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Yield Farming And How To Reap Guaranteed, Steady Returns

adm1n69 — Thu, 16 Sep 2021 13:07:54 +0000

The uninitiated could be forgiven for thinking that “yield farming” refers to the latest crop of corn or peanuts. Rather, the term refers to a cutting-edge trend by which those who own cryptocurrency can reap guaranteed, steady returns.

Yield farming is a way for those who participate in specific cryptocurrency-powered products to use their crypto to earn crypto. By promising users tokens (and interest, in some cases) in exchange for their participation, founders and promoters of decentralized finance products aim to whip up interest in their platforms.

What Is Yield Farming?

Understanding yield farming may require you to grasp what “yield” means within the context of finance. Per Investopedia, yields are “earnings generated and realized on an investment over a particular period of time”. Yields may generally come in two specific forms:

Interest earned on an investment
Guaranteed dividends paid in return for your investment

Yields can apply to several classes of financial assets, including but not limited to stocks and bonds. Yields can be fixed or may fluctuate with different variables, such as the value of the security being invested in. These same tenets may apply to yields issued in cryptocurrency rather than dollars, but there are also some noteworthy differences between traditional yields and crypto yields.Yield farming is a term particular to cryptocurrency, and DeFi specifically. Simply put, to farm yields is to invest your cryptocurrency in a specific DeFi platform or product in exchange for rewards, which may come as interest and/or dividends.

Some of the most prominent projects to date for yield farming, such as Compound, involve both lenders and borrowers of cryptocurrency receiving Compound tokens (COMP) as their yield. This practice may also be referred to as liquidity mining, because those who invest their crypto in platforms while earning a yield are providing liquidity to administrators of that platform. In this sense, their role is similar to a lender who exchanges cash for:

The guarantee of future repayment, plus:
Interest payments

While the investor farming a yield certainly benefits from the arrangement, they may not be the only ones reaping a reward.

Who Benefits From Yield Farming?

It is clear why someone might invest their cryptocurrency in a platform or product that offers them a yield. If they were not planning to liquidate their crypto shares in the near-term, then why not earn some extra (guaranteed) coin on their stake by farming for yields? Here’s how it goes:

An investor lends their money to the platform, they receive tokens for their investment, they are ultimately repaid their principle investment, and may earn interest on top of it. It’s the classic lender’s benefit, along with some extra token. That extra token is a key distinction between traditional lending and yield farming with DeFi platforms. If the value of the token provided as a dividend skyrockets, then a DeFi lender-investor may experience returns far beyond what they could get in traditional, non-crypto markets.

Heck, if the token being used as a dividend accumulates value quickly enough, it may even be possible to make money farming yields as a borrower. Say someone borrows cryptocurrency and receives tokens as a reward for engaging in the lending platform. So long as the value of that token increases at a rate greater than the cost of borrowing, they may ultimately earn a profitable yield despite paying interest on their loan. There is always risk in borrowing, and one would have to be very confident in the rate of a token’s appreciation to bank on making money by borrowing crypto. Still, this scenario is not out of the realm of possibility, and the rapid increase in value of Compound’s COMP token in the spring of 2020 serves as real-world evidence.

The last party that may benefit from yield farming is the governors of a specific platform or token. Whether governors refers to a centralized collective or participant-investors in a decentralized platform, the interaction that yield farming incentivizes is generally positive for stakeholders. As investors flock to a platform offering worthwhile yields, the platform itself and any connected token becomes more valuable due to greater popularity. As the token accumulates value, the yields (tokens) provided by participation in the linked platform become more attractive, more farmers flock to reap those yields, and so the cycle of growth goes…

What Is the Current State of Yield Farming?

Like many specific genres of decentralized finance, yield farming has seen significant growth in participation over recent years, and in the past few months especially. With Compound paving the most viable blueprint for yield farming to date, subsequent projects have garnered similar popularity. Balancer Labs’ BAL token was issued shortly after COMP token’s debut, becoming the second governance token that would facilitate yield farming in the DeFi space, according to NASDAQ. It went on to debut with a single-day 235% spike in value, once again illustrating the fervor for yield farming, and by extension the tokens and platforms that allow for yield farming. As of August, 2021, Aave had the highest Total Value Locked among all DeFi protocols at $21 billion.

