Table of Contents
Comprehensive Guide to DEX Aggregators
What is a DEX?
A DEX, or decentralized exchange, is not an unfamiliar term in crypto and defi any more. There are now hundreds of them across every defi ecosystem. Like traditional exchanges, DEXs provide a venue for users to swap one asset or token for another. However, they differ from traditional exchanges because they rely on no centralized authority or third party to facilitate trading. Users can swap tokens using a DEX without forfeiting custody of their assets. This is made possible by the trustless nature of blockchain, and smart contract functionality; enabling complex, deterministic transactions.
There are a number of innovative mechanisms that enable DEXs to be decentralized. Arguably the most important is the concept of a liquidity pool - and the outsourcing of liquidity it enables. A liquidity pool is a collection of (typically) two tokens which users can transact with to swap between them. Healthy liquidity pools will have equal value (not necessarily equal quantity) of each token. Every DEX therefore doesn’t have just one liquidity pool, but rather, there exists a pool for every token pair, and maybe even more than one for the same pair if the DEX protocol wishes to implement different trading rules (for example, UniSwap has multiple pools for the same pairs but with different fee structures).
While DEXs do work as a non-custodial trading platform, their popularity and growth is limited by the liquidity available to these protocols. Because there are many different liquidity pools within a single DEX, and hundreds of DEXs across multiple ecosystems, the total liquidity existing in defi is splintered across each of these pools. This problem limits the growth of defi and the adoption of crypto among institutional participants, and inhibits DEXs from truly competing against centralized exchanges. This is evident when comparing the trading experience between a centralized exchange like Coinbase to a DEX like UniSwap. The graph below shows the trading volume on DEXs as a percentage of volume on centralized exchanges.
DEX aggregators are the key to bringing the DEX experience equal to, and even better than, the centralized exchange experience.
What is a DEX Aggregator?
A DEX aggregator is a tool designed to provide users with access to more liquidity than what is ever available on any single DEX through a single interface. Naturally, they are a much younger concept than DEXs, but are becoming increasingly popular as traders seek better prices than what is possible with a single DEX. 1Inch is undoubtedly the most popular protocol that provides these aggregation services. Born out of a hackathon in 2019 by two developers who made it for their own personal use, 1Inch was the first to introduce the idea of aggregation services in crypto. Since then, other protocols have been created but none compete with the size and volume of 1Inch. At the time of writing this article, DEX aggregators have grown in popularity amongst high volume traders, however retail traders typically continue operating directly with DEXs.
To do manually what DEX aggregators do would be tedious and inefficient - to check all platforms and their best prices and then calculating the most efficient trade routes. It would also be practically impossible to determine more complex trade routes, such as intermediary swaps that could provide an even better swap price. Furthermore, the size of the largest liquidity pools in defi can be too small for large trades, and traders placing such orders on DEXs would suffer from terrible slippage. DEX aggregators solve all these issues, and provide a single interface with access to liquidity across many venues.
The concept of splitting up an order and directing it to different trading venues has been employed in traditional finance for a long time. Doing so allows a large order to achieve a better overall price by fracturing the market impact across multiple trades and reducing slippage. What 1Inch, and other DEX aggregators provide in defi is no different.
It is important to note that DEX aggregators are not directly competing against DEXs themselves. Rather, they operate in tandem with DEXs, and can provide additional users and trading volume to DEX protocols.
For readers that are less familiar with trading mechanics and terminology, it can be easier to explain it with an analogy. Instead of making a trade, let’s imagine we are trying to travel from Sydney to San Francisco. One way of going about it is to go to an airline’s website, search for the flight, and purchase a ticket. This flight may be direct, or it may include a stopover. Maybe if you are not happy with the price or flight plan, you could go to another airline’s website and compare the same flight. Most people would not take this approach however. Instead, there are tools that allow you to easily search, compare and purchase flights from hundreds of airlines in the one interface. An example is Expedia, or Google Flights. Using these tools, the user can easily and quickly find the best flight for them, whether it be the cheapest, quickest, or some other criteria they choose.
This service is exactly that which DEX aggregators provide. However, instead of destinations, airlines and flights, they’re dealing with assets, DEXs and trades respectively. These DEX aggregators use real-time data to compare trades across multiple DEXs to find the user the best trade for them, whether it be the best price, quickest, or some other criteria the user chooses. For example, if a user wants to fly from Sydney to San Francisco, Google Flights may find the cheapest route to be from Sydney to Los Angeles with Airline A, then from Los Angeles to San Francisco with Airline B. Similarly, if a user wants to trade from USDT to Eth, a DEX aggregator may find that the best price possible is achieved by swapping USDT to WBTC on DEX A, then swapping from WBTC to Eth on DEX B.
Generally, DEX aggregators can come in two forms, trade aggregation and information aggregation. While there is a lot of overlap in functionality between the two, a trade aggregator will include the ability to trade and will find users the best trade route on given trades. On the other hand, the primary goal of information aggregators is to provide accurate, high quality information across the entire market in a single interface.
DEX aggregators maintain the unique characteristics of DEXs and defi generally; anonymity, transparency, open-source and decentralization. Importantly, like DEXs, DEX aggregators enable non-custodial swaps.
How do they work?
The best way to explain how they work is with an example and I will use the 1Inch interface for demonstration purposes. Let’s say we wanted to trade 7,000 Eth for WBTC. If we executed this trade on UniSwap, at the time of writing this article, the quoted price was 502.69 WBTC (~$10,076,000). This is a slippage of -1.15% or ~$116,890. Now taking this trade to 1Inch, at the time of writing, the quoted price was 506.97 WBTC (~$10,149,162). This is a slippage of -0.48% or ~$48,950. This is a significant saving, and is achieved by splitting the order across multiple DEXs and liquidity pools. See the image below for an illustration on exactly how it split the order.
