An easy intro to decentralized exchanges (DEXs), using Curve Finance as a case study
An unhealthy habit in the crypto space is the use of jargon and abbreviations to show how smart we are. It can get so bad that other people in the conversation feel obliged to pretend that they know what this babble means, which creates a vicious cycle.
This article is the first in a series of pieces from staff at BR Capital that are designed to demystify key topics, so that we can all stop pretending and really start communicating. After all, the underlying facts about crypto are so amazing that they need no embellishment.
Why are exchanges important?
Without exchanges, crypto would have died long ago. Exchanges are critical because they allow people to swap one token for another in order to achieve different end results with their wealth. One person might want to put their wealth in Bitcoin as a store of value, while another might want to convert to Ether for use in services that are regulated by smart contracts, and yet another might want TON Crystals for easy sending of micro-transactions through Telegram.
Plus, let’s not forget one of the most popular swaps of all: from an unstable asset like BTC to a stablecoin tied to a relatively stable asset like the dollar, or equally from one type of stablecoin to another, such as from DAI to USDT (both of which are tied to the dollar, but in different ways). This particular use case underpins the Curve Finance exchange, which specializes in stablecoins and as a result is riding a wave of popularity, not least because so many new stablecoins are getting launched (FEI, STABLEx, FRAX etc.).
(Disclaimer: Just so you know, BR Capital has a stake in many different DEXs and we’re not here to try to sell you Curve.fi. It’s simply a good case study, and we’ll list a whole bunch of Curve-like rivals at the end of this article.)
What is a decentralized exchange (DEX)?
The word “decentralized” is bandied about too easily, such that it is more practical to view it as a continuum rather than some theoretical ideal. Nevertheless, Curve Finance provides a relatively good example of a true DEX and one of the leaders of the Decentralized Finance (DeFi) movement.
Why? Because there is no human authority overseeing trading on Curve. There is no one to vet users and no one to oversee, hold, delay, lose or confiscate their funds. Instead, the whole things runs on three sets of decentralized components, which we’ll go through one by one:
Liquidity Pools (LPs)
These are war chests of ready-to-use wealth, in each of the supported tokens. These pools are the war chest that allows Curve to operate, as we’ll see in a moment. The wealth in the pools is staked by supporters of the DEX in return for yield. None of these stakers actually need to send their wealth to the DEX, because Curve is non-custodial. Stakers just need to connect their wallets and agree to lock in a certain amount of money, which is enforced by an irreversible smart contract. In return, Curve offers them around 10–15% of annual percentage yield (APY), or more if they double-down on supporting the platform (which we’ll get to in a bit).
The total amount staked in all pools is called the total value locked (TVL) and is a sign of a DEX’s popularity. Curve recently hit a TVL of over $4bn, making it significantly larger than the next biggest DEX, UniSwap.
Algorithmic Market Making (AMM)
DEXs can be simple peer-to-peer platforms, which means they connect buyers to sellers and allow the trading to commence at its own pace. The downside of this is that if there’s no one interested in buying your coins at the moment, then you can’t trade.
Curve Finance is different. Like Uniswap, it uses algorithmic market-making (AMM) to ensure that a trade can always be done, at a price determined not by a human counterparty but by some complicated maths. If the human user accepts the algorithms price, then the algorithm will use the liquidity pool to fund the transaction.
A Decentralized Autonomous Organisation (DAO) Token
Curve Finance constitutes a decentralized organization (DAO), not only thanks to its automatic way of working, but also thanks to the fact that it allows its users to vote on proposals to direct the future of the exchange. This is called decentralized governance.
For a DAO to work properly, it needs a token of its own, otherwise there is no way to recognize the different contributions of its supporters and thus allocate their different rewards or voting rights.
Curve’s DAO primary token is the CRV, which is paid out to liquidity providers in proportion to how much they wealth (and in what coin) they lock in. CRV tokens can be used in a number of different ways, all of which provide value to the holder. The tokens can be sold for other currencies (1 CRV = $3.47, for example), or they can be staked back into the system in order to gain voting rights and a share of trading fees, thereby boosting the yield that the liquidity provider will receive.
By doubling-down and locking their CRV tokens back into the system, APYs for Curve Finance users can get into the hundreds. This is particularly likely if the DEX has a good utilization ratio, which means it has a lot of trading activity relative to the amount of liquidity locked.
Competitor DEXs
Okay, we’ve covered the key concepts and terms for understanding a DEX like Curve. But one of the main uses of this understanding is to allow us to compare DEXs and find out which one we want to use (if any).
Curve Finance is akin to an old-school foreign exchange (forex) leader — a place people go to because it’s so well-established that they don’t feel any need to shop around. Nevertheless, competition is hotting up in this space, so there are plenty of comparisons to be made.
For example, Shell Protocol is another AMM-drive stablecoin swapping platform, which hit a 375% utilization ratio during February, implying very high fees to be paid back to its supporters. And then there are cross-chain liquidity protocols coming from the Cosmos and Polkadot ecosystems, which — unlike Curve — enable the swapping of non-Ethereum based coins.
In the end of course, there will be more than one winner in the battle of the DEXs, as there’ll be room for DEXs with different specialities. But the biggest victory will belong to the user, who will get to play the role of banker in a decentralized system that is far more efficient than any traditional bank and which will therefore pay out much greater rewards.
