Simplicity is the ultimate sophistication. This principle rings as loud and clear in DeFi as it does in all value systems keen on diffusing control and breaking corporate structures.
The rise of open finance solutions powered by publicly accessible code, continuously refined by the wider community, exemplifies how the benefits of simplicity, steeled by the premise of decentralization, can be revolutionary.
The Rise and Rise of the DEX
As of late July 2021, over $72 billion worth of digital assets were held across various DeFi protocols. These solutions provide financial services that adhere to the guiding principles of blockchain, one being decentralization.
One key example is the decentralized exchange, or DEX. Unlike their centralized cousins, decentralized exchanges, as the name suggests, have no central party. Instead, all aspects of the exchange – from liquidity provision to fee distribution to incentivization – are automated by smart contracts. They cut out the middle man while being liquid enough to enable the trading of billions of dollars worth of tokens.
Anchored by the Base
Interestingly, there is a relationship between the success of a decentralized exchange and the activity of its parent chain. For example, Ethereum enjoys great popularity and high activity levels, partly because it was the first platform of its kind. And because it’s home to some of the most intensive decentralized applications (dapps), products launching on the platform have a higher chance of taking off with the existing activity as a tailwind.
Statistics support this observation. Ethereum dapps incur more transaction fees than Bitcoin, despite Bitcoin being the world’s most valuable cryptocurrency network because there is a much higher activity level on the Ethereum blockchain.
Mitigation against Slippage and Swapping Risks
Token swapping as a means of exchange (the phrase also refers to the wholesale migration of a project from one blockchain to another) via DEXs is extremely popular.
However, one of the biggest problems facing these platforms is that of slippage.
Slippage is the difference between a quoted price of a token and the cost that’s actually paid. This difference will be negligible for small swaps but grow in proportion to the size of the deal. The result is that users get less in return for their tokens than they should.
This happens because, unlike centralized exchanges, DEX protocols use a communal pool of tokens funded by liquidity providers (who are compensated for their contribution with collected transaction fees). The problem is that DEXs employ a conservation function, which determines asset prices according to available liquidity, and that liquidity drops when large numbers of tokens are removed. So with large swaps, traders typically see significant variation in token prices.
However, the crypto community is working on solutions. For example, Kirobo’s P2P Swap Button allows traders to avoid DEX slippage by allowing them to swap directly with each other safely while setting their own prices. Traders can also agree on the exact time they want to swap, thereby avoiding high gas fees and congestion during peak hours.
That traders can avoid the high trading fees is also welcomed, especially for traders who frequently trade via activity-dense networks like Ethereum. The scalability limitation in Ethereum is continuously working against the swappers’ interest whenever demand picks up due to low processing speeds. At peaks, Gas fees tend to fluctuate – even rising, impacting swapping amounts, a negative for traders since trading is on-chain, requiring the involvement of miners who have to confirm transactions. The prearrangement of swapping time offered by some protocols saves time and money. It also introduces convenience for busy traders.
Building Solutions of Convenience and Efficiency
Beyond precise timing and scheduled swaps for convenience and cost reduction, the crypto community is working on alternative solutions to overcome existing obstacles. Although scalability is a primary challenge that requires collaborative efforts from the global network of developers for resolution, being a public chain, incorporating solutions in Ethereum can be a tedious process. First, the idea must be accepted and approved by the mining community and other stakeholders who must upgrade. However, participants now agree with Vitalik Buterin’s call for off-chain solutions as a means of scaling the base layer. In this arrangement, swapping will be expeditiously executed via external conduits leading to high throughput and negligibly low transaction fees without compromising security. Solutions such as Roll-Ups by Optimism and Arbitrum are gaining traction. Optimism is currently in Alpha testing and has so far been integrated by Uniswap—DeFi’s most valuable DeFi token and leading swapping protocol.
At the same time, the drive by the community is for the complete interconnectedness of the various DeFi-centric blockchains and protocols operating actively in parallel chains. The emergence of high-performance networks like Solana, Polkadot, and Polygon, for example, is accelerating the development of bridges to Ethereum—which boasts of superior infrastructural and dApp density due to its first-mover advantage.
Most emerging smart contracting platforms are EVM-compatible, a reprieve for swapping media who wish to enjoy the benefit of high scalability and high low transaction fees while still desirous of plugging into the Ethereum ecosystem standing out because of the number of users. Accordingly, due to this development, developers competing for smart contracting platforms are dedicating resources to release coupling bridges linking their ecosystem with Ethereum.
Privacy Preservation and Financial Inclusiveness
A big takeaway and one of the main advantages of trustless swapping is the privacy that comes with the transaction. Unlike CEXes, where regulators have succeeded in twisting the arm of platform owners, DEXes are immune to information-squeezing maneuvers. To execute a swap, all a trader has to do is connect the protocol with a non-custodial wallet like MetaMask or Formatic and approve the transaction regardless of geographical location. The cryptography in Ethereum would automatically shield the trader’s identity while swapping will proceed without hitches, any time of the day. No requests or personal information, even email addresses, have to be shared as part of the compliance process.
That DEX users can’t submit personal information as part of compliance on AML and KYC rules while still controlling funds is a big draw. Ordinarily, people are increasingly reluctant to submit personal data to third parties because they would lose control and won’t know what happens to their data when they press the “submit” button. The decentralized nature of swapping nature avoids such, making it hard for authorities to profile traders.
This decentralization and global reach of the underlying infrastructure from where swapping dApps ride on promotes financial inclusiveness. It is especially the case whenever regulators turn the screw, introducing new restrictions that dampen user experience in centralized portals. DEXes emerge as alternative options overriding geo-fencing techniques ensuring continuity of swapping.
Cryptocurrencies are here to stay. As crypto is adopted, reliable token swapping protocols will continue to carve market share, growing in prominence and stature, evolving to eliminate the problem of high slippage.
Non-custodial swapping solutions bring to the table speed, efficiency, and affordability. Moreover, most are globally accessible without regulatory morass, of which centralized versions must remain compliant.
The author does not have any vested interest in the projects mentioned above.
The opinions in this article belong to the author alone. Nothing in this article constitutes investment advice. Please conduct your own thorough research before making any investment decisions.
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