As more and more investors sink their crypto capital into platforms offering yields in return for liquidity, the sustainability of the practice appears real. Unless regulators crash the party, the attractiveness of yield farming may persist.

How Do Regulators View Yield Farming?

You’d have to be a regulator to answer this question. Generally speaking, there is some worry that regulators will eventually want to have a say in how the DeFi sector is run, including how punitive measures are doled out to fraudsters. Yield farming may not be immune to this development if and when it occurs. Whenever the term “risk” becomes associated, fairly or not, with a financial sector, you can bet that at some point regulators will act. Whatever you think of their motives, this generally tends to be the case.

Like any investment, yield farming carries risk, with questions about the token issuers’ legitimacy being one of those risks. However, it is not yet possible to know for certain how regulation will affect yield farming. For now, yield farmers seem to be of the opinion that they may as well be getting it (yields) while the getting is good.

Stablecoins – What are they, and why are they?

adm1n69 — Fri, 10 Sep 2021 09:24:22 +0000

One concern that crypto skeptics might share is that cryptocurrencies such as Bitcoin are subject to significant price fluctuations. This, they might say, makes cryptocurrency impractical as a medium of exchange.

While the dollar and other widely-used currencies also fluctuate in value, consumers may be less likely to experience inflation or deflation of the dollar (or Euro, or other fiat currency) as immediately as they would a change in their Bitcoin’s value. Prices may go up over time, ultimately reducing the purchasing power of your paper money, but the changes are generally more subtle than those that affect cryptocurrency.

The crypto sector’s answer to these concerns about volatility: stablecoins.

What Are Stablecoins?

Investopedia defines stablecoins as “a new class of cryptocurrencies that attempts to offer price stability and are backed by a reserve asset”. Different stablecoins are backed by different types of “reserve assets”, including:

Other cryptocurrencies, with the most popular coins like Bitcoin and Ethereum serving as value tethers for a lesser-known stablecoins
Fiat currency, with the dollar being one example
Tangible assets such as gold, silver, or other commodities with real value

The asset that backs a given stablecoin may affect how the issuer of the stablecoin sets a token’s price. For example, backing a stablecoin with Bitcoin obviously comes with a level of risk. If the price of Bitcoin drops significantly, then pricing stablecoins too high in relation to Bitcoin could leave the issuer of the stablecoin unable to exchange users’ coins for its equal value in Bitcoin.

Therefore, stablecoins tied to comparatively volatile assets like other cryptocurrencies must link value conservatively, ensuring that even if Bitcoin’s value dips significantly, they have a cushion to be able to redeem all of the stablecoins in circulation.

There are also unique considerations when the backing of a stablecoin is a commodity such as oil. Accounted for in the price of such a stablecoin is not only the value of having a real asset-backing, but also the cost of compliance by the coin issuer: legal fees, maintenance fees, and all of the real costs that come with keeping the operation above board. These fees may be greater than those required for a dollar- or Euro-backed stablecoin—there are simply more moving parts.

There is another class of stablecoin with no asset backing, referred to as Seigniorage-style or algorithmic stablecoin.

Rather than being tied to a commodity, these coins are even more fixed in terms of price and value. Their supply and price are built into code, and are generally managed by smart contracts to provide true stability.

What Are the Benefits of Stablecoins?

The primary benefit of stablecoins is a dead giveaway: they’re stable. Or, at least, they are viewed as stable relative to other cryptocurrency classes.

There are two primary benefits of stablecoins:

They have less volatility than non-stablecoin tokens
By reducing volatility, cryptocurrency becomes a more viable means of exchange

To illustrate the value of stablecoins, consider the following scenario.

Say that I would like to purchase a pizza or a motorcycle from you. I offer to pay you the price of the pie or the bike in Bitcoin or Ether, but you’ve got some understandable concerns:

Sure, the value of the Bitcoin you are offering is equal to that of the product now, but will it be in five minutes? What about five days?

