DeFi Education

What is a Swap?

Decentralized exchanges, or DEXs, are digital asset trading platforms that operate without a central authority.

Decentralized exchanges, or DEXs, are digital asset trading platforms that operate without a central authority. Decentralized Exchanges can take the form of Automatic Market Makers(AMMs) or DeFi marketplaces like OpenSea, which are similar to decentralized exchanges, but instead, they allow users to trade digital goods or non-fungible tokens (NFTs) in a trustless manner, usually using a smart contract-based escrow system.

What is an Automated Market Maker (AMM)?

An Automated Market Maker (AMM) replaces traditional order books with pricing algorithms that automatically price any asset pairing in real-time (e.g., Bitcoin-US dollar).

In traditional market-making, the firms provide an accurate price and a tight spread on an order book, AMMs decentralize this process and allow users to create a market on a blockchain using smart contracts technology. No counter party is needed to make a trade, the AMM simply interacts with the blockchain to “create” a market and interact with it.

How do Automated Market Makers work?

On AMM platforms, instead of trading between buyers and sellers, users trade against a pool of tokens (a liquidity pool) in a Smart Contract. In little words, a liquidity pool is a shared pot of tokens. Users supply liquidity pools with tokens and the price of the tokens in the pool is determined by a mathematical formula. Adjusting this formula, liquidity pools can be optimized for different purposes.

Anyone with an internet connection and in possession of any type of tokens can become a liquidity provider by supplying tokens to an AMM liquidity pool. Liquidity providers normally earn a fee for providing tokens to the pool. This fee is paid by traders who interact with the liquidity pool contract. Recently, liquidity providers have also been able to earn yield in the form of project tokens through what is known as “Yield Farming.”

What are the pros and the cons of Decentralized Exchanges?

Pros:

  • No KYC or ID Verification: DEXs are trustless, meaning users’ funds, privacy, and personal data are well preserved.
  • No Counterparty Risks: Because users don't have to transfer their assets to a centralized exchange, decentralized exchanges can reduce risks of theft and loss of funds due to hacks. DEXs can also prevent price manipulation or fake trading a volume as everything is publicly available on the blockchain.
  • Any Token Can Be Traded: With a DEX, users can trade new cryptocurrencies that previously were difficult to exchange elsewhere.

Cons

  • No Recovery Ability: DEXs don’t have any underlying authority to recover lost, stolen, or misplaced funds, neither loss of private keys since all transactions are processed and stored in smart contracts on the blockchain without any owners or overseers, which makes users totally responsible for their funds and keys.
  • Limited Trading Functionality: Decentralized exchanges are a new thing, so they tend to focus on executing simple buy and sell orders. Users may find advanced trading functions such as stop losses, margin trading, and lending are unavailable on most DEXs, but recently there has been a lot of implementations of other protocols that enables some of these features.

What is Slippage Tolerance?

Slippage tolerance is an important term that you need to understand before executing a trade on decentralized exchanges.

Slippage is the pricing difference between the time the user sends the transaction and the actual price when the transaction is confirmed. The tolerance is the percentage of slippage users are willing to accept when swapping on AMMs. Slippage tolerance is set as a percentage of the total swap value.

Slippage is caused by the amount of liquidity, which is how quickly you can buy and sell an asset without impacting the price. So, if there is low liquidity or low trading activity in the market for a specific asset, then the slippage percentage will be higher.

What are the Gas Fees?

Gas refers to the fees required to successfully conduct a transaction or execute a contract on the blockchain. In Avalanche, gas fees are paid in Avalanche's native currency, (AVAX).

Gas fees help keep the Avalanche network secure. By requiring a fee for every transaction executed on the network, it prevents bad actors from spamming the network.

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