How a Decentralized Cryptocurrency Exchange Works (DEX) - YouTube

Crypto exchanges are a crucial source of liquidity for any cryptocurrency.

One of the foundational ideas of Bitcoin, and other cryptocurrencies is decentralization.

However, in order to trade these crypto assets people had to use centralized exchanges.

Decentralized exchanges, or DEXs, emerged in recent years as reliable alternatives.

DEXs also present a unique opportunity to rethink how to design an exchange from scratch

based on first principles.

In this video we will look at the three main models used for building a DEX:

The order book model The automated market making model and

The Dutch auction model We will also look at the advantages and disadvantages

of each of these models and a quick look at DEX aggregators.

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And as such a lot of time and love goes into making these videos.

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Now, let’s talk about exchanges.

Centralized exchanges Before we start talking about DEXs, let us

quickly recap how Centralized exchanges work.

Because these are the precursors to DEXs and the journey tells a more cogent story than

just the destination!

Almost all centralized exchanges work on the order book model.

In this users can place two types of orders: A limit order or a market order.

A limit order allows traders to buy or sell an asset at a specified price.

A buy order is called bid and a sell order is called an ask.

The order book is sorted such that the highest bid and the lowest ask are at the top of the

lists.

The difference between these two is called the spread.

A market order is simply an order to buy or sell an asset at the best available price

on the order book.

Markets with high liquidity have much smaller spreads, since the demand and supply at each

price level is high.

Tight spreads are desirable in any market because they imply efficient price discovery.

And that’s where market makers come in.

They provide more liquidity into the market by taking on risk and reducing the spread.

They make a profit when the short term market moves in the direction they predicted.

Market makers are crucial to efficient functioning of an order book model.

In centralized exchanges, assets have to be deposited into the exchange before trading

and all trades are executed by a central server.

This makes the central exchanges a huge target for hacks and there were many of them in the

past.

And also the ever present risk of running away with user’s funds.

On top of all these they often require KYC verifications, and also inherit all the drawbacks

of an order book model that we will discuss in a bit.

DEXs: The order book model Examples of order book DEXs include dYdX,

0x, Binance DEX etc.

Order books can be stored either on-chain or off-chain.

Off-chain order books need additional infrastructure to store and maintain the order books.

Relayers in 0x are a good example of such infrastructure.

0x provides a framework for building different DEXs and maintaining order books for these

DEXs.

Users still maintain custody of their assets at all times.

All trades are settled on the Ethereum blockchain.

Given that the Ethereum network is currently limited to 15 transactions per second, storing

order books off-chain can help with scalability.

DEXs with On-chain order books keep their order book on the blockchain and thus have

the benefit of censorship resistance.

On the flip side, users will need to create blockchain transactions and pay for gas to

post limit orders and to cancel existing orders.

ViteX is a good example here.

ViteX runs on its own blockchain called Vite which supports high performance, low latency,

and zero transaction fees.

This makes sense given the low throughput of the Ethereum blockchain.

There are also layer 2 solutions on Ethereum such as Loopring exchange that uses zkRollups

to achieve similar results on the Ethereum blockchain in a scalable manner.

The solution space is just so vast and exciting to look at!

Order book DEXs also employ different techniques for order matching and trade execution.

We shall look at some examples of these as we go through the Pros and Cons of this model.

Pros Good for liquid markets: When there is a lot

of trading volume and market makers maintaining tight spreads, exchanges that use the order

book model are great for finding the market price and filling large orders without much

slippage.

This is the reason why high volume centralized exchanges like Binance, Coinbase and traditional

venues like the New York Stock Exchange use the order book model.

Cons They also have their share of downsides.

Bad for illiquid markets: An order can be fulfilled, only if a bid price matches an

ask price or vice versa.

This means, you won’t be able to trade in these markets if your highest bid is still

lower than the lowest ask.

With illiquid markets, order book exchanges result in large spreads and variable prices.

Front-running: Front-running is a process in which someone who has knowledge of a large

future buy order, buys up that asset before the original order and sells it immediately

to make a profit.

In centralized exchanges only the exchange has such knowledge and front-running is banned

by law.

However, this can be a more serious problem on DEXs that use on-chain order books.

Because, to place an order, you would need to submit a transaction to the blockchain,

and miners can see all the transactions before they are included in the block.

If the order is large enough, miners could create their own buy and sell orders in this

block and place them before your transaction.

Thus earning a risk-free return.

There are several novel solutions to prevent front-running for order book DEXs.

The Injective Protocol uses Verifiable Delay Functions (VDFs) to “timestamp” orders

so miners can’t frontrun users.

Binance DEX uses Fast Matching and Periodic Auction Matching to make front-running impractical.

Market manipulation: The order book model is by design very susceptible to market manipulation.

The order book gives hints about the short time price direction of an asset.

For example, a large number of buy orders could signal a rising price due to high demand

for that asset.

These signals are just clues that can change at any moment.

This opens up possibilities for many kinds of market manipulations such as: spoofing,

wash trading and pumps & dumps.

All these tactics could create unstable market conditions for all participants.

Traditional exchanges, such as the New York Stock Exchange, have strict regulations to

punish such unethical behavior.