It could be more, could be significantly less. Merchants may not generally be willing to gamble that they will be left taking a loss on their product, particularly when other customers are willing to pay for the pizza or motorcycle with a more stable asset such as cash.

Furthermore, in order to minimize the risk of a value fluctuation after being paid with traditional cryptocurrency, a seller would have to rush to their digital wallet and convert the coin to dollars as quickly as possible. This costs them time, effort, and fees. Even then, they may still lose out on the transaction even before fees are considered.

With stablecoins, and especially those tied to an unchanging reserve of assets, this price volatility becomes far less of a concern. In turn, proponents see stablecoins as a more readily-usable medium of exchange.

What Is the Current State of Stablecoin Usage?

There are two different categories of stablecoin, and each may be assessed individually to gauge their popularity and usefulness. They are:

Centralized stablecoins, also known as collateralized stablecoins
Decentralized stablecoins

Centralized stablecoins are ones backed by real-value assets, and their volatility may vary from one coin to the next. For example, a stablecoin that is tied to the price of oil may be more volatile than one tied to a fixed reserve of untouched gold. These coins generally involve custodians to manage supply and handle administrative aspects of the coin ecosystem, as opposed to…

Decentralized stablecoins. This second category of stablecoins relies on algorithms, which is why they are sometimes known as algorithmic stablecoins, to maintain price consistency. These coin-regulating algorithms incentivize users to buy or sell based on intentional economic motivators, with the end goal of keeping the coin’s value within a predefined price range. That is, to keep the coin stable.

Generally speaking, the combined popularity of stablecoins is massive (in crypto terms) and growing. In May 2021, the market capitalization for all stablecoins surpassed $100 billion.

Stablecoins may have more promise as a model for wider adoption than other types of cryptocurrencies. With major governments including China embracing digital currency and financial stalwarts like MasterCard jumping on board, the relative stability and economic viability of stablecoins may only shine a brighter light on the merits of this class of crypto.

How Do Regulators View Stablecoins?

Ask a question about regulation and (insert cryptocurrency-related topic here), and you’re liable to get a variation of the same answers:

We can’t be certain
Historical precedent indicates potential trouble
It’s not looking good
We can hope for the best

While doom and gloom may be a fair projection for the more cutting-edge, fraud-ripe crypto projects, there truly is reason for hope that regulators will not drop a heavy hand on stablecoins.

Yes, there is generally a need for some level of regulation in the crypto space. Where there is a way to take advantage of others for massive financial reward, there is a need for a system of checks and balances.

And yes, reports by powerful bodies such as the G-20 indicate that they are wary of stablecoins in particular. This may be legitimately viewed as a harbinger for future regulation.

But signs also exist to indicate the mainstream may be more receptive to stablecoins than they have been to other classes of crypto. The Office of the Comptroller of the Currency (OCC) now formally permits certain national banks to deal in funds generated from the issuance of stablecoins. The decision is limited to stablecoins backed by the U.S. dollar (read the details here), but from a regulatory standpoint it is a step in the right direction.

The hope is that regulators will see stablecoins as a critical component of the emerging digitalized economy, rather than a threat to centralized financial systems to be “squashed”.

Whether this hope becomes a reality is largely up to regulators, and the specific decisions they issue as stablecoins’ influence becomes increasingly difficult to ignore will be worth paying attention to.

Automated Market Makers, explained as simply as possible

adm1n69 — Fri, 10 Sep 2021 08:57:16 +0000

Automated market makers (AMMs) are an increasingly-popular branch of decentralized finance (DeFi), falling into the specific subset of decentralized exchanges (DEXs). AMMs’ broad goal is to reduce the number of moving parts that facilitate cryptocurrency trades by replacing limit orders (and the resources that go into fulfilling them) with an automated means of token price valuation. Sounds complicated, right? Well, it’s admittedly a concept that experienced crypto traders might grasp more easily than laymen. Put in simple terms, however, it’s not beyond your comprehension.

