DEX or CEX: Where Should I List My Token?
From a Capital Efficiency vs. Liquidity Efficiency standpoint
If you want your token or coin to be tradable on the secondary market, you essentially have two options:
Either create a trading pair on a centralized exchange (CEX) or
create a trading pair on a decentralized exchange (DEX)
There would also be the option that buyers and sellers directly engage in peer-to-peer (P2P) transactions, but this option is not discussed in this article as it is not commonly used. It is not commonly used because it is inconvenient to find a seller if you are the buyer (and vice versa). An intermediary element, such as an order book (most commonly a central limit order book, aka CLOB) used by CEXs or an AMM used by DEXs, solves this problem and enables transactions to be executed immediately.
There are advantages and disadvantages of each option that have been discussed well in other articles, but we want to dive deeper into the liquidity question in this article. While CEXs usually facilitate trades using a CLOB mechanism, decentralized exchanges often facilitate trades using a v2 AMM - a mathematical formula. This results in different liquidity requirements for each option, which will be discussed in this article.
This article aims to help decision-makers, advisors, and entrepreneurs of blockchain-based ventures determine if they should list their token on a CEX or DEX.
Introduction to Decentralized Exchanges
An important clarification upfront: By decentralized exchanges or DEXs, we mean those like Uniswap that use AMMs, not order books.
Decentralized exchanges represent a fundamental shift in the way digital assets are traded, offering an alternative to the traditional centralized exchange model. In this section, you will understand the inner workings of conventional DEXs, learn how prices are determined, the role of liquidity, and the capital efficiency considerations associated with providing liquidity as an early-stage venture.
The Mechanics of Decentralized Exchanges
Decentralized Exchanges facilitate transactions through a Peer-to-Contract (P2C) mechanism. At the core of this is the liquidity pool (the contract), which can be described as the intermediary element and is usually set up by the project that lists its token on the DEX.
A liquidity pool comprises two tokens: the project's token (from now abbreviated with PT) as the base token and another well-established cryptocurrency, such as ETH or USDT as the quote token. Although some DEXs accommodate pools with up to eight different assets, the two-token structure remains the standard.
Price Formation in Liquidity Pools
Price determination within a liquidity pool used by a majority of DEXs revolves around the initial liquidity deposit. Consider a scenario where a liquidity pool contains, e.g., 100,000 PT and 200,000 USDT. In this case, 1 PT would equal 2 USDT.
When a trader wishes to acquire PT, they execute a swap, exchanging their USDT for the PT within the liquidity pool. The calculation of the amount of PT acquired for a given amount of USDT is determined by a specific formula. Most DEXs employ the constant-product market maker model, which entails the following calculation:
Firstly, the constant product must be calculated, representing the product of PT and USDT held within the liquidity pool. In our example, this would be 100,000 times 200,000, equating to 20 billion (I am saving you the zeros…).
The trader wants to buy PT for, let’s say, 1,000 USDT, thereby increasing the total size of USDT tokens within the liquidity pool by 1,000. As the name implies, the constant product remains unchanging. The equation to be solved becomes:
(200,000 USDT + 1,000 USDT) * X PT = 20 billion
For the product to stay constant, a new amount of PT within the liquidity pool must be calculated.
Dividing 20 billion by 201,000 USDT reveals the number of PT remaining in the pool after the trade, approximately 99,502 tokens. This outcome may appear to deviate from the expected 500 PT the trader expects to receive, given the initial price of 2 USDT per PT. However, it is important to understand that the price or ratio between PT and USDT is calculated not just once for the swap, but for each smaller possible swap within the transaction.
Consequently, the new price for 1 PT is adjusted to 2.02 USDT, reflecting a 1% (or a 0.02 USDT) increase paid by the trader.
Importantly, we intentionally avoided mentioning fees in the calculation, as including fee structures would exceed the scope of this article. The main goal was to provide a basic understanding of the fundamental principles contributing to price determination in DEXs. However, it's worth mentioning that DEXs typically impose transaction fees, which generally range from 0.05% to 0.3%. These fees can typically be set by the entity that sets up the liquidity pool. These transaction fees primarily go to the liquidity providers who contribute to the pool's liquidity.
The Role of Liquidity and Capital Efficiency
The importance of liquidity on a DEX extends to two key functions:
Enabling the trading of the token on the exchange.
Facilitating a seamless trading experience by minimizing price impact.
However, engaging in liquidity provision on a DEX entails - like everything else - opportunity costs. The anticipated Return on Invested Capital (ROIC) for providing liquidity barely exceeds market-standard returns, which typically approximate around 10% per annum.
