Trading is making up a vital part within today’s crypto asset markets. Newly established players like Coinbase, Binance or FTX are showing an immense growth. At the same time, the numbers of fintech companies like Robinhood that also offer crypto trading speak volumes and point to area’s explosiveness.
Crypto trading is a success and hugely profitable. However, the blockchain world has been criticized for carrying the torch of disintermediation and decentralization, while simultaneously giving rise to new centralized super companies in the form of crypto exchanges. After all, their existence runs counter to Bitcoin’s actual ethos and the importance they have within the space is somewhat comical.
As a matter of fact, today’s crypto exchange fall prey to the same risk any centralized systems inherently have: They represent honeypots and counterparty risk. Centralized databases storing users’ identification details and passwords are susceptible cyber-attacks. Also, as reality shows, most of the popular crypto exchanges keep running into server downtime issues – especially during volatile time when access to trading facilities is most needed.
The more crypto and blockchain took hold, the greater the desire for decentralized trading grew. Early attempts included the creation of decentralized order books on the blockchain directly. Although ambitious, these projects never really took off due to the blockchain’s inherent scaling limitations on its base layer. No meaningful competitors to centralized exchanges managed to emerge.
All of a sudden this changed with the advent of Uniswap. For the first time, Uniswap’s innovation provided an efficient and user-friendly way to swap tokens in a decentralized manner. To this day, Uniswap remains the biggest decentralized exchange. At times its volume even surpassed that of Coinbase. While Uniswap keeps on innovating and is already on its third protocol version, a host of other decentralized exchanges – so called DEXs – have launched. Additionally, there are already DEX aggregators and cross-chain liquidity protocols. These projects pool liquidity from different decentralized exchanges, even across different public blockchains.
But why did decentralized exchanges take off seemingly over night? The innovation was to have found a way around the order book model. A DEX like Uniswap works on a so-called “automated market maker” (AMM) protocol. Instead of operating a centralized market makers as traditional exchanges do, decentralized exchanges do not use an intermediary entity to clear transactions but rely on self-executing smart contracts to facilitate trading.
So ultimately, AMMs consist of smart contracts holding liquidity in what is referred to as a liquidity pool. The liquidity is provided by liquidity providers. Since decentralized exchanges exist on the blockchain and can be accessed anywhere and anytime, every user can become a liquidity provider, thereby earning liquidity provision fees.
In this regard, decentralized exchanges do pretty much operate in the true spirit of blockchain technology. They enable peer-to-peer trading by using automated smart contracts to execute trades within liquidity but without the use of any intermediary. The trading activity happens on the blockchain itself, with sellers interacting with buyers directly.
The beauty of a DEX is the fact that trading infrastructure is run by the users itself. The need of a central authority is done away with. The users themselves can decide on what assets can be traded and when. This has the potential to make the trading of assets possible that would traditionally not make it onto any trading platform. Also, the revenues that are generated through trading are given back to users as they can either be liquidity providers themselves or have a stake in the protocol through a revenue-sharing token. And security might also be enhanced. By integrating with hardware wallets, users can safely store their crypto assets in cold storage while conveniently trading them on preferred DEX when needed.
A liquidity pool on a DEX usually holds a trading pair of two assets. They are held in accordance with a pool’s token ratio. If the prices of either asset within a pool deviates from prices on outside exchanges, traders step in to arbitrage the price difference. So, if the prices of the tokens in a pool develop in different directions, the better performing asset will get drained from the pool. Therefore, the pool and its liquidity providers are left with more of the underperforming asset. This situation is commonly referred to as impermanent loss that liquidity providers can be experiencing. If the asset’s price does not bounce back, the loss will come permanent. If liquidity provision fees don’t compensate for this, a liquidity provider would have been better off not providing any liquidity. A pool with stablecoins and stable exchange rates mitigates this risk. Also there are new ideas on how to eliminate impermanent loss altogether.
Liquidity mining is an activity that has been popularized through DEXs. Through it a liquidity pool attracts liquidity by not only providing liquidity provision fees but extra rewards in the form of an additional token to liquidity provider. For users, these additional tokens boost their return on investing, depending on the value of the tokens received. For platforms, opting for liquidity mining can be a way to gain initial liquidity and trading activity around its token, thereby potentially bootstrapping the project itself.
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