Why DeFi is the future of exchanges and trading | The Radix Blog | Radix DLT

What is an exchange, and how do they work?

Exchanges work on one simple premise: bring buyers and sellers together, so that their buys and sells are efficiently matched. Doing this well results in more transparent pricing and a quicker time to find a counterparty to trade with than without an exchange. It also results in efficient discovery of a market price for whatever assets are being traded.

How do Decentralized Exchanges work?

Like traditional exchanges, DEXs allow groups of buyers and sellers to exchange assets more efficiently. The key difference is that in the case of a DEX, there are no intermediaries — all transactions are executed peer-to-peer through smart contracts defined on public decentralized ledgers.

How does a CFMM work?

Let’s walk through an example transaction below — a user exchanging Token A for Token B.

Where do the pools get their liquidity?

The Token A and Token B pools receive their liquidity from users who contribute tokens through a different type of transaction.

But why provide liquidity?

Typically, whenever a trade occurs, the CFMM charges a small fee — such as 0.05%, 0.3%, or 1% of the assets, depending on the CFMM. These fees accrue directly to the pools, and so as trades take place, the LP token represents a claim on a larger pool of underlying tokens. Liquidity Providers are therefore rewarded for providing liquidity as they earn fees over time proportional to the amount of liquidity they provided.

Why CFMMs are a game changer

So what’s so special about having a smart contract (effectively a machine) that incentivizes people to provide it with liquidity and allows anyone to trade with it?

24/7 global composable markets

The first thing is that CFMMs operate 24/7 and can be accessed by anyone around the world. Because this is a smart contract that lives on a global decentralized public ledger, you don’t need an exchange to be open, and you don’t need people submitting orders. Exchanges in traditional finance are typically only open eight hours a day, five days a week, and accessible only after the exchange, or a broker, has given the permission to do so.

Instantaneous and permissionless settlement

Second, there is no separation between trade and settlement — it all happens instantly without the need to trust any third party — eliminating counterparty risk and allowing for capital to be used much more quickly and efficiently. By comparison, in traditional finance, trading and settlement are two separate processes undertaken by separate sets of intermediaries, with each bringing some level of counterparty risk. The processing required to complete a transaction often takes two or more days.

Access and choice

Third, a CFMM exchange makes it possible to create a market for anything — so long as it can be tokenized — for just the cost of a transaction. In traditional finance, the exchanges and other financial institutions act as gatekeepers, limiting the types of assets that can be traded on an exchange. It only makes sense to include assets on a traditional exchange that justify the significant costs of running it.

Guaranteed liquidity

Last, CFMMs provide guaranteed liquidity at all price points. This is possible because the constant function tends towards infinity as the relative price between assets becomes more extreme. The price may change dramatically at the extremes, but there will always be liquidity for the trade.

Concluding Thoughts

DEXs are a real innovation. They allow for anyone, no matter where they are, to be able to trade any tokenized asset instantly without needing to trust anyone else. That’s a game changer.

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