a more stable and predictable trading landscape and leads to better price discovery and faster trade execution for both market makers and their clients.
  • Institutional Participation: Being the most similar to TradFi environments, CEXs attract more institutional traders, providing market makers with more trading participants and volume, thus creating more ‘liquidity’.

At Artis, one exchange does not rule them all. DEXs offer autonomy and innovative yield-earning mechanisms but come with liquidity and smart contract risks that need mitigating. CEXs provide high liquidity and advanced tools but require regulatory compliance and have increased counterparty risk. Liquidity provision strategies also vary, with DEXs having passive income strategies and CEXs having more controlled, incentivized market-making strategies similar to traditional financial markets.

For our clients, the choice between DEXs and CEXs often boils down to the trade-off between transparency and innovation versus stability and liquidity. Each environment necessitates a different approach from market makers, who must balance these risk factors when it comes to delivering effective liquidity. We help our clients navigate these tradeoffs and understand which liquidity environment is best for them.

Reach out to ck@faculty.group if you want to learn more.

About Artis

Artis is a client-focused market maker that works closely with our clients to provide tailored, synchronised solutions that meet their specific requirements every step of the way. Our USP is our ability to customise services around the needs of our clients, regardless of market conditions or business life cycle. We help our clients navigate the complexities of market making, treasury management and CEX support in order to achieve their critical milestones, increase the number of token holders, build their user base and extend their financial runway.  We believe in building long-term relationships that grow with our clients to deliver financial success for everyone.

Hendo Verbeek

Hendo Verbeek

Hendo Verbeek is Director of Artis, Faculty Group's Market Maker. A keen sports car enthusiast, his passion is connecting his automotive sources of joy with children's charities.