BIn 2012, as an enthusiastic economics undergraduate, I decided that I wanted to invest some of the money I had in bitcoin (BTC). It was a complicated process that involved going to Walmart (WMT) and sending a MoneyGram money order to a company called ZipZap, which would then send my money to a company called BitInstant. After a few weeks, BitInstant was depositing my bitcoin into my wallet on Japanese bitcoin exchange Mt. Gox. The whole process took over three weeks, and I always wondered how this innovative digital currency would ever replace its competition if this was the process.
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Shortly after my first experience with bitcoin, centralized companies such as Coinbase (COIN), QuadrigaCX, and Bitstamp appeared on the scene. These companies had bank accounts, which meant that they were essentially connected to the modern financial system and made buying cryptocurrencies much easier.
These centralized crypto exchanges seemed to work just fine – until they stopped working. Mt. Gox was attacked in 2014 and over 850,000 bitcoins were stolen. Bitstamp was hacked in 2015, BTC-e was shut down in 2017, and the infamous QuadrigaCX was hacked – by its owner and CEO – in 2018 and finally shut down, after losing all customer coins, in 2019 .
All centralized exchanges have had no issues. There are many currently in operation that have had years of successful business operations and many satisfied customers. Centralized exchanges have their own drawbacks, however. They are forced to obey the know-your-consumer (KYC) regulations of the country they reside in, they have limits in terms of order book size, and they require the user to trust the creditworthiness of the company , which is often seen as a negative by native crypto users.
A combination of these issues, along with the development of smart contracts, ultimately led to an elegant solution: an exchange platform built entirely on crypto, completely trustless and decentralized – a decentralized exchange. For part two of this series on decentralized finance (DeFi), we will explore why decentralized exchanges, or DEXs, are so important in the crypto economy.
Read the first part of this series on understanding DeFi.
What are the benefits of DEXs?
DEXs are very complex smart contracts but they serve simple purposes: to provide liquidity to anyone who wants to trade cryptocurrencies. The most popular DEX is Uniswap, which is built entirely on the Ethereum blockchain. Uniswap provides a decentralized trading platform for any crypto user who wants to trade Ethereum-based tokens.
DEXs have a few important advantages over centralized exchanges. They do not require KYC and operate 24/7. They also provide investors with yield farming opportunities, which are opportunities to facilitate the decentralized exchange – or trade – of digital assets in exchange for a small fee. And the smart contract code (Uniswap is written in Solidity) is open and transparent, allowing crypto-natives to simply verify the code instead of trusting a centralized company to be creditworthy.
DEXs do have a few downsides, though. Transactions are irrevocable, they only allow you to trade the asset of a single chain – Uniswap is only on Ethereum, for example – and there is rug pull risk and impermanent risk (subjects that we will discuss in more detail in the next article in this series).
So how do these DEXes work?
Unlike centralized exchanges (both in crypto and traditional finance, or TradFi) that use order books, a system that has worked well for over two centuries, DEXs use two innovations to provide services to their users: liquidity pools and automated market maker services.
Essentially, DEXs provide liquidity — pools of matched assets — that traders can use to swap one token for another. Liquidity pools are smart contracts that traders use to enter and exit certain tokens based on their goals. Automated market maker services are complex smart contracts within the liquidity pool smart contracts that control the price of certain crypto-trading pairs within the liquidity pools and increase or decrease the price based on supply and demand in the market.
The smart contract that governs liquidity pools relies on a specific formula to determine the price of each token. The formula is X * Y = k. X and Y are represented by tokens and k represents the constant. This formula essentially governs the liquidity pool. (We’ll go deeper into liquidity pools and automated market maker systems in my next article.)
Not only do liquidity pools provide traders with access to decentralized liquidity, they also provide investment opportunities for those who wish to invest assets in the liquidity pool. When a user trades assets through a liquidity pool, a very small commission is paid to the people providing the liquidity. To put this in common TradFi terms, those who contribute capital to liquidity pools essentially earn a commission similar to that of a market maker. Liquidity pools, especially new ones, offer very high returns to investors. This concept is called yield farming and provides income opportunities for those who understand the concept.
In Q4 2021, for example, Uniswap processed $238.4 billion in transactions, a 61% increase from Q3. A total of $681.1 billion was traded through Uniswap liquidity pools in 2021.
Take away food
The main takeaway is that DEXs provide all the same services as centralized exchanges, but they do so anonymously and without trust. Technology now allows this to exist outside of any regulated industry and increases access to these financial services for all.
Before the creation of Ethereum, traders were forced to use a centralized system to exchange and trade any asset. Smart contracts have opened the doors to a completely open, trustless financial system that, if used correctly, has the potential to bring economic benefits to all participants.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.