As a result, early-stage ventures are presented with a choice: they can either allocate a substantial portion of their available capital resources towards liquidity provision to enable (smooth) secondary market trading of their token, or they can invest the capital in, e.g., Research & Development (R&D) offering a potentially more promising ROIC.
Brief digression in value creation
Every business, be it a startup or an established corporation, thrives when its Return on Invested Capital (ROIC) exceeds its cost of capital.
Conversely, when a business generates an ROIC lower than its cost of capital, it erodes value.
Investors are naturally inclined to allocate their resources to a business that presents a compelling plan promising an ROIC higher than what they could obtain from a similar investment opportunity. Crucially, this ROIC should surpass the average market returns; otherwise, investors would face losses.
Therefore, it's essential to consider the implications of capital allocation, extending beyond the choice between opening a liquidity pool or pursuing a listing on a Centralized Exchange (CEX). Decisions regarding capital allocation profoundly impact a company's ability to create and preserve value in the long run.
The book "Valuation: Measuring and Managing the Value of Companies" by McKinsey contains valuable insights into value creation and the associated decision-making process. It's worth a read if you want to learn more about it!
How Much Liquidity Do I Need?
This is essentially a question that you can’t answer with one number as it depends on the venture’s stage and target group. However, there are ways to estimate how much liquidity the pool should contain to offer a pleasant trading experience.
Understand your Target Group
When considering a listing on a DEX, it's important to understand your target group. If the token is aimed at retail investors, you won't need as much liquidity as with a token aimed at investors with larger ticket sizes. The reason for this is that larger transactions have a greater impact on the price and therefore require more liquidity acting as a buffer.
Provide Liquidity as your Venture Would Already Be In The Next Phase
The liquidity you provide should preferably be one step ahead of the phase your company is in to enable a seamless transition to the next phase. Think of it like this: If you are running an early-stage start-up, you will initially attract small investors, but you already want to be attractive to larger investors. Imagine you are at a stage where serious larger investors are interested in your venture but cannot invest because their ticket sizes are too big for your liquidity pool to handle.
Another solution to this problem would be an over-the-counter (OTC) transaction, where the two parties (venture and investor) perform a P2P transaction. However, this is something that the venture needs to plan for when creating the tokenomics, as some tokens should be set aside for this purpose.
Competitor Analysis
An alternative method for estimating your liquidity requirements involves examining your competitor’s actions. If you have a competitor who has listed their token on a DEX, you can discover the initial liquidity they provided. Tools like Dexscreener can prove helpful in accessing such information. You can also use such a tool to find out what the current liquidity of a given pool is. This allows you to see how it has developed over time, which can serve as a reference.
It's essential to note that the initial liquidity necessary to provide a smooth trading experience can often reach several hundreds of thousands of dollars, representing a substantial allocation of your capital resources.
Introduction to Centralized Exchanges
Centralized Exchanges (CEXs) represent a conventional means of trading digital assets, distinct from DEXs. In this section, you will learn about the basic mechanics of CEXs and get insights into how swaps are executed and prices are determined.
Order-Book Mechanism
Buy Orders: A buyer places an order indicating the maximum price they are willing to pay for a specific quantity of an asset. This order is added to the exchange's order book.
Sell Orders: Conversely, a seller places an order indicating the minimum price at which they are willing to sell a specific quantity of an asset. This order also becomes part of the exchange's order book.
Market Orders: In addition to limit orders, CEXs often support market orders, where users buy or sell assets at the current market price. Market orders execute immediately, but the final price may vary slightly from the last traded price due to market fluctuations.
Market makers, a crucial participant group within centralized exchanges, play an integral role in maintaining liquidity and facilitating trades. Market makers are entities or individuals who continuously provide buy and sell orders in the order book, often with a narrow bid-ask spread. They aim to profit from the bid-ask spread while simultaneously ensuring there are consistently available orders for other users to execute against.
This dynamic interaction involving market makers helps maintain liquidity, reducing price volatility, and ensuring that there are consistently available orders for traders to execute against. Market makers contribute to price stability by absorbing the impact of sudden large buy or sell orders.
Price Determination through Matching
Price determination in CEXs relies on matching orders within the order book, a process where market makers play a significant role. The exchange continually evaluates and matches buy and sell orders based on their specified prices. When a buy order price intersects with a sell order price, a trade execution occurs, and the assets are swapped between the parties involved.
