What is A Decentralized Exchange?
There are some risks as well as rewards to using an emerging technology commonly referred to as a “DEX”. Neither this post nor any other on cryptofal.com should be taken as financial advice. It is not.
The technology behind cryptocurrencies has many benefits and even shakes up the traditional financial sector. You have projects that allow you to be able to lend, borrow, and provide liquidity with the ability to make a passive income. Decentralized exchanges are one of the most popular applications being built on top of platforms like Ethereum. Most notably, Uniswap had a lot of success last year when people started looking for Defi alternatives.
Using smart contracts these applications can operate without using the traditional order book system that the NYSE uses. DEXs use liquidity pools to facilitate trades. If someone has an abundance of cryptocurrency they can put it in the pool and if someone is looking to buy the smart contract executes the trade. The liquidity pool is just a pot of paired currencies that can be exchanged or swapped between each other.
The added benefit of using this system is that you receive Liquidity provider tokens (LP) when you pledge your assets to the pool. When someone initiates a swap on the platform there is a fee involved and that goes to those who have pledged assets to the pool. The amount you will make varies depending on how much volume the pool you pledged your assets has. If there is more volume, there are more rewards. If there’s less volume, there are fewer rewards. If you are using Uniswap the LP reward is paid in the UNI token.
As with any type of new technology (and investing in general), there are always risks involved. The biggest issue plaguing Defi is hacks and rug pulls that have caused victims to lose a significant amount of money. Aside from the human scamming element, there is also impermanent loss which has hurt the value of Uniswap amongst other issues. This occurs when the price of one token in the pool changes significantly compared to the other. Once the liquidity provider removes what they have from the pool, the total can be lower than what they originally pledged. If the LP does decide to leave the asset in the pool, there is always the chance that the value does come back to a break-even point, but that is not a guarantee.
While there are risks that can be avoided by using a traditional system, there is no doubt that there is potential in this technology. It takes out the need for a middleman in executing trades. Utilizing blockchain and smart contracts makes it a direct peer-2-peer application. The blockchain also improves efficiency and associated fees to an extent. There are no credit checks or limitations on what you can do with your money as long as you have the collateral to back what you are doing. It also gives you the ability to earn a passive income on your pledged assets. It will be interesting to see where Defi goes in a few years as the tech continues to grow.