How Do Automated Market Makers Work?

To explain how AMMs work, we’ll first clear up a couple terms.

First, ERC-20 tokens. These are tokens designed specifically for use on Ethereum blockchains.

Next, liquidity pool. This term has been described as “levels at which price frequently ‘makes a decision’ as a large amount of orders hit the market”. You may think of a liquidity pool as the intersection between orders which ultimately determines where an asset is priced. Or, just think of it as the supply of a given asset, which determines the price of that asset.

Now, on to automated market makers. AMMs are platforms for trading cryptocurrency, generally built using the Ethereum blockchain and using a liquidity pool of ERC-20 tokens, as well as other coin types. The liquidity pool that funds AMMs takes the role of limit order books in other types of exchanges. Traditionally, an exchange host would have to process buyers’ and sellers’ orders to acquire or sell assets, then find a corresponding party that agrees to the terms of the limit order or sale. Not so with AMMs.

Rather, an algorithmic smart contract continually monitors the store of assets in the liquidity pool. As certain tradable assets are purchased in greater amounts, their supply declines and their price rises correspondingly. As an ERC-20 token in the liquidity pool is deposited back into the liquidity pool, its availability increases and its price therefore declines. The algorithm uses these relative supplies of certain tokens to determine their price in real-time. Rather than issue purchase orders or sale orders and arrange trading parties, the algorithm simply sets the price, and buyers and sellers are free to act based on that price range.

What Are the Benefits of AMMs?

The upside of automated market makers can be discussed relative to centralized markets as well as decentralized exchanges (DEXs). The primary advantage of AMMs over centralized alternatives is their decentralization. Rather than requiring human parties to match and process purchase orders (and possibly perform other administrative tasks required of a centralized exchange), smart contracts occupy the central role in AMMs.

Generally speaking, there are several benefits of decentralized governance. They include:

Fewer middlemen
Less opportunity for human grift
Fewer parties who justify their efforts by extracting value from the product (which oftentimes means the user)

Some “decentralized” forms of cryptocurrency exchange are only partially so, as they may have certain features of decentralization but ultimately have a centralized system of governance. For example, an exchange may outsource the processing of purchase and sale orders to humans in the name of expediency, or may have a centralized board of human directors. With AMMs, decentralization reigns to a significant degree (though the precise setup of each AMM must be evaluated individually). The very act of placing algorithmic smart contracts at the heart of pricing and order execution illustrates AMMs’ decentralized nature.

So what are the benefits of this decentralization, in real-world terms? They are:

Pricing, because it is determined mathematically, can be laid out in extensive detail (see Uniswap’s explanation on how it prices assets)
Total liquidity of an AMM can be fixed, which maintains a certain amount of price predictability for buyers and sellers
There is no need for third parties in between trading partners, as the contract handles the execution of trades
AMMs represent an efficient, streamlined means of trading cryptocurrency (at least in theory, as every AMM is different)

Another feature of AMMs is that those willing to provide liquidity to these markets may be able to do so, taking home some extra coin for their service.

How Do AMMs Benefit Liquidity Providers (LPs)?

You may understand by now that liquidity is critical to allowing AMMs to work. Without assets in the coffers, the entire operation falls apart—smart contracts cannot determine prices (which are based on the liquidity of specific assets) or fulfill trades if there are no assets to trade. So where does liquidity in these automated markets come from? In short, it comes from liquidity providers (LPs). Different types of AMMs may rely to varying degrees on liquidity providers, but they are important in every case.

Liquidity providers have a clear incentive to provide assets to the pool: fees, and possibly interest. LPs may generally receive a portion of trading fees in return for providing liquidity to the marketplace.

The crypto assets that LPs provide generally serve a couple of purposes:

To reduce the amount of “slippage”, or the difference between an algorithm’s projected price and the actual executed price of a trade, which may be due to drastic and sudden changes in supply
To provide liquidity for fulfilling trades

These LPs provide a crucial service to AMMs, and may generally make out well for doing so. However, there is risk in pledging their assets to markets, as negative changes in their tokens’ value due to market forces in a specific AMM may result in a phenomenon known as impermanent loss.

