Understanding How To Properly Use DEXs in DeFi To Gain An Edge
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Understanding How To Properly Use DEXs in DeFi To Gain An Edge
DeFi Slate Fam:
I’ve been trading on decentralized exchanges (DEXs) on Ethereum since 2020 and honestly have maybe done 10 trades on Coinbase, Binance, or Gemini since summer 2020.
But my metamask nonce (# of tx’s) is well over 1000 across multiple accounts.
Yea imma degen for sure.
But, we have been crushing it this bull market trading on decentralized exchanges and we will absolutely keep doing so.
Gas fees aren’t a problem using SushiSwap on Polygon.
No KYC needed.
Listen, DEXs are without a doubt the future of trading. We’re getting you in early, educating you so you can be empowered to use this tech…
…and then enrich yourself!
BTW, the DeFi Slate DAO is absolutely rocking from the ground floor up as we speak and we are busting out what is needed for it to be a powerhouse.
More coming on this, big stuff happening in our DeFi Degens community this week (mostly new farms, community call, hype gains, and exciting convo about building out your bull market strategy).
Chat soon, enjoy this one.
- Andy
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Understanding How To Properly Use DEXs in DeFi To Gain An Edge
Guest Post by DeFi Slate DAO Contributor Master Roshi
Decentralized exchanges, or DEXs, are a fundamental and crucial part of building a new paradigm of open finance. DEXs allow users to trade assets in a peer to peer manner, all while never giving up custody of their assets. This makes it much more difficult for an authority figure to censor or exercise control over trade than it is with centralized exchanges previously. This makes DEXs much more aligned with the ethos of the crypto movement, as well as a much more efficient process as we will see.
The Fallen Soldier: Ether Delta (The Order Book Model)
In searching for a place to start to best explain DEXs and what currently makes them so great, I thought it would be good to start with the original DEX to give context on what changes have been made to allow them to flourish.
EtherDelta was the O.G in the DEX space. It peaked with the 2017 bull market, and while it did have significant traction at the time, it would not be able to compete with the DEXs of today. The main reason is that it ran on a model that was pretty inefficient. EtherDelta relied on an “order book” model, trying to basically facilitate trade in the exact same way that centralized exchanges do, by matching up buyers and sellers directly. While this worked well enough with larger assets that had sufficient liquidity, like ETH and stablecoins for example, it did not for the many altcoins that made up Ethereum's ecosystem. This is because if only a few thousand people hold a certain token, the odds of one of them wanting to trade with you on a certain day and at a certain price are quite low. This can lead to large spreads between offers and bids and general inefficiency of capital.
Another downside of EtherDelta was that to both create and remove orders users had to pay gas fees. With gas fees already being what they are today, this would have been a huge inhibitor to trade.
All this being said, what really enabled the new wave of decentralized exchanges to succeed (besides a vastly superior UI and UX) was the innovation of a much better model for running DEX’s known as an automated market maker, or AMM for short.
Automated Market Makers
The concept of an AMM was actually put forward by none other than Vitalik Buterin himself in a now classic reddit post. Vitalik contended that DEXs would be much better off if run by the model that Ethereum based prediction markets like Augur were already using instead of trying to work like a centralized exchange.
From there, the post was shown to a recently laid off engineer named Hayden Adams, by a friend Karl Floersch who was an Ethereum junkie. Hayden quickly became obsessed with building apps on Ethereum and after months of practice and learning Uniswap was born. The AMM model is what separated Uniswap from DEXs that came before it. Instead of trying to constantly match up buyers and sellers, Uniswap utilized liquidity pools to make the process much more efficient. How liquidity pools work to set price is based on the x * y = k curve. What this means in english is that you create a pool of two assets, say Ethereum and USDC, that starts out with an amount in which the value of both are equal. From there users of the exchange can buy and sell directly from the liquidity pool. The price is set in an automated manner because whenever someone makes a trade with the pool, say sells USDC into the pool in exchange for ETH that comes out out of the pool, now that there is more USDC in the pool than ETH the pool automatically updates the price of ETH, in this case pushing it upwards, to once again match the total value of the ETH to the total value of USDC. This means that buyers and sellers no longer face the downside of having to interact with other buyers and sellers but the market still retains the input of supply and demand that it needs to set accurate prices.
So you’re probably wondering where the funds in the pool come from? That’s where things get interesting. For many reasons, it would not work if the creators of the exchange did it themselves, mainly because it would then not be decentralized, they probably don’t have enough money, and the market prices would likely not be set properly. This means that it is the users of the protocol that supply the funds to the pools. Why would they do this? Because those who do, known as liquidity providers (or LPs), receive a proportional share of the transaction fees from the protocol in relation to how much they are providing. This means if you are providing 1% of the liquidity for the entire ETH-USDC pool on uniswap, you will receive 1% of all the trading fees the pool collects in exchange.