Using real-time data feeds of the liquidity pools across all DEXs and an efficient path-finding algorithm, a DEX aggregator can predict the most effective order route by calculating the slippage and market impact in each pool and proactively allocating a percentage of the order that minimizes these factors. DEX aggregators can also maintain other data on liquidity pools to ensure users are not exposed to unnecessary risk.
Why are they important?
The value proposition of DEX aggregators, which is identical to the benefits of aggregators in other industries or sectors, is threefold. Firstly, they will provide fast, easy trade execution. Secondly, they will offer access to a vast range of available products, in this case tokens. And last but not least, DEX aggregators will offer the best prices.
A Better Trade Experience
The DEX trading experience is clunky, sometimes fails, and is ruined by front-running. DEX aggregators can improve the trading experience in all of these areas. Firstly, a DEX aggregator can implement mechanisms not possible with DEXs to streamline the trading process. For example, failed transactions can be reduced by enabling partial orders. When an order is submitted, if the price in a liquidity pool that has part of the order routed to it changes unfavorably, that part of the order can be canceled without the rest being affected. Another example is transaction fee refunds; a mechanism implemented by 1Inch.
DEX aggregators are also in a position to prevent front-running. 1Inch is an example, which implements ‘virtual rates’. In an ordinary liquidity pool, the swap rate is determined by the number of assets in the pool, combined with some AMM formula. 1Inch’s virtual rates will adjust in one direction only - for further swaps of the same kind - and the reverse rate will remain the same. This mechanism makes the second trade, and the entire strategy, of front-running bots not profitable. These virtual rates are effective for only a short period of time - known as the decay period - and are set by the protocol’s governance.
To further improve the defi trading experience, aggregators are implementing features typically only found on centralized exchanges such as limit orders. 1Inch is even offering gasless limit orders for ETH. For users, this means they can swap tokens without an ETH balance to pay for gas.
Because a DEX aggregator is connected to many liquidity pools across many DEXs, it will have access to many more tokens than any one DEX could have. This not only improves the convenience for users, but also the swap prices they can get and the gas fees they will have to pay. As cross-chain solutions grow and mature, the possible token exposure will also grow. A protocol in this area is ThorSwap.
This may seem quite novel for people such as retail traders, who are making notionally small trades. However, with respect to notionally large trades, this could result in the saving of hundreds of thousands of dollars. While slippage is unavoidable, there can still be significant savings for traders through the use of DEX aggregators when compared to DEXs alone. These savings are caused by increasing the depth of liquidity available (deeper liquidity means better trading prices for users). This was illustrated in the Eth/WBTC example above. The importance of DEX aggregators will only grow as the adoption of defi and crypto ramps up and as the number of DEX liquidity pools grows. Furthermore, the availability of DEX aggregation services will accelerate the adoption of defi among institutional participants, who are deterred from defi because of the relatively low liquidity (in comparison to what is available on centralized exchanges).
Furthermore, by splitting a large order up across multiple liquidity pools, the user’s risk is reduced by avoiding exposure to the risk associated with any single pool. Additionally, DEX aggregators maintain the non-custodial and anonymous principles propounded by DEXs. While it is possible to achieve these benefits without an aggregator, and manually checking the price in each pool, in practice this is impossible. DEX aggregators provide a single interface for users to find the best price for their trade, while giving them access to deeper liquidity than ever before, as well as real-time information across entire markets.
These are just some of the many benefits that DEX aggregators bring to the table, and there will be many more discovered as they evolve and mature. For a discussion on the value capture of DEXs and DEX aggregators, this article has a great section at the end.
The Future of DEX Aggregators
The service provided by DEX aggregators is not unique to defi, in fact we already touched on another aggregation service early; Expedia or Google Flights. These are all examples of what Ben Thompson referred to as aggregation theory (https://stratechery.com/2015/aggregation-theory/). Thompson advocates that these aggregators, despite not owning the services they aggregate, increase the productivity and value of such services. If we observe the status of defi and crypto at the moment, a comparison between centralized exchanges and DEXs shows that centralized exchanges are dominating. This is because, at the moment, they provide a better trading experience. The trading experience with DEXs is very complex and splintered. This is where DEX aggregators will benefit DEXs. According to aggregation theory, DEXs will experience an increase in productivity and value output. By driving this increase in productivity, and enriching the trading experience through a better interface, DEX aggregators will level the competition between DEXs and centralized exchanges.
Some advocates see DEX aggregators benefiting defi adoption from a compliance perspective. Similar to the way Google removes malicious or illegal websites from search results, DEX aggregators can be a champion of compliance in defi by removing non-compliant DEXs or liquidity pools from its service.
As the range of defi products, services and protocols grows, aggregation services will become invaluable. At the moment, 1Inch has the vast majority of market share for DEX aggregators, but the future may feature a different protocol entirely. What will be important for users is a DEX aggregator that is DEX/liquidity pool agnostic; an aggregator that does not have any stake in the services they aggregate in order to truly provide the user with the best, unbiased information. It is also important that DEX aggregators be modular and standardized. These are important principles that good DEX aggregators should implement in order for them to best serve users.
In the same sense that Google has become every users’ go-to service to find information on the internet, DEX aggregators will become every traders go-to service for price discovery, smart order routing, better slippage, and data aggregation. This innovation will drive productivity in the defi space, and maximize the value output for all users.