Glossary
Decentralized exchanges
As we know, the financial market has some limitations. Large corporations own and maintain it without transparency and often fearfully. Recent economic and banking crises have shown us that the financial market is far from being as safe as it preaches and that the consequences of its mistakes can be disastrous for the entire population.
The blockchain made possible the emergence of a new type of financial market, the decentralized finance. Such a name is given to applications owned by their users and where they can do financial transactions without intermediaries. The rules are defined by the protocol that controls the application, usually through smart contracts.
Decentralized exchanges (DEX) are blockchain applications that allow users to trade assets without intermediaries, unlike traditional currency swaps that require multiple intermediaries and fees. For instance, exchanging USD for another currency usually involves intermediaries such as banks and payment processors. In contrast, DEXs use an algorithm to enable users to buy and sell tokens efficiently and cost-effectively, without intermediaries.
Blockchain technology has enabled a new type of financial market called decentralized finance, DeFi. Decentralized exchanges are one example of DeFi applications in which users can trade assets represented by tokens without intermediaries. Unlike centralized exchanges, DEX transactions are defined by a protocol, ensuring transparency and eliminating arbitrary brokerage prices. Additionally, DEX applications are owned and governed by their users, either through community ownership or tokens.
Examples of decentralized exchanges are UniSwap on Ethereum, Raydium on Solana, and Flamingo Finance on Neo. Unlike centralized exchanges, DEXs do not usually work with order books but with an algorithm called an automated market maker, AMM for short. Through this algorithm, it is possible to buy and sell tokens at anytime without waiting for a price match.
In decentralized finance, the same token can be traded on multiple exchanges. This opens up a new business opportunity: arbitrage. Assets may be quoted differently on two exchanges, what allows users to buy the asset on the cheaper exchange and resell it on the more expensive one. Such price arbitrage is necessary to maintain a single value for the asset across the entire network, generating profits for whoever performs it. In general, arbitrage is performed by pre-programmed bots.
Another advantage of decentralized exchanges is that the custody of the assets remains in the hands of its holder, in contrast with centralized exchanges, which maintain control of the asset on behalf of their clients. This makes the system more secure because transactions are transparent, and assets are managed by a code, not by people. Being a peer-to-peer system, fees are also usually lower, as it does not involve third parties.
It is important to note that while DeFi presents new opportunities for financial transactions, it is not immune to problems. Market volatility, lack of regulation, and potential for fraudulent activities are among the challenges that DeFi faces. Nevertheless, the emergence of DeFi marks a significant milestone in the evolution of the financial market and could be a step towards a more transparent and democratic financial system.