Liquidity and Price Volatility
Liquidity on CEXs is a critical factor influencing the efficiency and price stability of asset trading. Assets with higher liquidity tend to have narrower bid-ask spreads, reducing price volatility. Liquidity is often provided by market makers and traders who maintain a continuous presence on the exchange, offering to buy or sell assets at competitive prices.
Listing Fees
However, a listing on a CEX doesn’t come for free, much like an Initial Public Offering (IPO). The listing fee varies significantly and is influenced by multiple factors, such as the exchange's jurisdiction, reputation, and trading volume, among others. Typically, CEXs can be categorized into:
Small-scale exchanges, where listing fees may range up to $30,000.
Medium-scale exchanges may charge listing fees of up to $300,000.
Large-scale exchanges, which can impose substantial listing fees, often reach up to +$1,000,000.
To gain insight into the categorization of exchanges as large-scale, medium-scale, or small-scale, you can refer to CoinGecko's list of exchanges. While the boundaries between these categories are not strictly defined, it's worth noting that the higher a particular exchange ranks on the list, the greater the expected listing fees tend to be.
Due to the listing fees, the initial costs for CEX listings could be considered “high”, regardless of the market-making model used.
In this article, you can learn more about the fees when listing your token on a CEX.
Capital Efficiency Considerations
CEXs typically do not require ventures to provide liquidity for their token as we know it from DEXs. Instead, traders execute transactions against the order book, with market makers playing a pivotal role in maintaining liquidity. Consequently, projects listing their tokens on CEXs don’t face the liquidity requirements they do on DEXs.
Early-stage tokenized projects aiming to trade on centralized exchanges often need to engage a market maker to handle liquidity. There's a common misconception that these projects will naturally possess sufficient organic liquidity to sustain healthy market trading. However, as per Jelle Buth of Enflux, projects typically don't outgrow the need for a market maker until they achieve a trading volume of 1 million USD organically. This benchmark is challenging for most early-stage and mid-cap projects to attain.
Two market-making models:
There are two prevalent models for engaging market makers on centralized exchanges, affecting capital efficiency and liquidity quality.
The first model, known as the retainer model, involves projects paying a monthly fee to market makers for liquidity management. This approach is commonly adopted, especially by emerging projects. Under this model, the project funds trading accounts with both base and quote assets, while the market maker handles liquidity through "trade-only" API keys on the project's account. It's frequently utilized by small- and mid-cap projects and is favored over the "token load option model" due to the control over the quality of liquidity that is provided. This article provides insights into the metrics that define quality liquidity and how it could be measured.
As the project is required to provide both the base and the quote asset, it is important to keep in mind the capital required for market making. Different exchanges have varying liquidity requirements; for instance, Binance necessitates more liquidity compared to Tier 3 exchanges. MEXC, for example, requires projects to provide at least $30,000 worth of USDT and $30,000 worth of tokens for market-making purposes.
In the "token loan option model”, the project lends tokens to the market maker, enabling liquidity provision. However, the market maker retains the right to repurchase these tokens at a prearranged price when the agreement concludes. In this setup, the project is solely responsible for providing the base asset, while the market maker supplies the quote asset. Despite its initial appeal, this model may harbor significant drawbacks for the project. For instance, potential issues may arise, including diminished liquidity quality and the possibility that, owing to the agreement's terms, the market maker acquires a substantial portion of the token supply at a lower price. More on this can be found in the article here.
Conclusion
Both options, listing on a DEX or CEX, hold distinct popularity within the space, yet they diverge significantly in their advantages and drawbacks. A DEX listing embodies the essence of Web3 technology with its complete permissionless nature, but it demands substantial capital. Establishing a liquidity pool involves expenses not only in the native token but also in ETH or often a stablecoin, shaping the trading pair. While a larger liquidity pool ensures smoother trading with lower slippage, the returns from providing liquidity tend to be modest compared to the broader market. Moreover, this capital could potentially yield higher ROIC if directed toward research and development activities - as it would be typical for a startup.
On the other hand, a CEX listing necessitates greater legal compliance but holds financial allure. Despite the listing fee varying based on the exchange's size and reputation, the order-book mechanism drastically reduces liquidity requirements as market makers handle these needs. In essence, while a DEX listing demands a one-time liquidity investment, a CEX listing entails a listing fee and subsequent payments for market-making services. Depending on the exchange, a CEX listing might be more cost-effective than a DEX listing when factoring in liquidity demands, allowing the project to allocate more capital towards opportunities promising higher ROIC.
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