Liquidity Pools & Automated Market Makers (AMMs)
1. Liquidity Pools & Automated Market Makers (AMMs)
Most modern DEXs (Uniswap, PancakeSwap) rely on **liquidity pools** instead of traditional order books.
How AMMs Work
- **Liquidity Providers (LPs)** deposit **two tokens** in a pool (e.g., ETH/USDC).
- The pool uses a **mathematical formula** to determine prices (e.g., `x * y = k` in Uniswap).
- When traders swap tokens, the pool adjusts prices **automatically** based on supply and demand.
Example: Uniswap’s Constant Product Formula
- If a pool has **100 ETH** and **200,000 USDC**, then `k = 100 * 200,000 = 20,000,000`.
- If a trader buys **1 ETH**, the new pool balance must satisfy:
- `(100 - 1) * (200,000 + Price) = 20,000,000`
- Solving gives **~2,020.20 USDC per ETH** (price adjusts dynamically).
Slippage & Impermanent Loss
- **Slippage**: Large trades move prices unfavorably (especially in low-liquidity pools).
- **Impermanent Loss (IL)**: LPs lose value if token ratios change significantly (e.g., ETH price surges vs. USDC).
2. Order Book DEXs (Like Traditional Exks)
Some DEXs (e.g., **Serum on Solana, dYdX**) use **on-chain order books** where:
- Buy/sell orders are stored on the blockchain.
- Matching is done via **smart contracts** (not a central server).
- Requires **high throughput** (Solana is fast, Ethereum struggles).
**Hybrid DEXs (Off-Chain Order Book + On-Chain Settlement)**
- **Example**: Loopring, Immutable X.
- Orders are matched **off-chain** (for speed) but settled **on-chain** (for security).
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3. Cross-Chain DEXs (Swapping Between Blockchains)
Some DEXs allow trading between different blockchains **without wrapping tokens**:
- **Thorchain**: Uses a network of vaults to swap BTC, ETH, BNB, etc.
- **Chainflip**: Similar, but with improved security.
How Cross-Chain Swaps Work
1. User sends **BTC** to Thorchain’s vault.
2. Thorchain locks BTC, mints **synthetic BTC (Rune-based)**.
3. Swaps to **ETH** via liquidity pools.
4. ETH is sent to the user’s wallet.
4. Aggregators (Finding Best Prices Across DEXs)
DEX aggregators (like **1inch, Matcha, Paraswap**) scan multiple DEXs to find the **best swap rates** by:
- Splitting trades across pools to reduce slippage.
- Using gas optimization to save fees.
Example: 1inch’s Pathfinder
- If swapping **1000 USDC → ETH**, 1inch might:
- Split 500 USDC on Uniswap.
- Route 300 USDC to SushiSwap.
- Send 200 USDC to Balancer.
- Combine for the **best overall rate**.
5. DEX Governance & Tokens
Many DEXs have **governance tokens** (e.g., UNI, SUSHI, CAKE) that allow:
- Voting on protocol changes.
- Earning fees from trading.
- Staking for rewards.
Example: Uniswap’s Fee Switch Debate
- UNI holders can vote to enable **0.05% protocol fees** (currently off).
- If turned on, fees go to **UNI stakers** instead of just LPs.
6. Security Risks in DEXs
While DEXs are **non-custodial**, they still face risks:
Ri s k | Ex a m p le | Solution |
Smart Contract Bugs | 2021 Uranium Finance hack ($50M loss) | Audits, bug bounties. |
Rug Pulls | Fake tokens with malicious code | Use verified tokens (CoinGecko). |
Front-Running | Bots exploit pending trades. | Use private transactions (Flashbots). |
Oracle Manipulation | False price feeds trick swaps. | Use decentralized oracles (Chainlink). |
7. Future of DEXs
- **Layer 2 Scaling**: Uniswap on Arbitrum, Optimism (lower fees).
- **NFT DEXs**: Blur, Sudoswap (NFT trading via AMMs).
- **MEV Protection**: CowSwap, Flashbots (reduce bot exploitation).
- **Institutional DEXs**: Aave Arc, Fireblocks (compliant DeFi).
Final Thoughts
DEXs are evolving rapidly, solving issues like **high fees, slippage, and security**. While **CEXs still dominate volume**, DEXs offer **true ownership, privacy, and innovation** in DeFi.
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