In May 2022, at the tail of the crypto bull market, economist Eswar Prasad wrote an op-ed for the Financial Times arguing that DeFi’s promise as a means of democratizing finance was a long way from being realized. In his words, “For all its promise in democratizing finance and broadening financial access, the emerging reality suggests a concentration of economic power, while the risks fall largely on those investors least able to handle them.”
Prasad is right that early DeFi projects catered almost exclusively to crypto natives, often called “degens” in Twitter parlance. However, he didn’t acknowledge that this is in fact a common pattern for any nascent industry crossing the chasm from fringe to mainstream adoption. New, transformative technology frequently starts out looking like a toy. The internet went through this same phase, as did many of its formative companies, such as Facebook, whose target audience grew from college students to anyone in the world with an internet connection.
This article explores how one foundational building block of DeFi — the decentralized exchange — emerged and continues to evolve from being a toy to a serious product that rivals traditional centralized exchanges.
The heart of DeFi — The decentralized exchange
At the core of any financial system, DeFi included, is the ability to exchange assets. In order for DeFi to rise from nothing to hundreds of billions of dollars in value, it required an easy way to trade tokens. This gave rise to the decentralized exchange, or DEX. The best example is Uniswap, which is by far the most popular and successful DEX in DeFi.
The idea behind the exchange adheres to the tenets of DeFi: It serves as a transaction hub where users can exchange a variety of different currencies without the necessity of an intermediary. However, Uniswap acts as an automated market maker (or AMM), where users can trade against a smart contract acting as a counterparty.
While fulfilling those functions was enough for the platform to break out onto the world stage and carve out the biggest slice of the emerging market share — one that the exchange maintains today — Uniswap is not a perfect solution and the AMM model has several flaws.
The trade-off with AMMs
AMM exchanges pool the liquidity they get from liquidity providers, and employ algorithms to price their supported assets within that pool. This model proved hugely successful for Uniswap in its early days, as it allowed easy sourcing and aggregation of liquidity, against which trades were possible on Ethereum.
Source: Twitter
AMMs work great for two use cases: stable swaps between two stablecoins or price stable assets, and in the initial process of bootstrapping permissionless liquidity for long-tail assets. However, for use cases outside of these, AMMs are not ideal for either the liquidity provider or the trader.
For liquidity providers, AMMs can prove problematic due to toxic flaws where an overabundance of liquidity can get taken advantage of by arbitrageurs and impermanent loss risks. For traders, on the other hand, AMMs have another set of risks including MEV and slippage that can translate to significant losses.
On-chain settlement with off-chain pricing
The main issues with AMMs described above all owe to one simple fact: AMM-style exchanges price assets on chain. This means that smart contracts on Ethereum (or other chains) are required to determine the fair value of an asset via math formulas encoded on the chain. The beauty of this is that you need no additional infrastructure to facilitate a trade. However, the trade-off is that price discovery becomes muddled and a bevy of problems stemming from manipulating prices via transaction ordering end up impacting users.
An alternative approach is the RFQ (request-for-quote) model that allows users to get quotes directly from market makers and trade with zero slippage and full MEV protection. Instead of pricing assets on chain, RFQ-style exchanges handle the settlement and swapping of assets on the blockchain, but enable off-chain actors to price assets. This latter distinction enables far more capital efficiency as well, helping bring in market makers and traditional players unable to provide liquidity via AMMs.
Hashflow, one of the top-10 DEXs by transaction volume, has made it its goal to simplify the decentralized exchange experience with an eye to optimizing it for the retail user. Rather than employing an AMM system, Hashflow uses the RFQ model described above, and has demonstrated its success to the tune of over $11 billion transacted in just over a year.
Source: Hashflow trading metrics
Native, cross-chain swaps and the way forward
Beyond its model, Hashflow also introduces native cross-chain swaps. Hashflow was the first platform to introduce this technology and the end result is a reliable exchange model that is similar in practice to the more convenient experience offered by centralized exchanges, but carries with it all of the advantages that come with decentralized finance. Looking forward, after recently adding Wormhole’s messaging protocol, Hashflow will be integrating more non-EVM chains and introducing structured products along with limit orders.
If there is to be a true democratization of finance, DeFi as a whole needs to change and re-orient itself with retail users as its center of focus. To make that happen, platforms like Hashflow have taken steps to simplify and streamline the transaction process and make it less burdensome for the everyday user. Time will tell whether the rest of the industry follows suit.
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