Understanding the Technology at the Heart of Decentralized Exchanges

A closer look at liquidity pools, automated market makers, yield farming, and other DEX-related topics. This is the third installment of a three-part series on understanding DeFi.

Financial advisors are well-versed in traditional finance and how the industry operates. Registered investment advice businesses are clients of custodians such as Fidelity, Schwab, and IBRK, which have links with exchanges such as the NYSE and Nasdaq.

Individual securities trade on exchanges, and securities portfolios are held by custodians. Clients of firms have log-in access to custodian platforms, and advisers can manage those assets through the custodian. For decades, this has been the way of the traditional banking system.

Decentralized finance (DeFi), on the other hand, is quite different. It is critical that advisers grasp this new system so that they can explain it to customers and provide recommendations on crypto assets.

Decentralized exchanges, or DEXs for short, are at the heart of DeFi. (In the second installment of our ongoing series on understanding DeFi, I talked about the relevance of DEXs in last week's email.) DEXs make it easier for users all around the world to trade digital assets.

Unlike centralized exchanges such as the NYSE, DEXs do not employ the order book system, which has been in use for decades and, to be honest, still works fairly well today. DEXs do not employ the time-tested order book mechanism because it requires a centralized team of personnel and technology to operate. DEXs, on the other hand, use smart contracts to facilitate trading. A liquidity pool is the smart contract that oversees trade on a DEX.

What precisely is a liquidity pool?

A liquidity pool is basically a collection of locked assets regulated by a smart contract (or a piece of software code) that the DEX uses to trade – or "swap" – crypto assets. The paired assets in liquidity pools are crowdsourced, which means they are not promised by a single individual or entity. Liquidity pools are created by contributions from the crypto community, in keeping with the decentralized and grassroots nature of crypto. Liquidity pools can be thought of as a large pot of coupled assets that supports currency swaps.

What exactly are automated market makers (AMMs)?

Liquidity pools are managed by automated market makers, or AMMs, which are pieces of software that govern and automate the process of swapping assets and providing liquidity, allowing digital assets to be exchanged on a DEX via the liquidity pool. Users on platforms employing AMMs do not trade with another counterparty (as in the classic order book system), but rather against a pool of paired assets.

To comprehend AMMs, one must first comprehend the mathematical formula at the heart of the AMM:

X * Y = k.

The AMM formula was suggested by Ethereum co-founder Vitalik Buterin in a blog post, and AMM protocols were established shortly after. In the formula, X stands for Token A, Y stands for Token B, and k stands for a constant balance between the two tokens.

If the price of X rises, the price of Y falls, and therefore the constant, k, remains constant in a liquidity pool of two paired assets. The entire pool volume increases only when additional assets are pledged to the liquidity pool. This formula manages the liquidity pool and ensures that the token prices are in balance. Purchasing Token A raises the price of Token A, whereas selling Token A lowers the price of Token A. Token B in the liquidity pool will experience the inverse effect.

The arbitrage function is another aspect of AMMs. These smart contracts can compare the prices of paired assets in their own pools to those in the DeFi ecosystem as a whole. If the price changes too much, the AMM will incentivize traders to take advantage of the mispricing in both the native liquidity and the outside pools, and with this incentive, the native AMM will re-establish equilibrium.

Understanding Farming Yield

AMMs not only attract traders to arbitrage cross-pool prices, but the liquidity pools themselves incentivize members to pledge assets to the pools. Yield farming is a popular approach to make money in the crypto ecosystem, and it provides token holders with an appealing option to create a return other than price appreciation.

When a person pledges paired assets into the liquidity pool, he starts generating tokenized rewards. When a user wants to trade assets through a pool, the pool charges the user a nominal fee to effectuate the switch. This charge is subsequently distributed to those who have pledged their assets to the pool. This charge is frequently paid in the form of a liquidity provider (LP) token.

A user, for example, might pledge assets to a liquidity pool on a decentralized exchange like PancakeSwap. The pledger will get a yield on his pledged asset based on the AMM, and in exchange for providing liquidity, the user will be compensated in CAKE, PancakeSwap's native LP currency. The user can then exchange his LP token for any other token.

What to watch out for

When it comes to produce farming, caution is essential. Individuals are typically incentivized to contribute to new asset pairs with very limited liquidity by promising a very high yield. Because these pairs and pools are frequently new, users are at a higher risk of becoming a victim of fraud or theft. The majority of the new pools offer an appealing opportunity for malevolent actors to engage in an exit fraud known as a "rug pull." This is a fraud in which project creators gather community tokens and then exit the project without repaying the tokens.

Another type of risk is temporary loss, which occurs primarily during periods of extreme volatility, which is prevalent in cryptocurrencies. When the price of one token in a pool fluctuates dramatically relative to the price of the other token and liquidity providers opt to withdraw assets from the pool, individuals who have committed assets may have less than their original commitment. If the liquidity provider decides to keep the assets in the pool, given enough time and a decrease in volatility, the liquidity value may revert to break-even.

Getting to know a new system

So, how can an advisor manage this totally new system of asset swapping, decentralization, and yield farming, as well as the hazards that come with it? It is critical to understand that the existing banking system is not going away anytime soon. The blockchain technology that drives DeFi, on the other hand, is immensely appealing to both customers and providers in the finance business.

Advisors must understand how this technology works and be ready to see the DeFi sector expand in the next years. The cost and efficiency gains are appealing to consumers and will improve the user experience for our clients.

** Information on these pages contains forward-looking statements that involve risks and uncertainties. Markets and instruments profiled on this page are for informational purposes only and should not in any way come across as a recommendation to buy or sell in these assets. You should do your own thorough research before making any investment decisions. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility. The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of USA GAG nor its advertisers. The author will not be held responsible for information that is found at the end of links posted on this page.

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