What Is the Future of AMMs?

Right now, the four big fish in AMMs are Uniswap, PancakeSwap, Sushi, and Bancor. These have proven to be viable means for trading cryptocurrency, and appear to be an integral part of the growing decentralized finance (DeFi) sector. There is clear appeal in AMMs. Namely, the ability to create a largely self-regulating market for cryptocurrency swaps has significant appeal for those who loathe middlemen.

There are also challenges. Attracting and maintaining the backing of liquidity providers is just one of those challenges. As trust in legacy financial systems continues to wane, the future of AMMs may become more clear. Will these automated markets become increasingly popular, and therefore sustainable, or will the challenges prove too great to achieve longevity?

An overview of Decentralized Autonomous Organizations (DAOs)

adm1n69 — Thu, 09 Sep 2021 13:00:17 +0000

The sphere of decentralized finance (DeFi) is ripe with specific use cases serving specialized purposes. The concept of decentralized autonomous organizations (DAOs) is certainly relevant to conversations about DeFi, but it does not necessarily fit into the DeFi box—its potential applications are simply too great to be relegated to decentralized finance alone.

Decentralized (or distributed) autonomous organizations are more of a model for governance than a specific use case within the blockchain-powered financial product sector. DAOs now take specific forms, and many of them are DeFi products. But the concept of the DAO may, in the future, be applied in many different sectors of society.

What Is a Decentralized Autonomous Organization (DAO)?

As we tend to do when it is time to explain blockchain-related concepts, we will get to the heart of the term “decentralized autonomous organization”, or DAO, by breaking it down in simple English terms. Per Oxford Languages, to decentralize something is to “transfer (control of an activity or organization) to several local offices or authorities rather than one single one.” Something that is decentralized, therefore, is defined by shared control of power over a system.

A task or system that is autonomous, according to Merriam-Webster, is one that is “undertaken or carried on without outside control” while “existing or [being] capable of existing independently”. An organization is some type of administrative or functional structure. Therefore, a decentralized autonomous organization is one with distributed, non-central control that is able to exist independently without outside intervention while having an organized structure. Decisions in these systems are, at least in theory, made by its participants.

DAOs adhere to these principles, but they refer specifically to systems that are built on blockchain technology. Networks of computers, known as nodes, execute protocols built into self-executing smart contracts in order to make the system function as intended.

How Do DAOs Work?

The blockchain element of DAOs accounts for the “decentralized” aspect of these autonomous organizations. Blockchains are composed of nodes that decentralize each transaction. Instead of a single computer handling tasks such as security checks, financial transactions, and other essential processes, blockchains rely on a network of independent-yet-connected nodes. In this way, all aspects of a blockchain are dispersed, and therefore decentralized. This decentralized system of nodes also facilitates democratic governance by stakeholders.

Smart contracts provide autonomy to a DAO. These contracts are programmed, algorithmic protocols that execute when pre-specified conditions arise. For example, say a buyer inputs a purchase request in a blockchain system. A seller then inputs a sale request and all nodes in the system verify the legitimacy of the transaction. A smart contract then releases the funds to the purchasing party, crediting the seller’s account to reflect the transaction. Because of the powers of smart contracts, no human intervention is required after they are set in motion. Therefore, the entire system remains autonomous.

Smart contracts may also govern voting processes that determine how a DAO is run. When such autonomous smart contracts are built into a decentralized, blockchain-powered platform with a specific organizational purpose, you’ve got a DAO.

What Is the Purpose of a DAO?

The specific purpose of a DAO depends on the DAO which you are referring to. Because this series is meant to explain the world of decentralized finance, we’ll focus on DAOs as they pertain to the DeFi sector. The organization may exist to help users transfer cryptocurrencies across different blockchains, or to serve some of the most popular DeFi use cases such as crypto lending or yield farming.

