Decentralized Exchanges

Throughout human history we’ve meet up at markets to buy and sell goods. This was a requirement for efficiency, you had to be where the buyers or the sellers meet to ensure you had a fair chance of transacting.

Depending on where, when and what, different types of markets emerged, specializing in different goods. And before we invented money, you had to also meet someone who wanted the specific item or service you had in exchange, known as a barter economy.

The Internet made the physical aspect of a marketplace less important, but still we have centralized marketplaces. You go the eBay or Amazon websites, which are new forms of old school marketplaces. A lot more efficient and convenient, but still centralized. Or you have a stock exchange, a place where you can transact company shares. While you don’t need to physically be at the stock exchange anymore, you still trade on their terms on their centralized exchange.

DLTs and blockchains allow us to invent a new type of marketplace, one which is not tied to any given location or single actor. This type of marketplace is called the decentralized exchange, or DEX for short.

Like I did on the anchoring post, which introduced the concept of putting assets on the blockchain through tokenization, I’m going to borrow the below video introducing us to the terms.

The key concept of a DEX is having an order book with order matchmaking functionality as part of the DLT. It should be obvious from basic DLT concepts that I can send tokens to you. And in return you can send token to me. And with that we’ve just done a trade. But it’s not logistically speaking an efficient trade because I need to know that you want what I have and vice versa. We have no easy method of discovering our offers. And there’s no atomic trade between us if we were to do it manually. I would have to trust that you gave me in return what we agreed to exchange while I send my tokens to your account.

A centralized exchange would typically ensure that the trade took place, but with this functionality being available on the ledger, there is no need for this centralized actor anymore. I can put my offer for some tokens against other tokens on the DEX orderbook. And as soon as someone globally meets my offer, the exchange takes place for us.

Also because it’s not centralized the opportunity for me to ask for any specific token against a token I’m offering opens up an ability to provide a much broader marketplace. I am not constraint by a set number of trading pairs. If you think about it, it’s almost as if we could return back to a barter economy, while still maintaining efficiency because its global and decentralized. At the same time you likely want to focus your trading pairs towards those with liquidity for your own pricing benefit and volume opportunities. Which trading pairs these would be is left open to the market to conclude on, not a centralized maintainer.