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Economics 102
How DODO Enables an Efficient, Decentralized Cryptocurrency Marketplace
Financial markets have always been powered by the need to match buyers with sellers. Throughout the world’s long history of buying and selling, liquidity – the ease with which a transaction can be completed without a drastic change in its price – has always been essential to the success of this endeavor.
If there are too few people on one side of a trade, a transaction becomes harder to complete, forcing sellers to offer discounts to attract buyers, or forcing buyers to raise their bids to secure a desired asset. This drives an increase in the difference between prices sought and prices offered, and increases both volatility and risk.
Large swings in the market can scare off cautious investors, leading to further reductions in trading volume - resulting in a downward spiral.
Cryptocurrency exchanges are not exempt from these factors.
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.
These exchanges have become "islands of liquidity" 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 bitcoins are 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.
There are two types of cryptocurrency exchanges on the market today: centralized exchanges (CEXs), where transactions are handled by a third party that controls the funds and keys, and decentralized exchanges (DEXs), where transactions and settlements take place on the blockchain and can be traded directly between buyers and sellers without intermediaries.
Decentralized exchanges offer a host of advantages: high anonymity, customizability, lower costs, and less vulnerability to hacking and manipulation. But centralized exchanges have traditionally had an edge on the liquidity front: since they are larger, and are perceived by some as easier to use, they have attracted the majority of cryptocurrency investors.
The DeFi Summer of 2020 started to swing the pendulum in favor of decentralized exchanges. 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 U.S. Securities and Exchange Commission in February of 2021 along with its stock offering statement, Coinbase cited the rise of decentralized exchanges as a key risk to its business model.
Several liquidity innovations have helped drive the boom in DEX trading volume. Liquidity mining offers investors willing to set up liquidity pools an incentive in the form of governance tokens, which give holders influence over a project. These proliferated throughout 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. AMMs rely on liquidity pools provided by users who receive incentives for locking their tokens to help ease transactions.
However, AMMs also has their drawbacks. These include slippage - the gap between the target price and the actual price, and impermanent losses - the temporary disappearance of funds liquidity providers can experience because of volatility in a trading pair.
DODO has found a way to provide liquidity that’s comparable to centralized exchanges without the drawbacks listed above. Our highly customizable Proactive Market Maker (PMM) algorithm uses oracles to find the actual price of an asset. The system then provides sufficient liquidity at or near this market price and reduces availability further out. This makes the PMM more efficient than traditional AMMs and reduces both impermanent loss and slippage.
With no minimum deposit and the ability to provide liquidity in the form of just one token in a pair, liquidity providers can use tokens they already own, without taking on price risk.
Primary crypto markets have their own liquidity issues. During initial token offerings, liquidity is inherently limited because bidders can only buy tokens but can't sell them.
Decentralized exchanges have rolled out numerous ways to solve this puzzle, including yield farming, AMMs and bonding curves, where a token’s price rises along a pre-set arc. All of these, however, have their disadvantages – including a risk of frontrunning and high costs.
DODO has developed a liquidity solution for primary markets as well. Crowdpooling – the name is a portmanteau of “crowdfunding” and “liquidity pool” – enables issuers to keep costs down while still providing investors highly liquid capital pools.
Inspired by the call auction mechanism common in securities markets, Crowdpooling is safe from both frontrunning and bot interference. It also offers a guaranteed liquidity protection period, so investors can feel confident in backing projects they believe in.
DEX activity has picked up steadily since 2021. And with innovations like Crowdpooling, decentralized liquidity is now a reality. That means the crypto space finally has the tools it needs to enable truly decentralized economies. And DODO is leading the charge.
Last modified 29d ago