However, real-world laws don’t apply neatly to DEXs or it’s participants.

DEXs: The automated market maker (AMM) model The AMM model fixes some of the shortcomings

of order books.

AMMs as a concept has been known among academic game theory researchers for over a decade

now.

Yet, AMM DEXs are the first public applications built on this model, at scale.

AMMs do not contain any order books.

Instead they pool liquidity from different users and anyone can buy or sell an asset

from the liquidity pool.

AMMs use deterministic algorithms to quote the price of the asset for each trade.

The algorithm could be different for each AMM.

Uniswap is the most popular DEX by daily volume.

It’s an AMM that uses the Constant Product Market Maker model.

On Uniswap liquidity pools are maintained for each trading pair.

Anyone can be a liquidity provider by depositing pairs of tokens to a pool.

In return they earn fees from all trading activity in that pool.

For example, in an ETH-DAI pool, the price of ETH for a given trade is determined by

the constant product equation.

The goal is to maintain the product constant, before and after each trade.

Bancor is another DEX that uses a similar strategy but a slightly more complex equation

to determine the price of assets for each trade.

Pros AMM DEXs are Good for illiquid markets: As

long as there is a liquidity pool for a given asset, you will be able to trade that asset,

regardless of the order size.

This is great for assets with a low market cap or when the liquidity is fragmented across

different markets.

Since all trades are made directly with a pool, there is no need for order matching.

Cons Of course, it’s not a free lunch.

There are downsides to this model too.

Such as:

High slippage for large orders: The price you pay for an asset can change significantly

if the size of your order is comparable to the size of the liquidity pool.

For example if you are buying 50% of the ETH in an ETH-DAI pool, the average price per

ETH can double during your trade!

A slippage rate of 100% would be outrageous in the order book model!

To keep slippage under 1%, the liquidity pool would need to be 100x greater than the size

of the order.

AMM exchanges are great for getting the best average price for illiquid tokens only when

the order size is a small percentage of the liquidity pool.

This is one of the reasons why large institutional traders placing orders worth billions of dollars

per day don't use AMMs.

Risks for liquidity providers: When providing liquidity to a pool, you face the risk of

Impermanent loss.

Impermanent loss happens when the current price of your deposited assets changes compared

to their price at the time of depositing.

The bigger this change, the more you are exposed to impermanent loss.

The loss here refers to less dollar value at the time of withdrawal than at the time

of deposit.

I will cover Impermanent loss in more detail in a future video but for now, it is sufficient

to know that providing liquidity to a pool is not risk free.

The Dutch auction model is based on the Dutch auction principle.

In a Dutch auction the price of an item starts high and it is lowered until it gets a matching

bid.

The first matching bid results in a sale.

There are different variations in the model to determine when a sale occurs and at what

price.

When Google launched its public offering, it relied on a Dutch auction to earn a fair

price.

DutchX is a popular DEX built on this model.

On DutchX, there are 2 phases in the trading process.

In the first phase, which is before the auction starts, sellers deposit their tokens to place

sell orders.

If the deposits pass over 1000 USD worth of tokens, then the auction begins.

With the price per token set at double the closing price of the last auction.

Now the 2nd phase begins.

The price starts falling according to a decreasing function and buyers can actively place their

bids at different price levels.

When the entire volume is bid upon, the auction ends and the closing price of this auction

is determined.

All buyers with bids before auction close will receive their tokens at the same closing

price.

And similarly sellers will receive their proceeds according to the closing price.

Pros Advantages of this model include: Good price

discovery of illiquid tokens: The Dutch auction process is better at determining the fair

market price for illiquid tokens compared to the other models.

This is why Dutch auctions are commonly used by platforms like Decentraland and CryptoKitties

to allow price discovery of new or rare NFTs.

Reduces front-running: Since all buy orders in an auction are executed at the same closing

price , this prevents miners from front-running individual trades.

Cons One big down side of this model is Slow trading

time.

The trades aren’t executed until the auction is over, which can take up to several hours.

Since trades aren’t instantaneous, Dutch auctions are impractical to do fast trades

like market orders (in order books) or quick swaps (in AMMs).

To sum up, Order book exchanges are great for highly liquid markets, AMMs are good for

illiquid markets, and Dutch auctions are perfect for price discovery of new and rare items

like NFTs.

There are many implementations within each DEX model.

This gives users a lot of choice and developers a chance to innovate on different mechanisms.

However, this approach also results in liquidity getting fragmented across various platforms.

This lack of concentrated liquidity on one platform can result in high slippage for large

trades.

DEX aggregators aim to fix this exact problem.

1inch Exchange is a popular DEX aggregator.

The 1inch platform aggregates liquidity from different DEXs.

It does this by splitting orders between many other DEXs and private liquidity providers

to find the best possible exchange rate for each trade.

We covered a lot of concepts and protocols today.

To learn more about these topics, checkout the links in the description.

And if you like to see a video about a specific DEX, or concept, let me know in the comments

section.

That is it folks, don’t forget those like and subscribe buttons.

Thanks for your time, my name’s Praveen and I will see you again soon!