We will get into the details of how people approach this, known as yield farming, in a minute, but it is important for now just to note that this is how protocols incentivize users to supply the capital they desperately need to function.
One downside of AMM’s is that it is possible for prices to get out of line with other exchanges, luckily once again market forces are able to save the day as there are many arbitrageurs who are happy to simply buy and sell onto one exchange from another to take advantage of differences in price. This means that any time prices get out of line they will likely get quickly corrected.
In his original post, Vitalik had thought that there would need to remain both DEXs that ran on the order book model as well as an AMM model. He thought this because if all AMMs ran on the same model if prices got out of line there would be no way for them to get back in line because a discrepancy on one exchange would likely lead to a bigger discrepancy on another, and that process would cycle without any way to pull back to equilibrium. What he didn’t take into account is that with multiple AMM’s functioning on slightly different models that serves the same function as an order book in being able to pull prices back to reality.
Major DEX’s (The Basics and What Separates Them)
Uniswap
As we have already alluded to, Uniswap is both the main pioneer and current leader in the DEX space. We have already covered what they have done with AMM’s, but it is almost equally as important to highlight the improvements they made in UI and UX (user interface and user experience). On EtherDelta the interface was a bit daunting for a new user, as compared to Uniswap as you can see here which is incredibly simple and intuitive.
Uniswap V1 was launched in November of 2018, and at the time only allowed ETH-ERC20 trading pairs. That changed in May of 2020, just as Uniswap was really starting to get popular, when it introduced Uniswap v2, which allowed ERC20-ERC20 trading pairs, making Uniswaps services much more valuable for both people making trades as well as liquidity providers. Uniswap V3, which launched this month in May of 2021, is a bit more technical of an upgrade that deserves it’s own entire post, but it is a massive innovation in the AMM model and makes the use of capital by the protocol much more efficient.
Sushiswap
Sushiswap is the now infamous (and very popular) fork of Uniswap that occurred in August 2020 just as the entire DeFi space was really blowing up. Many still view Sushiswap as just a copy & paste of Uniswap with a different name, but the team has been working hard to dispel that notion by creating new and unique features like sushi bar, bento box , and now miso.
Because of these efforts, Sushiswap has formed a very strong community in a short amount of time.
Curve
Curve Finance was launched at the beginning of 2020, and you could say is targeted at a bit more experienced DeFi users. Along with it’s vintage styled user interface, what makes Curve unique is the model it uses to make stablecoin trading much more capital efficient. To sum it up briefly, what Curve does is acknowledges the fact that stablecoins are not going to have the same kind of volatility that other coins are, and uses that notion to stop as much capital from needing to be deployed around all parts of the x * y = k curve spectrum.
Balancer
Balancer is the fourth largest DEX, and what makes it unique it’s ability for liquidity providers to supply trading pools of up to eight tokens instead of two, and allows the liquidity providers to set the trading fees manually. Balancer does this using a variation of the AMM model referred to as a constant mean market maker (CMMM). This approach makes the process of entering, swapping and removing from pools a more seamless transaction.
Explaining How Yield Farming Works Using DEXs
As mentioned earlier, supplying the necessary liquidity to DEXs can be a very profitable move, if you know what you’re doing. Like other DeFi protocols, DEXs offer liquidity providers not just the straight forward yield they earn on their capital, but also additional yield in the form of the protocol native tokens, such as UNI, SUSHI, CRV, BAL or whatever other protocol you may be using. This can end up being extremely rewarding because due to the speculative nature of crypto, the native tokens you receive from an early stage project can sometimes 10x or more in a short period of time.
However, chasing high yields from early stage projects is an incredibly risky endeavor for many reasons, and I highly recommend any beginners start out by providing liquidity to large cap tokens on any of the projects we have mentioned here.
Since the yield that a pool provides is based on supply and demand, and since that ratio is always changing, yields are constantly fluctuating and experienced LPs make a good profit by routinely changing around the pools their in based on what is providing the best yield, calculated for risk and reward.
The Present and Future
While DEXs have made incredible progress over the last couple years, there is still huge innovation happening in the space. And as of this writing, the mainstream still hasn’t caught on to how big of a deal being able to swap assets without an intermediary really is.
Founder of leading centralized crypto exchange Binance, Changpeng Zhao has already stated that he is aware DEXs are the future and that he somehow intends to transition to that model over time, even though that will likely be an incredibly difficult transition to make.
Going forward, if crypto takes off, we will likely see DEXs become the standard model of exchange for all kinds of assets, not just crypto native ones.
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⚠️ DISCLAIMER: Investing into cryptocurrency and DeFi platforms comes with inherent risk including technical risk, human error, platform failure and more. At certain points throughout this post, we might get commission for promoting certain projects, if this is the case we will always make sure it is clear. We are strictly an educational content platform, nothing we offer is financial advice. We are not professionals or licensed advisors.
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