Ethereum and Polygon are battling to become the platform for DEX traders
The collapse of cryptocurrency exchange FTX that saw at least $1 billion of customers’ money lost has brought the benefits of decentralised exchanges (DEX) sharply into the spotlight.
When putting crypto into a DEX users keep custody of their assets, executing trades directly from their own wallet, as the exchanges use smart contracts based on blockchain technology.
Indeed, having more control over their cryptocurrency is luring more and more people to DEX platforms. Crypto exchange Kriptomat report that DEXs handled $122 billion in transactions during the record-breaking April 2021 bull market, compared to just $1 billion in April 2020.
But the price of using a more secure environment is ‘gas fees’, which must be paid to third parties – known as miners – whose specialised computer programs validate the transaction. These are paid by both traders and liquidity providers, with the latter facing these each time they want to add or remove liquidity from the exchange or to change their current position.
DEXs were first launched on Ethereum mainnet – the primary public Ethereum production blockchain – starting with Uniswap v2 in May 2020, which was upgraded to Uniswap v3 in May 2021. Recently, though, Uniswap v3 has also launched on the blockchain scaling solution Polygon, raising the potential of a battle for supremacy between the two blockchains.
Polygon can validate transactions quicker than Ethereum; handling up to 700 transactions per second compared to Ethereum’s average of 10. It charges much lower gas fees as a result; around $0.01 per trade compared to the average fee of $14 on Ethereum for a trade on Uniswap v3 in 2022.
It is also one of several potential solutions that has been developed to help scale blockchain, although there is a trade-off between lower gas fees and increased speed on the one hand and security on the other, as there are fewer validators on Polygon.
My research with Amit Chaudhary, Research Fellow at the school's Gillmore Centre for Financial Technology and Co-founder of web 3.0 product developer ChainSolid Labs, and Basile Caparros, Quantitative Researcher at ChainSolid Labs, has focused on the effect of a reduction of gas fees on liquidity on Uniswap because of the entry of the Polygon blockchain. Specifically, this looked at liquidity concentration and slippage, ie the ability to buy and sell cryptocurrency without having a significant immediate impact on price.
Our main prediction was that the introduction of Polygon and lower gas fees on Uniswap v3 would lead to a higher concentration of liquidity – ie liquidity providers submitting tighter ranges around the current price for their positions.
With lower gas fees, liquidity providers can update their positions more frequently. Therefore, they can better protect themselves from arbitrageurs – traders who make money from different rates offered by exchanges for the same pair of cryptos – profiting from their 'stale' positions in case of a permanent price change. This ability to update their positions faster should then incentivise them to set tighter ranges for their positions to maximise their earnings from liquidity provision.
We tested this hypothesis using three of the most liquid ETH (Ethereum’s crypto coin) pools on Polygon and Ethereum, where ETH is exchanged against a stablecoin (either a USDC or USDT). We looked at the average daily volume and liquidity on each exchange in 2022.
We found liquidity is smaller overall on Polygon pools compared to Ethereum; something we believe is due to the poorer security of Polygon.
In all, the average slippage of a trade – the difference between the average execution price and the pre-execution market price – on Uniswap v3 is some 16-18 basis points higher on Polygon than it is on Ethereum. Traders want slippage to be as low as possible, but this is determined by the aggregate liquidity as well as the ratio of reserves in the pool. For example, if ETH was relatively scarce in the pool, it would require much more USDC per ETH, meaning there was a high level of slippage.
But, for smaller trades of less than $10,000, slippage was significantly lower on Polygon than Ethereum. We found that this was indeed due to a higher concentration of liquidity around market price on Polygon. Thus, it can successfully compete with Ethereum in providing liquidity for small trades, for which gas fees are relatively more important.
Larger trades, however, are more expensive to execute on Polygon, as the negative effect of worse liquidity outweighs the benefits of lower gas fees. Ethereum has better liquidity overall for trades of more than $10,000, partly due to its strong base of liquidity providers and because gas fees are relatively less significant for larger trades.
Which DEX platform is best for big trades?
Lower gas fees also mean it is easier for liquidity providers to adjust their positions, and the research revealed a trend towards more re-positioning of liquidity providers on Polygon. The research confirmed that this, in turn, leads to a greater concentration of liquidity around market price. We are also seeing much tighter price ranges being provided on Polygon, centered around the current price.
This greater liquidity concentration is especially important for the execution of smaller trades, and we found Polygon is mostly used to execute transactions of up to $10,000. But liquidity providers are reluctant to deposit large amounts on Polygon, and larger trades are typically conducted on Ethereum, which has overall bigger total value locked (TVL).
We do not believe the arrival of Polygon represents a threat to the future of Ethereum, but it does create a more efficient transaction process which will appeal more to retail investors who want to trade small amounts. Blockchain scaling solutions such as this are both viable and necessary and will facilitate a higher usage of DEXs in future.
Yet while Polygon provides faster transaction processing, cheaper gas fees and greater liquidity for small trades, concerns around security remain, and it is not currently as robust in this space as Ethereum.
But efforts to improve security are ongoing, as can be seen in Polygon’s release of the zero knowledge Ethereum Virtual Machine (zkEVM). This is compatible with any smart contract used across Ethereum and uses its security technology, while also reducing cost and improving transaction speed.
With the ability to attract a much higher throughput than the original Polygon PoS (Proof of stake) platform, the zkEVM could improve Uniswap v3’s liquidity significantly This would further reduce slippage, taking it potentially below levels seen on Ethereum.
If security concerns can be resolved, it will open the door for smaller trades to be conducted on DEXs in a secure and cost-efficient manner. We believe this will make DEXs more competitive and further increase their market share, relative to CEXs.
In the long term, higher security combined with lower fees and blockchain scaling solutions is likely to encourage people towards DEXs. While scepticism remains around trading cryptocurrencies, DEXs can potentially be used for trading any type of financial instruments in the future, such as stocks or derivatives. It’s possible that one day this will be the standard solution for everything that is traded on financial markets.
As for the battle between Ethereum and blockchain scaling solutions, we believe both have a place in the emerging blockchain infrastructure. But, as in any market, a spot of healthy competition will go a long way to create better conditions for customers.
Caparros, Basile and Chaudhary, Amit and Klein, Olga, Blockchain Scaling and Liquidity Concentration on Decentralized Exchanges (July 3, 2023). Available at SSRN: https://ssrn.com/abstract=4475460 or http://dx.doi.org/10.2139/ssrn.4475460.
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