One could argue that any cryptocurrency is, if it has a decentralized organizational structure, a DAO. Cryptocurrency transactions are generally executed by smart contracts, are intrinsically tied to blockchain technology, and function within some sort of organizational structure. This seemingly checks all the boxes of what makes a DAO a DAO. However, when someone who knows their crypto refers to a DAO today, they are likely referring to something more specific, and generally something that is built on the Ethereum blockchain.

Ironically, decentralized autonomous organizations require human participation to have any value, and in this way they are not completely autonomous. These organizations also generally require a native token to reward users with when they participate in the DAO. The more human participants in a DAO, the more legitimate its purpose, the more valuable its token, and the more participants may be rewarded for their stake through ownership of increasingly valuable native tokens of that DAO.

Once a DAO is funded, launched, and active, decisions about its material function (where will funds generated by the network be invested, for example) becomes a democratic process among stakeholders. This crystallizes the decentralized nature of a DAO, or at least a DAO that functions as it purports to. At this point, a DAO can go on to fulfill its purpose, whatever that purpose may be.

What Is the Current State of DAOs?

For now, these decentralized organizations are largely used to execute financial transactions. They allow users to borrow crypto, lend crypto for interest (and in some cases, additional tokens), purchase, and sell crypto. Use cases continue to emerge, but these are the most established DAO purposes to date. In the future, DAOs may administer elections, execute real estate transactions, or govern some other sector of society. For now, they exist largely in the secretary of decentralized, cryptocurrency-related finance.

Some of the DAOs that have the most on-paper success to date, and the most notoriety as a result, include Maker, MetaCartel, and Aragon. Maker is particularly notable in the DeFi space for providing cryptocurrency lending services which have proven to be massively popular. The concept of DAOs, still relatively young, will only continue to experience a greater number of players entering the markets and, with increased competition, hopefully better and better options for crypto-inclined consumers.

How Do Regulators View DAOs?

One issue always seems to come up in conversations about regulation and blockchain-powered, crypto-linked projects: fraud. If fraud proves to be a significant issue within a sector, the regulators may poke their heads into the picture sooner rather than later. But, it appears that DAOs are getting better at working out kinks and providing self-governance over time.

One of the first widely-hyped forays into DAOs, the originally-named “The DAO”, was structurally unsound and fell victim to a hack. The damage: 3.6 million ETH tokens. Had “The DAO” been the last impression left by DAOs, then regulators might be inclined to swoop in and protect investors from the sort of mismanagement that would result in 3.6 million Ether being absconded with thanks to vulnerable safety protocols.

But, it was not the last impression. Though time will tell the extent to which regulators get involved in the DeFi space generally and specific DAOs particularly, it appears for now that DAOs in the decentralized finance sector are doing a quality job of protecting their investors’ assets and being generally trustworthy.

Everything You Need To Know About Decentralized Exchanges

adm1n69 — Thu, 09 Sep 2021 12:46:15 +0000

Cryptocurrency exchanges, also known as EXs, are a means for consumers to purchase and sell tokens. They bring together buyers and sellers on a proven platform to trade cryptocurrency and, in doing so, help establish the market price for a given token. Many cryptocurrency exchanges to date have been centralized. That is, they are created and managed by a central authority. Exchanges such as Binance, Kraken, Coinbase, and Gemini are all centrally-managed crypto exchanges with significant user bases.

A newer form of cryptocurrency exchange has entered the marketplace, however, and appears to be gaining traction by the month: decentralized exchanges. A decentralized exchange (DEX) serves the same or a very similar function to a centralized cryptocurrency exchange, yet is not centrally managed. Instead, a decentralized exchange may function largely as the result of smart contracts that execute trades based on programmed code. The idea is to take the middle person—the managers of a given exchange—out of the transaction. Achieving this goal may serve multiple functions.

How Do Decentralized Exchanges Work?

The mechanisms of a decentralized exchange may be illustrated best by comparing them with those of a centralized crypto exchange. So how do centralized crypto exchanges work? First, a person who wants to purchase cryptocurrency chooses an exchange. They complete any necessary sign-up or sign-in processes, and then they deposit their dollars, Euros, or other fiat currency of choice in exchange for some form of cryptocurrency. One may also deposit their own cryptocurrency to be traded on the exchange.

