Over the last few days I have taken a dive into Decentralized Finance, or DeFi. DeFi is the blockchain communities effort to invade the financial world. While Bitcoin has chipped away at gold as a store of value, DeFi could flip the financial world. DeFi has Decentralized Exchanges (DEXs), which allow the private and efficient exchange of crypto. In this piece you’ll learn about the importance DEXs, and how they will to revolutionize the exchange of crypto and soon enough, everything.
Decentralized Exchanges Explained
To complete a transaction, there are three essential elements; a buyer, a seller, and a place for them to meet. Have you ever looked for something specific, but couldn’t find where you could get it? You know you’d buy it at or above market price, but can’t figure out where it is. In the early 2000s eBay & Amazon did their best to solve this problem. In finance an exchange serves the purpose of a marketplace; a place where buyers and sellers can easily find each other.
Currently, if a you want to sell a cryptocurrency you must move it to an exchange. Once on an exchange currencies are free to swap for one another. Exchanges are generally centralized, which creates a single point of failure. This makes the tokens more liable to be hacked, like Mt. Gox in 2011. When you put crypto on an exchange you relinquish control of that crypto. Today exchanges are more professional than in the early days of crypto; but it is important to know the associated risks. Centralized also charge fees for each transaction, much like a traditional stock broker.
DEXs allow for permission-less peer to peer transactions. This is a paradigm shift in crypto, because it eliminates the need for exchanges. With a Web3 wallet like MetaMask, you can swap currencies with minimal fees from the comfort of your own cold storage. THIS IS NUTS! You can keep control over your crypto and still have access to swap capabilities.
The best analogy that comes to mind is Amazon. Both DEX’s and Amazon connect Buyers and Sellers and allow both to do their business from their chosen location. But better than Amazon, a DEX doesn’t need any personal information. To me this is peak internet. There is no negotiation, an algorithm decides that moments fair price. There is no contact, you have no idea who is selling to you.
Uniswap is the most well known decentralized exchange protocol. It automates transactions on the Ethereum Blockchain with smart contracts. Any ERC-20 token (Uses the Ethereum Blockchain) can use the Uniswap protocol to swap between other applicable tokens.
Traditional exchanges work using an order-book mechanism. An order-book lists the orders to record the interest of buyers and sellers in a market. To fill an order, a buyer and seller must agree on a price.
Uniswap offers swap pairs for ERC-20 tokens that are backed by $ETH (the native currency of the Ethereum Network). Let’s imagine we create a project that has something to do with Home education and we decide to call its token $LRN. Any token that you want to swap must have some level of liquidity, which is why Uniswap requires$ETH to back all tokens. To create a token you must provide both an equal amount of $ETH and $LRN.
Instead of using a classic buyers and sellers model (like the order book), Uniswap uses Automated Market Makers. Buyers and sellers never agree on a price; instead the protocol uses a constant equation x * y = k. K is a constant and x, y are the quantity of $ETH and the $LRN. When someone buys the $LRN token the supply of $ETH goes up and the supply of the token goes down, causing a price increase.
This innovation of an Automated Market Maker creates an automated system for the exchange of coins. Liquidity providers (Those who put up the $ETH & $LRN) are incentivized with a small transaction fee of around 0.3% and an additional fee is paid to the Ethereum network. Compared to what an exchange would take for the same swap, this is a wildly low number. Once Ethereum handles the transaction cost on their network, this number could become negligibly small.
DEX’s like Uniswap are an sign of a larger trend towards decentralization. They reduce fees, increase security and are private. They offer a better way to do transactions on the Ethereum Blockchain and show that there is a better way to use crypto networks.
Decentralization will be the “killer feature” of the 2020’s, and will have its moment by the end of the decade. The chaos within existing systems has caused for an over correction within Big Tech. We will see psuedonymous social networks that encourage constructive dialog and hold their users accountable for their words. We’ve seen the first transitions throughout the COVID-19 crisis. 2020 brought a move towards Work from Home and the value of lifestyle over location. The maturing of the internet is allowing us to decouple our location on the planet from our work.
What if we could apply the DEX model to other spaces, like high end dining. Imagine you’ve got it like that and want to have an amazing dinner from Mr. Chow on a Friday Night. A DEX system could determine pricing based on; number of clients, weekday, time, season and menu. Restaurants could fill their dining rooms on weekdays and boost profit on weekends. This would create a better pricing model for restaurants and a better market. While this creates a whole host of other issues (out of scope for this post), it is an interesting lens to connect the real world to the blockchain world.
Overall the crypto ecosystem is the current hotbed for innovation, and DeFi is what seems to be growing the fastest in this space. It’s a space I look forward to learning more about and see potential in over the coming years.