Why decentralized exchanges are important in the crypto economy
In 2012, being an avid economics student, I decided I wanted to invest some of the money I had in bitcoin (BTC). decentralized exchange script It was a complicated process that involved driving to Walmart (WMT) and sending a MoneyGram money order to a company called ZipZap, who would then send my money to a company called BitInstant. After a few weeks, BitInstant deposited my bitcoin in my wallet at the Japanese exchange Mt. Gox. The entire process took more than three weeks, and I always wondered how this innovative digital currency could possibly replace its competition if it required such a long process.
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 it significantly easier to purchase cryptocurrencies.
These centralized exchanges seemed to work perfectly, until they stopped doing so. Mt. Gox was attacked in 2014 and more than 850,000 bitcoins were stolen. Bitstamp was hacked in 2015, BTC-e closed in 2017, and the infamous QuadrigaCX was hacked by its owner and CEO in 2018, finally closing in 2019 having lost all of its customers’ cryptocurrencies.
Not all centralized exchanges have had problems. There are many that are currently in business and have had years of successful business operations and many happy customers. However, these companies have their own downsides. They are required to obey the know-your-consumer (KYC) regulations of the country in which they reside, have limits on the size of the order book and require the user to trust the creditworthiness of the business, something which is often seen as negative by native crypto users.
A combination of these issues, coupled with the development of smart contracts , ultimately led to an elegant solution: an exchange built entirely in crypto, requiring no trust, and decentralized: a decentralized exchange.
DEX Benefits
DEXs are very complex smart contracts, but they have simple goals: to provide liquidity to anyone who wants to trade cryptocurrencies. The most popular DEX is Uniswap, Uniswap clone which is built entirely on top of the Ethereum blockchain . Uniswap provides a decentralized trading platform for any crypto user who wants to trade Ethereum-based tokens .
DEXs have some significant benefits compared to centralized exchanges. They do not require KYC and operate 24/7. They also provide investors with yield farming opportunities, which are opportunities to help facilitate decentralized trading 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 rather than trust a centralized company to be creditworthy.
However, DEXs have some drawbacks. The transactions are irrevocable, they only allow trading with a single asset on the chain — Uniswap is only on Ethereum, for example — and there is the risk of fraud and impermanent risk.
How DEXs work
Unlike centralized exchanges (both in cryptocurrency and traditional finance, or TradFi) that use order books, a system that has worked well for more than two centuries, DEXs use two innovations to provide services to their users: pools of liquidity and automated services of market makers (or market makers).
Essentially, DEXs provide liquidity — pools of matched assets — that traders can use to trade one token for another. Liquidity pools are smart contracts that traders use to move in and out of certain tokens based on their goals. Automated market maker services are complex smart contracts within liquidity pools that control the price of certain trading pairs in liquidity pools and increase or decrease the price based on supply and demand in the market.
The smart contract that governs the liquidity pools is based on a specific formula to determine the price of each token. Both X and Y are represented by tokens, and k represents the constant. This formula essentially governs the liquidity pool.
Liquidity pools not only offer traders access to decentralized liquidity, but also offer investment opportunities to those who wish to stake assets in the liquidity pool. When a user trades assets through a liquidity pool, a very small commission is paid to the people who provide the liquidity.
Uniswap clone script To put it 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 it offers income opportunities to those who understand the concept.
In the fourth quarter of 2021, for example, Uniswap processed $238.4 billion in trade, an increase of 61% compared to the third quarter. A total of $681.1 billion was traded through Uniswap’s liquidity pools in 2021.
Conclusions
The main takeaway is that DEXs offer the same services as centralized exchanges, but 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.
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