Decentralised exchanges powering the crypto-economy
While the majority of cryptocurrency exchange (92%) takes place on centralised exchanges such as Binance, Coinbase, and OKX, the remaining volume is exchanged on decentralised exchanges (DEX) that leverage the power of blockchain and smart contracts in their true sense.
As an informed investor, it is important to understand the difference between the 2 types of exchanges. 💡
How do traditional exchanges work?
Traditional exchanges (like NASDAQ) help buyers/sellers exchange value through market makers. Market makers (like BNP Paribas, Morgan Stanley) provide healthy liquidity on the exchange (in the form of an order book) to buy/sell stocks. Say you want to sell 1 Apple stock — you can simply go to a broker (like Robinhood) where market makers can buy it at a fair price. Without these market makers, there wouldn’t be enough stock liquidity on the exchange.
The market makers make money on the spread between their buy and sell orders. 💵
Why decentralised exchanges matter and how do they work?
Now the whole point of decentralisation is to remove middlemen (like banks, brokers, and market makers). Enter decentralised exchanges i.e DEXs.
There are 2 types of DEXs, depending on whether they maintain an order book or not (swap type DEX). For simplicity, let’s look at how the Swap type DEXs (like Uniswap, SushiSwap) work. DEXs allow crypto traders to exchange value through Automated Market Making (AMM) algorithms. Uniswap in particular works on the basis of the Constant Product Market Maker model (quite a mouthful), where the product of the assets in a liquidity pool remains fixed (X*Y = K, X and Y being the assets, K being the constant).
Here’s an example to simplify:
- Say I want to exchange 1 $ETH for $USDC (stablecoin), which would require us to tap into the ETH↔USDC liquidity pool on Uniswap
- Pre-transaction: Let’s assume that there are 10 ETH and 30,000 USDC in this liquidity pool. K (the constant in the AMM model) here would be 10*30,000 = 300,000
- Post-transaction: Now a sale of 1 $ETH requires balancing the USDC in the pool to satisfy 9*Y = 300,000. Solving for Y, we get Y = 33,333
- Now comparing the pre and post-transaction models, I need to add 3,333 USDC to the pool, in order to take out 1 $ETH
- Hence, the price of ETH is automatically determined (3,333 USDC) — hence the automated market-making model
Liquidity on these exchanges is provided by individuals/institutions called Liquidity providers (LPs), who earn a transaction fee for the price risk they undertake.
This way, we only need DEX, liquidity providers, and traders to exchange crypto (w/o involving other parties). This will make the trading process faster, cheaper, and safer. Isn’t it great! 👏
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