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March 29, 2024

Decrypting Cryptocurrency by Focusing on Decentralized Exchanges

Author(s): Jeffrey Armstrong

Cryptocurrency exchanges are driving much of the dynamism of the cryptocurrency economy.[1]  These exchanges, built on blockchain and smart contract technology, provide not only a trading venue but an access point and a platform for a wide range of cryptocurrency commerce utilizing the blockchain, including launching, lending and staking coins and tokens.  It’s difficult to recall (or even imagine) an industry that emerged so fast and has offered a new way of engaging in commerce whose underlying technology has simultaneously become the building block for valuing the technology itself.[2]

Certain cryptocurrency exchanges built on blockchain technology known as a Decentralized Exchange or “DEX” are a major driver of this phenomenon.  For thousands of new cryptocurrencies, DEXs have been a primary launch and trading venue.  By the end of 2023, as shown in the chart below, there were over 10,000 cryptocurrencies (coins and tokens) in circulation.  A large number of these new cryptocurrencies were first traded on a decentralized exchange.[3]

This blog takes a close look at DEXs and the novel way in which they utilize blockchain and smart contract technology to create markets and generate market prices.  Because of their highly decentralized structure and organizational transparency, DEXs add to our understanding of the formation of cryptocurrency markets and importantly how market prices are determined through the application of blockchain technology.

Market prices generated on cryptocurrency exchanges have also become integral to financial exchanges outside of blockchain commerce.  For example, price indexes and reference prices, i.e., “benchmarks” generated on cryptocurrency exchanges are referenced by cryptocurrency futures contracts traded on the Chicago Mercantile Exchange[4] (“CME”) and the Chicago Board Options Exchange[5] (“Cboe”). They are also referenced by spot bitcoin Exchange Traded Funds[6] (“ETFs”) that were recently approved by the Securities Exchange Commission (“SEC”).[7]

US regulators including the SEC and Commodity Futures Trading Commission (“CFTC”) as well as state regulators of securities and financial markets are also actively engaged in developing policies and regulations affecting cryptocurrencies and exchanges.  The last section of this blog summarizes several points to guide these efforts that market participants should also be aware of.

The 2022 Cryptocurrency Market Correction

Cryptocurrency markets have been viewed as highly speculative, especially given the absence of a tangible commodity or widespread use as a medium of exchange to anchor its value.  This underscores the importance of knowing how cryptocurrency prices are determined in the marketplace.  In spite of their highly volatile nature, there are rational economic forces operating on cryptocurrency prices that help determine their values.  The exchanges also provide a source of organized price discovery based on market supply and demand factors.

Before turning to that topic in the context of DEXs, it is worth reviewing the recent market turmoil referred to as the cryptocurrency “winter” of 2022.  This was a period of extreme market stress for cryptocurrencies, which ironically bears some resemblance to other market crises that cryptocurrencies were envisioned to be immune to.[8]

In 2022, the prices of the two most highly traded cryptocurrencies Bitcoin and Ether (the native coins of the Bitcoin and Ethereum blockchains, respectively) fell by almost 70 percent from their December 2021 peaks as shown in the graph below.  The decline coincided with several well-known cryptocurrency business failures including the scandal and bankruptcy of FTX, the surprise collapse of the supposed stablecoin issued by Terraform Labs,[9] and a sharp slowdown in the launch of new coins and tokens, which had previously been added at a rate of thousands per year (over 4,000 in 2021 alone) versus just 142 new tokens in 2022 as shown in the chart up above.

The rapid deterioration of the cryptocurrency market in 2022 on so many dimensions appeared to corroborate the view that cryptocurrencies were indeed speculative assets driven by irrational behavior.  Some of the 2022 price decline, however, may have reflected rational investment behavior as well.

Looking at the chart below shows how short-term interest rates (red line) rose in 2022 from a base of near zero to over 5 percent in less than half a year.  As seen in the chart, the rise in rates coincides with the bulk of the decline in the prices of Ether (the Ethereum blockchain’s native coin).  The steep rise in interest rates by the U.S. Federal Reserve actually caught many financial market participants by surprise, causing a disruption and adjustment in many markets, not just cryptocurrency.

The linkage between the two series is actually not surprising given that many coins and tokens are used to generate short-term interest via lending through yield farming and staking.[10]  Higher interest rates in financial markets organized around fiat currencies would naturally – and rationally – draw some investor demand away from cryptocurrencies causing downward pressure on market prices.