There are some noted benefits of centralized exchanges. Because assets are held by the exchange, transactions do not necessarily have to be facilitated by underlying blockchains. While blockchains have several benefits, speed is not generally considered one of them. Therefore, centralized exchanges may offer transaction speeds that are quicker than decentralized alternatives. When a user puts in a purchase or sale order, it may be processed near-instantaneously by the mechanisms that govern a given exchange.

Essentially, a centralized cryptocurrency exchange functions much in the same way that an app like Robinhood does: you deposit funds into the platform, conduct trades, and can withdraw funds when you desire (with certain legal restrictions). With centralized exchanges, you are ultimately trusting that the managers of the exchange will return your funds when you request them, and that they are not misappropriating your deposited funds in any way. You may also pay a cut of each transaction to those managers. While decentralized exchanges share the same basic function as centralized exchanges, they rely far less on the integrity and actions of human managers.

What Is the Purpose of a Decentralized Exchange?

The purpose of a decentralized exchange is generally the same as a centralized cryptocurrency exchange: to facilitate the purchase and sale of cryptocurrency and other crypto-adjacent assets. With this basic purpose in mind, both centralized and decentralized exchanges may allow investors to engage in a number of different transaction types, from simple cryptocurrency purchases to the placing of options and betting on futures.

The more relevant question may be what the purpose of decentralizing exchanges is. As previously stated, a decentralized exchange is one in which no centralized authority stands between two or more individuals involved in a transaction. Or, at least, no human authority does.

At least in theory, purchases and sales of cryptocurrency issued through decentralized exchanges are executed by smart contracts. Rather than the human managers of an exchange collecting and disbursing funds to buyers and sellers, self-executing smart contracts handle each transaction.

From the simplest of standpoints, the benefits of a decentralized exchange may include:

A lesser need to trust a central authority to act ethically
Lower management fees
Democratic participation in exchange-related management decisions by participants in an exchange
Greater flexibility in terms of listing, purchasing, and selling less-mainstream tokens, as the Stanford Journal of Blockchain Law & Policy explains

These potential benefits come with some risks, however.

What Are the Cons of Decentralized Exchanges?

Recent history has shown that there is the ideal of decentralized exchanges (to decentralize, decentralize, and then decentralize some more), and then there are more practically-minded alternatives.

Complete decentralization means:

No central authority
Confirming every transaction through every node in a blockchain
Heightened security through distributed hosting
Maintaining a comprehensive, permanent ledger of transactions on a blockchain

The primary downsides of this ideal is that transactions can become both slow and costly.

To minimize these downsides of full decentralization, hybrid models of decentralized exchanges have emerged. Decentralized exchanges with off-chain order books are one example of how DEXs may outsource elements of their exchange away from the blockchain in the name of efficiency.

Exchanges with off-chain order books may still utilize smart contracts in some capacity to ensure the integrity of a transaction. However, they may also rely on off-chain humans to fulfill certain orders manually. The intent of this is to prevent clogging a certain blockchain pipeline with too many orders on it. The downside is the addition of third parties, which generally moves any blockchain-linked system further away from the ideal of true decentralization. This balance between uber-decentralization and scalability is one that each decentralized exchange must strike in their own unique way.

What Is the Current State of Decentralized Exchanges?

Decentralized exchanges have fallen in line with the broader trend in decentralized finance (DeFi): growth. The general uncertainty that has defined 2020 has further accelerated investment in decentralized exchanges. Cointelegraph notes that a specific brand of algorithm-governed decentralized exchange known as automated market makers (AMMs) are particularly hot right now.

While high demand seems to be proof of value for decentralized exchanges, some concerns remain. One concern is the scalability of blockchains as the number of transactions on a given chain increases. This concern hits on another issue: the relative sluggishness of transactions on decentralized exchanges when compared with centralized alternatives.

As decentralized exchanges continue to feel out the appropriate blend of centralized speed and decentralized security, the hope is that products will continue to evolve to accommodate high demand for decentralized exchanges.