Lavaswap — DEX. Liquidity providing & DEX pros/cons
Tags: Decentralized Finance, Decentralized Exchange, Dex, Crypto, Defi

Lavaswap — DEX

We have had a number of new users request some general information in regards to decentralized exchanges (DEXs), their functionalities, and what it’s like to be a liquidity provider. This article will provide some general knowledge towards the DEX landscape

A decentralized exchange or DEX is a cryptocurrency exchange that operates on a blockchain. Centralized exchanges operate in the same way as traditional stock exchanges, with buyers and sellers trading through a process of matching bids and offers. However, a DEX eliminates the need for a third party, or middleman, to oversee and monitor transactions. Exchanges are considered to be centralized if the trading is done on an intermediary platform, and decentralized if the transactions are done on a peer-to-peer network.

Decentralized exchanges are similar to peer-to-peer markets, with users directly interacting with other users instead of trading with an intermediary. DEXs are distinct from their predecessors, centralized cryptocurrency exchanges, in that they are not controlled by any one party. Instead, trading occurs directly between users (peer-to-peer) through the use of smart contracts. Decentralized exchanges can be built on top of any blockchain, including Ethereum, NEO, Waves, and Bitshares.

Advantages of DEXs

DEXs are lauded for the enhanced privacy, stronger security, and greater user control they offer to owners of digital assets.‍

Security

The biggest risk inherent to centralized exchanges is hacking. Security breaches of exchanges like Coincheck, Mt. Gox and Bitfinex, have devastated the crypto industry and seriously eroded the public’s trust. The Coincheck theft alone resulted in a loss of $530 million worth of cryptocurrencies, breaking the previous record of Mt. Gox of $472 million.

The custodial nature of centralized exchanges is often singled out as the main reason why they are usual targets for hackers and thieves. They maintain their liquidity by keeping the funds of their users on the platform, which makes them susceptible to large-scale theft. It also allows them to conduct an “exit scam,” where they claim an event has caused them to lose control of the private keys and the connected funds. The most notable example is QuadrigaCX.

DEXs are less susceptible to this type of risk since users can freely trade on these platforms from either cold or hot wallets without having to use their private keys or recovery seeds. Basically, the users are the ones in charge of maintaining the security of their accounts. In addition, it would not be lucrative for hackers to steal funds from individual users since it would likely be too costly and difficult, considering that the crypto bounty won’t nearly be as large as those that are stored in exchange wallets.‍

Privacy

All centralized exchanges require sign-ups to comply with Know Your Customer (KYC) requirements. This forces cryptocurrency holders to give up their personal data to the exchange operator.

Most DEXs do not implement this. Since they are not maintained by any central authority, at present there’s no need to use KYC protocols. This offers users privacy when trading on DEXs. However, rumors have been circulating in late 2020 that U.S. regulators and the Financial Action Task Force (FATF) are looking for a way to enforce KYC on crypto wallets in 2021.‍

Sovereignty

Sovereignty, or control over one’s funds, can be exercised freely in DEXs. Users will have full custody of their funds and will be able to use them as they please. Concerns like exchanges freezing their assets or blocking withdrawals rarely happen in DEXs. It needs to be noted that not all decentralized exchanges are created equal, and in practice, they range from quasi-decentralized to fully decentralized.‍

Disadvantages of DEXs

As revolutionary as they are, decentralized exchanges have their fair share of drawbacks. It is important to weigh these cons before making a decision on which exchange to use.‍

Transaction Speed

The processing of orders on DEXs can be slow. This is because trading calls have to first be broadcasted to the network and confirmed by miners before they are processed. This is why trades on DEXs are more likely to suffer from “price slippage,” where the transaction doesn’t execute due to changes in the values of the cryptocurrencies being swapped.

“Front-running” is also a concern with public order books. In this scenario, users initiate trades with higher gas fees to have them executed earlier than those that are still pending.‍

Liquidity Issues

Liquidity is achieved by centralized exchanges through enormous capital. DEXs often have a problem on this end because, unlike centralized exchanges, their liquidity heavily relies on the number of users actively trading on the platform. They also often do not have access to any fund which they can move around to facilitate trades.

Fortunately, the decentralized finance (DeFi) space has come up with a solution to this through liquidity pools that DEXs can tap.

Lavaswap — Liquidity Providing

Automated Market Makers (AMM)

Automated market makers exploded in popularity in 2020, driving much of the DeFi boom. AMMs have no need to utilize order books. Instead, they utilize smart contracts to form liquidity pools that automatically execute trades based on certain parameters.‍

Liquidity providers provide funds to liquidity pools held on DEXs in order for users to perform swaps. There is a fee attached to the swap that is given to liquidity providers as a way to say thanks for providing the necessary liquidity to perform the swap. Liquidity providing is a great way to earn some passive income while still being exposed to the underlying crypto price fluctuations.

You can start providing liquidity to Lavaswap pools — HERE