The market turmoil in 2022 had widespread impacts.  It renewed efforts by US financial market regulators to oversee cryptocurrencies and exchanges.  It spurred private investors to file numerous lawsuits including class actions against cryptocurrencies for fraud, unregistered securities, and other claims.  And it has provided an ongoing stream of news stories about cryptocurrency failures, scandals and market disfunction.

The patterns of disruption and recovery – Ether prices actually rose as interest rates plateaued in late 2023 –  are likely given features of the cryptocurrency landscape for the near future as the blockchain technology continues to unfold.  As in any market economy, the patterns in prices tell an important part of the story about the views of investors, the interests of regulators and where markets are headed.

But the story would be incomplete without knowing how such closely watched market prices are generated on exchange platforms where cryptocurrencies are traded every day.  One of the many fascinating aspects of blockchain commerce is that the underlying technology forms the basis for the products and the venues on which they are priced.  The DEXs illustrate this nexus given that trade execution and settlement are conducted entirely on the blockchain and the systems used for organizing trades and determining exchange prices are rooted in blockchain technology.

Decentralized Exchanges for Trading and Pricing Cryptocurrency

A DEX is an all-to-all cryptocurrency exchange that allows anyone to anonymously trade directly on the exchange with all other end-users.  All that is needed to trade is to visit the DEX’s website (or app), enter a trade request, then execute the trade upon connecting one’s wallet to the DEX.  The real-time exchange rate and related trading fees are posted on the website’s trading page.

On a DEX platform (or platforms via a decentralized exchange aggregator) trading is permissionless, trustless and verified by the blockchain.  This means there is no need for brokers to handle trades, market makers to furnish liquidity, organizers to manage order books, or third-party clearing organizations to settle trades.  This applies to individual traders, corporations, sophisticated hedge funds, or any other small or large participant on the trading platform.  And since DEXs conduct trading on the blockchain, exchange participants retain control of the digital coins and tokens in their wallets rather than handing them over to a centralized exchange or other third party.[11]

In short, traders on DEXs have immediate access to virtually any DEX trading platform for any cryptocurrency and participate directly in the entire transaction process without the need for an intermediary.  Looking back at the history of market trading systems which often take decades for even incremental advancements, the emergence of fully all-to-all electronic trading exchanges in only a few years represents a remarkable innovation.

The DEXs also function as pathways for entry into cryptocurrency, for example, by facilitating users’ first-time purchases of coins and tokens and as platforms for launching new cryptocurrencies known as Initial Coin Offerings (“ICOs”).  Because they support trading of such a large and diverse universe of tokens, they further provide secondary markets for Decentralized Finance or “DeFi” activities known as yield farming and blockchain staking as noted above.  DEXs thus do more than serve as sophisticated trading platforms but help finance and build the cryptocurrency infrastructure itself.

Sources: see footnote 12.

A few of the largest and most active DEXs are shown in the table above.[12]  The four DEXs shown in the table – Uniswap, Curve, dYdX and PancakeSwap – were launched fairly recently and have attained significant trading volumes for a diverse set of products, including spot and derivatives.  Their current daily volumes range from $150 million to over $1 billion.  The Total Value Locked or “TVL” (coins and tokens deposited on the platform) also varies significantly from hundreds of millions to several billion dollars.[13]  These four DEXs alone show evidence of rapid scalability, appeal to diverse investor types, and ability to target specific markets.

The DEXs generally trade spot contracts, that is, trades for immediate settlement.  Some DEXs such as dYdX and PancakeSwap also trade derivatives known as “perpetual futures.”  A perpetual future is essentially a futures contract with no scheduled expiration date (unlike conventional futures which have pre-designated expiration dates a certain number of months in the future).  These may seem like a niche product but they are actually one of the fastest growing segments of the market, due in part to the leveraged positions that can be achieved through margin buying (like conventional futures).

For example, the dYdX exchange lists only 38 cryptocurrency pairs yet generates a high level of trading volumes, roughly $500 million daily.  The dYdX exchange is dedicated to trading derivatives including perpetual futures.

As shown in the table, DEXs are capable of listing a very large and diverse number of coins and tokens.  For example, Uniswap which runs on the Ethereum blockchain has over 7,000 pairs of cryptocurrencies listed.[14]  The PancakeSwap exchange lists over 1,700 cryptocurrency pairs.  This is an important characteristic of DEXs and raises the obvious question of how so many tokens can be priced in a decentralized market setting.[15]

DEX Price Discovery Through Automated Market Making

Organized exchanges, whether conventional central limit order book or old-fashioned pit trading, require liquidity and a means to execute trades and generate market prices.  As the previous section discussed, this is a challenging task for DEXs given the thousands of cryptocurrency pairs that are listed, and the likelihood that many cryptocurrencies are thinly traded or have unique features.

