Decentralized exchanges (DEXes), together with stablecoins, lending services, and trading aggregators, constitute the fundamental building blocks of DeFi. Among these components, DEXes have risen as the cornerstone, serving as the central hub of the DeFi ecosystem. In this post, we will provide a concise overview of the evolutionary progress of DEXes since 2018.

First Generation

The first generation of DEXes emerged between 2018 and 2019, primarily relying on the reserve model. Under this model, a DEX would maintain a reserve of tokens on a contract, allowing traders to exchange one type of token for another based on a price determined by the DEX developer. This approach had similarities to physical foreign currency exchange shops. Examples of DEXes operating under this model during this period included Bancor, Balancer, and Kyber in their initial versions. However, this reserve model faced challenges related to liquidity shortages, as reserves were often limited and could run out. Additionally, these DEXes relied on price feeds aggregated from centralized exchanges (CEXes). Some, like IDEX and Binance DEX, combined centralized order books with on-chain settlement. Nevertheless, this model did not endure for long.

Second Generation

The second generation of DEXes introduced the constant product or inverse function and liquidity pool model. Uniswap, launched in November 2018, pioneered this model, based on a simple mathematical formula: x * y = k, where x and y represent cryptocurrencies in a trading pair, and k is a constant parameter. For a more detailed mathematical explanation, refer to the relevant literature. Uniswap brought about a revolutionary change by introducing the Automated Market Making (AMM) mechanism, setting a trend in DeFi from 2020 to 2021. Other DEXes such as Balancer, Kyber, and Bancor followed suit by implementing AMM mechanisms, replacing the reserve model. AMM democratized market making, enabling anyone to become a liquidity provider, offering permissionless creation of trading pairs on Uniswap, and facilitating instant swaps with an always-available liquidity pool for any pair. These features contrasted with the limitations of reserve-based DEXes and centralized exchanges (CEXes). Moreover, the on-chain execution of Uniswap and AMM DEXes ensured transparency and resistance to censorship. Mathematically, this DEX model theoretically provided unlimited liquidity, a feat impossible for reserve-based DEXes and CEXes relying on order books and price matching mechanisms. However, the Uniswap model had its limitations, including impermanent loss (IL) and slippage, which were previously unseen.

Third Generation

The third generation of decentralized exchanges built upon the Uniswap model to reduce slippage and increase capital efficiency by concentrating liquidity and swap requests within specific price ranges, as opposed to spreading prices across the entire inverse curve. Uniswap V3 led this improvement, with other DEXes following suit. However, liquidity concentration made the trading experience more complex and somewhat limited liquidity capacity during extreme volatility, such as with newly listed tokens with low liquidity. An alternative enhancement to the constant product formula introduced by Uniswap was the Proactive Market Maker (PMM) algorithm developed by DodoEX. The PMM formula, essentially an integral curve of liquidity and price function, offered a more concentrated curve of unlimited liquidity around the current market price. This significantly reduced IL and slippage while enhancing the capital efficiency of the liquidity pool. Unfortunately, DodoEX required the (average) market price to be fed into its markets, which was unnecessary for Uniswap. Curve Finance introduced StableSwap, an efficient mechanism for Stablecoin liquidity, and several projects introduced various methods to improve capital efficiency for general token pairs, like the Maverick protocol.

Summary

Automated Market Maker (AMM) models, including the Uniswap model, its variations, and the Proactive Market Maker (PMM) algorithm, have matured significantly for spot trading. While some developers have worked to reduce impermanent loss (IL) and slippage through concentration techniques or improvements to mathematical curves for liquidity pools, another focus is on building DEXes for trading derivatives, synthetic assets, perpetual futures, or options. This marks the advent of the fourth evolutionary generation of DEXes. With these advancements, decentralized exchanges are poised to offer a broader range of financial products, enhancing their competitiveness with centralized exchanges

Decentralized exchanges (DEXes), together with stablecoins, lending services, and trading aggregators, constitute the fundamental building blocks of DeFi. Among these components, DEXes have risen as the cornerstone, serving as the central hub of the DeFi ecosystem. In this post, we will provide a concise overview of the evolutionary progress of DEXes since 2018.

First Generation

The first generation of DEXes emerged between 2018 and 2019, primarily relying on the reserve model. Under this model, a DEX would maintain a reserve of tokens on a contract, allowing traders to exchange one type of token for another based on a price determined by the DEX developer. This approach had similarities to physical foreign currency exchange shops. Examples of DEXes operating under this model during this period included Bancor, Balancer, and Kyber in their initial versions. However, this reserve model faced challenges related to liquidity shortages, as reserves were often limited and could run out. Additionally, these DEXes relied on price feeds aggregated from centralized exchanges (CEXes). Some, like IDEX and Binance DEX, combined centralized order books with on-chain settlement. Nevertheless, this model did not endure for long.

Second Generation

The second generation of DEXes introduced the constant product or inverse function and liquidity pool model. Uniswap, launched in November 2018, pioneered this model, based on a simple mathematical formula: x * y = k, where x and y represent cryptocurrencies in a trading pair, and k is a constant parameter. For a more detailed mathematical explanation, refer to the relevant literature. Uniswap brought about a revolutionary change by introducing the Automated Market Making (AMM) mechanism, setting a trend in DeFi from 2020 to 2021. Other DEXes such as Balancer, Kyber, and Bancor followed suit by implementing AMM mechanisms, replacing the reserve model. AMM democratized market making, enabling anyone to become a liquidity provider, offering permissionless creation of trading pairs on Uniswap, and facilitating instant swaps with an always-available liquidity pool for any pair. These features contrasted with the limitations of reserve-based DEXes and centralized exchanges (CEXes). Moreover, the on-chain execution of Uniswap and AMM DEXes ensured transparency and resistance to censorship. Mathematically, this DEX model theoretically provided unlimited liquidity, a feat impossible for reserve-based DEXes and CEXes relying on order books and price matching mechanisms. However, the Uniswap model had its limitations, including impermanent loss (IL) and slippage, which were previously unseen.

Third Generation

The third generation of decentralized exchanges built upon the Uniswap model to reduce slippage and increase capital efficiency by concentrating liquidity and swap requests within specific price ranges, as opposed to spreading prices across the entire inverse curve. Uniswap V3 led this improvement, with other DEXes following suit. However, liquidity concentration made the trading experience more complex and somewhat limited liquidity capacity during extreme volatility, such as with newly listed tokens with low liquidity. An alternative enhancement to the constant product formula introduced by Uniswap was the Proactive Market Maker (PMM) algorithm developed by DodoEX. The PMM formula, essentially an integral curve of liquidity and price function, offered a more concentrated curve of unlimited liquidity around the current market price. This significantly reduced IL and slippage while enhancing the capital efficiency of the liquidity pool. Unfortunately, DodoEX required the (average) market price to be fed into its markets, which was unnecessary for Uniswap. Curve Finance introduced StableSwap, an efficient mechanism for Stablecoin liquidity, and several projects introduced various methods to improve capital efficiency for general token pairs, like the Maverick protocol.

Summary

Automated Market Maker (AMM) models, including the Uniswap model, its variations, and the Proactive Market Maker (PMM) algorithm, have matured significantly for spot trading. While some developers have worked to reduce impermanent loss (IL) and slippage through concentration techniques or improvements to mathematical curves for liquidity pools, another focus is on building DEXes for trading derivatives, synthetic assets, perpetual futures, or options. This marks the advent of the fourth evolutionary generation of DEXes. With these advancements, decentralized exchanges are poised to offer a broader range of financial products, enhancing their competitiveness with centralized exchanges