The Case of Decentralized Exchanges: How is the Financial World Shaping Up?

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Coinmonks

5 min readJan 30, 2022

I remember when I was just an office boy walking the streets of Copacabana and downtown Rio de Janeiro in the scorching heat, wandering from bank to bank to pay a handful of bills. That was about 27 years ago.

The hyperinflation that hit Brazilians in the 1980s through the early 1990s motivated financial institutions to invest heavily in technology in response to the crazy dynamics of Brazilian monetary politics. Due to rampant inflation, money in “transit” or “stopped” a single day everywhere else would mean less value when it reached its destination.

Despite innovations in the financial services industry, I still had to face long bank lines to pay the company bills. And as I waited for my turn in line, few people were willing to use the ATMs. The reasons seemed so obvious:

ATMs were restricted to a few services, making it only proper up to a point;
People didn’t trust it;
And didn’t have the slightest idea how to operate that thingamajig either.

The ATM panic had been embodied in our culture. But by the end of the 1990s, ATMs had already reached a significant acceptance, they were more functional and secure, and almost everyone used them. Nowadays, these machines are in the palm of our hands. But that’s another story.

The case of ATMs demonstrates the fine line between innovation and the necessary adaptation until a new product, concept, or technology is widely accepted. And this is the case for decentralized exchanges and the future finance world.

Distinguishing Centralized and Decentralized Exchanges

A centralized exchange, also known as CEX, is characterized by the need for the customer to register before carrying out transactions. There is usually a process known as KYC (Know Your Customer), in which the customer must prove the information provided by submitting official documents. After this process, the user must deposit some money, generally through a bank account or debit/credit card, and start trading on the platform.

Transactions through centralized markets are not carried out on the blockchain but through an order book (a list of buy and sell orders) provided by the platform. This way, when you buy or sell an asset, this information is stored in a central brokerage database that must own the underlying asset.

And the moment you need to withdraw your funds to another wallet on the blockchain, the exchange will handle the transaction for you. It is the same as withdrawing money from one bank account to another. You do not do this directly, and the information is first passed to the bank responsible for the transfer.

Binance, Coinbase, FTX, Kraken, Kucoin, Huobi Global, Gate.io, Bitfinex, Gemini, Crypto.com, and Bitstamp are some of the most well-known centralized exchanges.

DEXs, or Decentralized Exchanges, on the other hand, allow users to exchange cryptocurrencies directly with each other without the need for intermediaries, as on centralized platforms. In this modality, there is also no KYC system. Uniswap, PancakeSwap, and dYdX are the Top 3 DEXs by market capitalization, according to CoinMarketCap at the time of writing.

Although some “decentralized” exchanges provide an order book, they are unnecessary. To transact through DEXs, you must have a cryptocurrency wallet like Metamask, Coinbase, Exodus, etc., to keep your assets in custody.

And once you have your assets stored in custody, the next step is to connect the wallet to a DEX and start trading peer to peer without relying on intermediaries. The last process is done algorithmically by Automated Market Makers (AMMs).

The Role of Automated Market Makers

AMMs are how bonding curves have become known in the cryptocurrency market. Bonding curves are mathematical equations that connect two variables. By linking the price of an asset to its supply, the bonding curve makes these variables dependent. And the token’s value alters “automatically” depending on the supply.

To summarize, bonding curves or automated market makers are equations encoded in smart contracts that allow cryptocurrency trading without relying on an order book, as in a centralized exchange.

However, for this engineering to work correctly, it is necessary to create a liquidity pool. Briefly explaining, liquidity pools are reserves of two or more tokens. And to start with a pool, decentralized exchanges offer incentives to participants who provide liquidity by depositing tokens into the pool. Thus, with each trade carried out, depositors, better known as liquidity providers, are rewarded with tokens according to the percentage provided to the pool.

The detailed explanation of how this mechanism works is beyond the scope of this text. Still, if you are interested and would like to delve a little deeper, I recommend this article: Understanding Automated Market-Makers, Part 1: Price Impact.

How is the Financial World Shaping Up?

Decentralized exchanges offer lenders or borrowers opportunities and are already a reality for those who want to earn a passive income. Fundraising, lottery, and curatorial initiatives are abundant in this decentralized world.

However, there are still issues to be addressed in order to make these services even more accessible. And they fit into what I call the ATM panic:

Decentralized organizations still lack many service offerings. The current portfolios are not satisfactory when compared to competing centralized services;
Security and accessibility issues scare away many potential customers;
And it is a market primarily restricted to the cryptocurrency universe, where it all started.

But don’t be fooled or get distracted. I really cannot remember the last day when I stood in a bank line to pay a bill.

Centralizing entities will not suddenly disappear. And although this might happen with some of them, I fairly believe most will become hybrid institutions based on CeFi and DeFi governance models.

In contrast, the emerging decentralized organizations already provide what the old ones have failed to deliver: freedom of choice, transparency, empowerment, autonomy, and respect. All encoded in smart contracts, the modeling clay of the new financial system.

If you’ve made it this far and liked it, don’t forget to follow me to get updates on new stories. Thank you!

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Twitter: GandaraMarcio

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The Case of Decentralized Exchanges: How is the Financial World Shaping Up?

Distinguishing Centralized and Decentralized Exchanges

The Role of Automated Market Makers

How is the Financial World Shaping Up?

Twitter: GandaraMarcio

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Written by Marcio Gandara