DEXs employ an innovative trading and pricing algorithm developed for cryptocurrencies known as Automated Market Marking (“AMM”).[16]  An AMM is a mathematically-based algorithm programmed into smart contracts that performs trade execution, balances liquidity, and determines market prices.  An AMM is essentially an extension of blockchain technology.  It is coded and administered through smart contracts which are automated, self-executing commands and functions controlling the interaction and movement of coins and tokens on a blockchain such as Ethereum.

There are different versions of AMMs.  The rest of this section describes Uniswap’s AMM whose algorithm has been adopted by other leading DEXs.[17]  The diagram below, taken from Uniswap’s website, illustrates the basic steps in the process.[18]

Starting from the left, the trader initiates a trade shown as “Execute Swap” in the red-colored box.  A trade is referred to as a swap (not a buy or sell) since a trade always entails exchanging one cryptocurrency (“Token A” in red) for another cryptocurrency (“Token B” in yellow).  In this illustration, the prevailing market price is 3 units of Token A to buy one unit of Token B.  For example, Token B might be a cryptocurrency like Ether and Token B a cryptocurrency with lesser value, in this illustration a third of Ether.

To execute a trade of “3 Token A” for one Token B, the trader actually receives less than one unit of Token B because of a transaction fee equal to 0.3% that gets applied to Token A.  Thus, as shown in the red box the “Output” received in terms of Token B is 0.997 units.  In the process of executing this trade, market supply and demand reveals a willingness to acquire Token B and depart with Token A that changes relative prices.

The large box on the right shows how the price adjustment works.  The market price of 3 at which the trade occurred is shown next to the “Pool Start.” It is determined by the starting Liquidity Pool balance which reflects an initial equilibrium relative value of 3 to 1.  The pool is at an equilibrium balance for any ratio of token quantities of 3:1, which in this illustration is shown by the 1,200 Token A coins and 400 Token B coins contributed to or “locked” in the pool.

Once the trade occurs, the 3 units of Token A (plus the 0.3% fee) alters the Liquidity Pool balance by adding 3.009 units of Token A and deducting the 0.997 units of Token B acquired by the trader.  This raises the total amount of Token A in the pool to 1,203.009 units and lowers the amount of Token B in the pool to 399.003 units (400 minus 0.997).  This is shown as the “Pool End” in the diagram.

With this new Liquidity Pool balance the “Next Price” is now 3.015 (the ratio of 1,203.009 to 399.003).  This becomes the prevailing market price for the next trade.  At this new price, it is more costly to purchase Token B with Token A, as expected based on the underlying market supply and demand shift revealed by obtaining Token B from the pool and adding Token A.

As trades occur that alter the pool balance, market prices adjust along the “Price Curve” highlighted in the right box.[19]  As the balance of the Liquidity Pool shifts toward either token, the relative prices of Token A and B move along the Price Curve depending on which token becomes more scarce or more abundant.  If prices move away from their market values, then arbitrage trades – swapping A for B and vice versa – will shift the Liquidity Pool back toward a mix consistent with equilibrium market values.

As the above discussion implies, the ability to trade requires an ample Liquidity Pool for the smooth and continuous operation of the market.  Unlike a central limit order book, there are no designated market makers to provide liquidity.  Liquidity instead comes from DEX participants, who are incentivized to lock pairs of cryptocurrencies into the Liquidity Pool in return for earning a portion of the 0.3% transaction fee.

Guidance for Market Participants, Legal Professionals and Regulators

Decentralized exchanges have made a significant contribution to the trading and growth potential of cryptocurrencies.  Investors have expressed an interest in autonomy when buying and selling cryptocurrencies and DEXs have found innovative ways to meet this demand with sophisticated trading and pricing methods.

Trading on DEXs can shift some of the burdens and risks associated with trading on decentralized exchanges that should make market participants, regulators and the exchanges themselves attentive to, including:

