The Pros and Cons of Decentralized Exchanges for Financial Institutions

Decentralized Exchanges (DEXs) have been one of the main drivers of decentralized finance (DeFi), thus raising considerable interest from institutional investors. But as DEXs strongly differ from traditional trading venues, financial institutions should be aware of the opportunities and risks involved. Decentralized finance (DeFi) is one of the biggest success stories in the digital asset space, all but killing the refrain that blockchain technology was a “solution in search of a problem,” After finding an initial home on Ethereum, developments in interoperability and scalability on other platforms have enabled the segment to attract close to $175 billion in locked-in funds, up from under $10 billion a year ago. Additionally, DeFi is now drawing in significant sums in venture capital. Although virtually every new initiative claims to be offering something different, the majority of DeFi’s growth has been driven by two main segments – lending pools and decentralized exchanges (DEX). The latter has undergone several iterations over the years, but the embedded model is broadly based on the ideas pioneered by exchanges such as Uniswap and Bancor. What exactly is a DEX? In a nutshell, a DEX connects sellers and buyers and automatically calculates exchange rates and fees based on supply and demand. Rather than buyers and sellers being matched through an order book like on a centralized exchange, smart contracts perform all trades. DEXs like Uniswap typically operate by means of liquidity pools comprising a pair of tokens. Such a liquidity pool might contain Bitcoin (BTC) and a US-dollar stablecoin like Tether (USDT), for example. In return for providing liquidity to the pool by “locking in” assets, users often referred to as “yield farmers” earn a share of the transaction fees paid by traders who use it to swap tokens. Yields adjust according to the relative scarcity of assets in the pool. Returning to the previous pair for instance, if the volume of USDT were running low, the yield would automatically increase to incentivize users to provide more liquidity. The goal is to create a decentralized and automated trading system. Other exchanges like Balancer operate multi-token pools, whereas Curve Finance…

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