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Economics 102: How DODO is enabling efficient, decentralized crypto markets

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 quest.

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 buyers to raise bids to secure a desired asset. This drives spreads between prices sought and prices offered wider and increases both volatility and risk.

The increased tumult can scare off more cautious investors, which further tamps down volumes. And so on.

Cryptocurrency exchanges are no exception to these forces.

The decentralized liquidity challenge#

The crypto markets are very young. From an initial handful of marketplaces set up for the buying and selling of Bitcoin, hundreds of exchanges now exist to deal with thousands of different cryptocurrencies and tokens. These exchanges have become “islands of liquidity” for the assets traded on them -- their siloed nature restricts activity since the same asset cannot easily be traded across platform. The result is a more turbulent market than those for more established assets.

The concentration of cryptocurrency ownership also feeds volatility. Some 95% of Bitcoin, for instance, is held by just 2% of accounts. If these accounts choose to buy or sell stakes when volumes are thin, transactions will have an outsized impact on prices.

Beware centralized convenience#

For all their variations, there are really only two categories of crypto exchange: Centralized exchanges (CEXs), where transactions are handled by a third party that controls funds and decryption keys; and decentralized exchanges (DEXs), where trading and settlement take place on a blockchain and peers can deal directly with one another without intermediaries.

Decentralized exchanges offer a host of advantages: they are anonymous, more customizable and less costly, and they are less prone to hacking and manipulation. But centralized exchanges have traditionally had an edge on the liquidity front: since they are larger, and perceived by some as easier to use, they have to date attracted the bulk of crypto investors. Until now.

Mid-2020’s summer of DeFi started to swing the pendulum in favor of distributed marketplaces. Volumes have spiked to levels comparable to centralized exchanges, as the sector has rolled out technical solutions to the liquidity problem. In fact, in a letter filed with the U.S. Securities and Exchange Commission in February alongside its share offering prospectus, Coinbase identified the rise in decentralized exchanges as a key risk to its business model.

DEXs: Innovating their way to greater liquidity#

Several liquidity innovations have helped drive the boom in DEX trading volume. Liquidity mining offers investors willing to set up liquidity pools a new type of asset – governance tokens, which give holders influence over a project – as an incentive. These proliferated throughout 2020. Many platforms are also taking steps to offer liquidity providers more sway over the maximum and minimum prices for their liquidity pools.

Perhaps the most common tool used by decentralized exchanges to boost liquidity is the Automated Market Maker (AMMs). AMMs rely on liquidity pools provided by users who receive incentives for locking up their tokens to help ease transactions.

AMMs have their downsides, however. These include slippage – the gap between the price sought and the price realised – and impermanent loss – the temporary disappearance of funds liquidity providers can experience because of volatility in a trading pair.

Now, 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.

And with no minimum deposit and the ability to use single tokens, liquidity providers can use tokens they already own, without taking on price risk.

Providing liquidity in primary markets#

Primary crypto markets have their own liquidity issues. In initial offerings of tokenized assets, liquidity is inherently limited in that bidders can only buy and not sell.

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 – from potential frontrunning to high cost.

Now DODO has developed a liquidity solution for primary markets as well. Crowdpooling – the name is a blend 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 and offers a guaranteed liquidity protection period so investors can support projects they believe in with peace of mind.

DEX activity has picked up steadily in 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.