  • The thousands of cryptocurrencies that are traded on numerous exchanges. This raises the possibility that cryptocurrencies could materially differ in features not easily observed by all exchange participants.  This could create opportunities for deception, fraud and other abuses such as token scams, pump-and-dump or Ponzi schemes that could cause harm to cryptocurrency traders and investors.
  • The DEX trading protocols including AMM, described above, are based on complex mathematical algorithms. While there is informative documentation about these trading systems, there are likely platform architecture features that have not been fully tested under alternative market conditions, still under development or lacking in transparency that influence the way trades are executed and prices generated.  As with any trading system, there could be design features that favor some traders or groups over others.
  • In traditional commodity and financial markets outside of cryptocurrency, the manipulation of market prices including price benchmarks has occurred. On DEXs, the low trading volumes for some cryptocurrencies, limited liquidity and lack of familiarity with some coins and tokens should make participants and regulators vigilant for potential manipulation of market prices.
  • Decentralized exchanges play an important role in cryptocurrency price discovery. Unlike price discovery in other markets, there is substantial overlap in the technologies from which cryptocurrencies are created and on which the exchange platforms are built. This may be one of the reasons for ongoing price uncertainty given that cryptocurrency’s perceived valuation alters both the expected financial rewards of cryptocurrency and the platforms on which they are launched, traded and priced.  Understanding their operations will enable market participants to more effectively utilize these platforms and guide regulators toward better oversight and policy making.

Econ One has experts in finance, economics, statistics and large-scale data analytics.  Econ One’s PhDs, expert economists,  and skilled technical support staff bring a multidisciplinary approach drawing on experience in financial and securities markets and the latest economics and finance research on cryptocurrency.

[1] According to a recent study, cryptocurrency exchanges are at the center of most cryptocurrency wallet transfer activity (see Makarov, Igor and Antoinette Schoar “Blockchain Analysis of the Bitcoin Market,” April 18, 2022).

[2] The late economist Zvi Griliches described these types of innovations as “inventions of a method of inventing.”  See Griliches, Zvi “Hybrid Corn: An Exploration in the Economics of Technological Change,” Econometrica, October 1957, 25 (4).

[3] There are two main types of cryptocurrency exchanges: a Centralized Exchange (“CEX”) and Decentralized Exchange.  This blog focuses on Decentralized Exchanges for reasons discussed below.

[4] See CMEGroup at www.cmegroup.com/markets/cryptocurrencies

[5] See Cboe at https://www.cboedigital.com/margin-futures/

[6] See www.sec.gov/news/statement/gensler-statement-spot-bitcoin-011023

[7] See CoinDesk.com for a list of cryptocurrency exchanges that contribute prices for indexes relating to Bitcoin and Ethereum coins and Uniswap tokens (“UNI”). 

[8] See “What crypto (still) gets wrong,” Financial Times March 16/17 2024, at https://www.ft.com/the-weekend-essay

[9] The stablecoin TerraUSD issued by Terraform Labs fell from its $1 peg to $0.10.

[10] Yield farming is a way for investors to earn short-term interest by depositing their tokens or coins into liquidity pools that compensate the lender with governance tokens, i.e., tokens that give holders governance rights over the management of the liquidity pool.  Staking refers to lending cryptocurrencies to finance “proof of stake” blockchain verification done by pledging financial resources (as opposed to “proof of work” verification done by pledging computing resources).

[11] A CEX requires wallet holders to transfer their cryptocurrency into the custody of the CEX.  Trade execution and settlement on CEXs is conducted off of the public blockchain whereas most DEXs operate entirely on-chain.

[12] Based on information from the following sources: www.uniswap.org, www.curve.fi, www.dYdX.exchange, www.pancakeswap.finance, www.coingecko.com, www.defillama.com

[13] Coins and tokens are “deposited” by users who transfer their cryptocurrencies to platforms for staking, lending and liquidity provision. The TVL is measured as of the date of this blog.  The Daily Volumes are based on the last 3 months of volume data. The source of data is www.coingecko.com and www.defillama.com

[14] As explained below, cryptocurrency pairs are traded or “swapped” on exchanges.  On the Uniswap DEX the types of cryptocurrencies exchanged are ERC-20 tokens, which defines standards for the token and its interaction with smart contracts. See www.uniswap.org

[15] Other types of CEX exchanges list far fewer cryptocurrency pairs.  For example, Binance, the largest CEX, lists roughly 1,100 pairs, while the next three largest CEXs Coinbase, Bybit and OKX each list only a few hundred pairs.

[16] Some DEXs such as dYdX, PancakeSwap and GMX utilize a centralized order book for trading derivatives.  This requires moving trade executions off-chain.

[17] See Uniswap V3 whitepaper at https://uniswap.org/whitepaper-v3.pdf

[18] Uniswap continues to update and refine its AMM.  A detailed description of Uniswap’s AMM is available on its website. See https://docs.uniswap.org/contracts/v2/concepts/protocol-overview/how-uniswap-works

[19] The Price Curve is based on the price model used by Uniswap known as the “Constant Product” formula. See https://docs.uniswap.org/contracts/v2/concepts/protocol-overview/how-uniswap-works

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