DEXes and AMMs: The democratization of stocks trading

IMAGE CREDIT:
Image credit
iStock

DEXes and AMMs: The democratization of stocks trading

DEXes and AMMs: The democratization of stocks trading

Subheading text
Cryptocurrency software developers have created a way for people to trade stocks and securities without going through a third party.
    • Author:
    • Author name
      Quantumrun Foresight
    • December 2, 2022

    Insight summary

    Stock exchanges like the New York Stock Exchange (NYSE) or Nasdaq keep trades of stocks and securities fair by monitoring prices and orders. Crypto developers have created software that decentralizes this process so investors can trade without a third party; automated market maker (AMM) algorithms enable these decentralized exchanges (DEXes). The long-term implications of these developments could include more complex asset hacking methods and startups focusing on developing better platforms.

    DEXes and AMMs context

    Decentralized exchanges with AMM protocols are often integral to the decentralized finance (DeFi) ecosystem. Rather than connecting buyers and sellers, AMMs link transactions together in a pool and determine asset prices via an algorithm known as a conservation function. AMM-based DEX exchanges offer decentralization, automation, and continuous liquidity (how quickly shares can be bought or sold without substantially affecting the stock price). 

    With traditional order-book-based exchanges (an electronic list of buy-and-sell orders for a specific security or financial instrument organized by price level), the market price of an asset is determined by the last matched buy-and-sell orders. This price is ultimately driven by the supply and demand of the investment. In contrast, an AMM-based DEX has a liquidity pool that works as a counterparty for each transaction. This pool then prices assets using an algorithm that only allows the price to move along specified paths, eliminating unpredictable price movements.

    An AMM algorithm uses a system where people who want to trade assets can do so without finding someone else who wants to exchange those same assets. Liquidity providers make money by providing assets to the pool and charging people a small fee for using the service. Also, by using a conservation function for price setting, AMMs eliminates the need to keep an updated order book state, which would be expensive on a decentralized ledger.

    Disruptive impact

    Between 2016 to 2017, the first generation of DEXes (e.g., IDEX, EtherDelta, and ForkDelta) were released in the market. However, they had unfriendly user experiences, limited liquidity, and partially centralized order books. In 2018, AMMs finally arrived and enabled a decentralized liquidity pool. DEXes, also known as DeFi hubs, offer a suite of services aside from trading, including asset swaps, lending, and launchpads.

    Most DEXes are asset-neutral, meaning that customers can trade any assets they want if there is a liquidity pool for that asset. However, a new generation of platform-specific DEXes has emerged since 2022. These typically focus on one ecosystem, only allowing users to trade specific assets. An example is Katana (2022), an AMM built on Ronin Chain (a sidechain from the blockchain platform Ethereum). Users can trade not only assets like Ronin (RON) and USD Coin (USDC) but also native assets specific to the Axie Infinity game ecosystem, such as Smooth Love Potion (SLP) and AXS.

    A regulated Central Bank Digital Currency (CBDC) DEX will likely launch in the late 2020s. Most CBDCs are expected to be built on permission blockchains since central banks in more than 100 countries are studying this technology. Permissioned blockchains refer to a form of DeFi that combines decentralization with centralized mechanisms like whitelisting for Know Your Customer and Anti-Money Laundering.

    Implications of DEXes and AMMs

    Wider implications of DEXes and AMMs may include: 

    • A rise in complicated hacking incidents', where asset prices are manipulated in AMM-based DEXes, resulting in the liquidity pool being drained.
    • Increased incidents' of money laundering and terrorist financing in early versions of DEXes.
    • Increasing pressure to create industry standards or governance policies, especially if CBDCs enter these platforms. However, this trend may lead to DEXes becoming centralized.
    • More organizations researching and investing in blockchain platforms to protect privacy and address cybersecurity concerns.
    • Startups establishing newer DEXes with better protocols and algorithms, making the space highly competitive, innovative, and secure.
    • An increasing diversification of where the public can invest their capital with minimal fees.

    Questions to consider

    • If you have traded in AMM-based DEXes, what are the advantages and limitations?
    • How else can DEX and DeFi change stock trading?

    Insight references

    The following popular and institutional links were referenced for this insight: