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Economics 102
How DODO Enables an Efficient, Decentralized Cryptocurrency Marketplace
Financial markets have always been driven by the need to match buyers and sellers. Throughout the world's long history of buying and selling, high liquidity, completing transactions without dramatic price changes, has been the highest pursuit of financial markets.
If there are too few parties to a transaction, it becomes more difficult to complete the deal, which will force sellers to offer discounts to attract buyers or buyers to increase their bids to obtain the desired asset. This drives up the target price spread between buyers and sellers, increasing volatility and risk.
Large swings in the market can turn away cautious investors, leading to further reductions in trading volume, and so on.
Cryptocurrency exchanges are no exception to these factors.
The liquidity challenges of decentralization
The cryptocurrency market is very young. From its humble beginnings as a marketplace for buying and selling bitcoins, there are now hundreds of exchanges dealing with thousands of different cryptocurrencies and tokens at the same time.
These exchanges have become "liquidity silos" for the assets traded on them, and their siloed nature limits activity because the same asset cannot be easily traded on different platforms. The result is a more volatile market than those for more established assets. The concentration of cryptocurrency ownership also contributes to volatility.
For example, about 95% of bitcoin is held by just 2% of accounts. If these accounts choose to buy and sell when trading volumes are low, the trades will have a huge impact on the price.
Advantages of Centralized Exchanges
There are two types of cryptocurrency exchanges on the market today: centralized exchanges (CEX), where transactions are handled by a third party that controls the funds and keys, and decentralized exchanges (DEX), where transactions and settlements take place on the blockchain and can be traded directly between them without an intermediary.
Decentralized exchanges offer a range of advantages: high anonymity, customizability, lower costs, and less vulnerability to hacking and manipulation. But centralized exchanges have historically had an advantage in terms of liquidity: they are larger and some users find them easier to use, and so far they have attracted the majority of cryptocurrency investors.
The DeFi Summer in mid-2020 kicked off the decentralized marketplaces boom. Trading volumes have soared to levels comparable to centralized exchanges as more technical solutions to liquidity problems have been introduced. In fact, in a letter filed with the SEC in February along with its stock offering statement, Coinbase cited the rise of decentralized exchanges as a key risk to its business model.
Decentralized Exchanges - Innovative Approaches to Greater Liquidity
Innovations in liquidity have helped drive the boom in DEX trading volume. Liquidity mining offers a new asset type for investors willing to build liquidity pools - governance tokens - and incentivizes holders to influence projects. This approach proliferated in 2020, and many platforms are taking a similar approach, allowing liquidity providers to have a greater impact on prices.
The most common tool used by decentralized exchanges to increase liquidity is the automated market maker (AMM) algorithm. AMM relies on a pool of liquidity provided by users who are rewarded for locking their tokens to help the liquidity pool trade.
However, AMM also has its drawbacks. These include slippage - the gap between the target price and the actual price, and impermanent losses - the liquidity provider's funds may lose money temporarily or over time due to the volatility of the trading pair's price.
Now, DODO has found a way to provide liquidity comparable to that of centralized exchanges and without the drawbacks of AMM mentioned above. The active market maker (PMM) algorithm is highly customizable and uses a prophecy machine (oracle) to help find the actual price of an asset. The system then provides sufficient liquidity at or near this market price and reduced availability further out. This makes PMMs more efficient than traditional AMMs and reduces impermanent losses and slippage.
And, because any number of tokens can be used to provide unilateral liquidity, liquidity providers can use the tokens they already own without taking price risk.
Providing liquidity in the primary market
The primary cryptocurrency market has its own liquidity issues. During initial token offerings, liquidity itself is limited because bidders can only buy but not sell.
Decentralized exchanges have introduced a number of methods to address this challenge, including liquidity mining, AMM, and ascending crowdfunding. However, each of these solutions has its own drawbacks.
Now, DODO has also developed a liquidity solution for the primary market, Crowdpooling - whose name combines "Crowdfunding" and "liquidity pool" (pool). Issuers are able to offer assets at low cost and provide investors with a highly liquid pool of funds.
Inspired by the call auction mechanism common in securities markets, Crowdpooling is free from scrambling and bots and offers liquidity protection periods as a guarantee of funding. Investors can thus feel confident in backing projects they believe in.
2021 also saw a steady increase in DEX activity. With innovations like Crowdpooling, liquidity in decentralized platforms is now a reality. This means that the cryptocurrency space finally has the tools it needs to achieve a truly decentralized economy. And DODO is leading the way.
Last modified 3mo ago
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