Retail and institutional capital continues to pour into cryptocurrencies at record speed, largely facilitated by centralized exchanges, such as Binance, Gemini and NASDAQ NDAQ +0.6%-listed Coinbase, processing a daily volume of over $50 billion USD. Despite hosting new and innovative crypto-assets which promote decentralization, centralized exchanges still require users to give up custody of their assets to a third party.
In 2020, we saw the rise of decentralized exchanges, or “DEXs,” from UniSwap and SushiSwap on Ethereum, to more niche products like Project Serum for Solana users and PancakeSwap on Binance Smart Chain. A DEX allows users to not only trade, but to also earn a portion of the platform transaction fees, by users staking or lending digital currencies to the exchange. Crowd-sourced liquidity is at the heart of so-called ‘decentralized finance’ (“DeFi”), but presents a double-edged sword, as decentralized exchanges are only as useful as the willingness of their users to stake assets.
With the upcoming launch of the Polkadot and Kusama ecosystems, an entirely new network of projects, including Plasm (a dApp platform on Polkadot), MoonBeam (an Ethereum-style Smart Contract platform on Polkadot) and Clover (an Operating System parachain on Polkadot). The goal of this new ecosystem is to bring blockchain from theoretical to practical, by facilitating cross-chain development.
Polkaswap is the first UniSwap-style DEX on the Polkadot and Kusuma ecosystems, created on the SORA Network. SORA’s mission is to build a new world economic system to allow efficient allocation of capital for creators to make new products, and act as a decentralized “central bank” that provides liquidity to the Polkadot ecosystem. SORA’s developer toolkit was created for a variety of use cases including parachains, atomic token swaps and cross-chain bridges.
This week I sat down with the team at SORA to discuss some of the technical elements involved in building a DEX. Polkaswap’s secret sauce is its token bonding curve, a smart contract that seamlessly exchanges one token for another, without any intermediaries or third parties. The DEX borrows the concept of liquidity injections by central banks for traditional trading, and uses this concept to boost liquidity for digital asset trading.
Commonly used by economists, a bonding curve is a mathematical concept that describes the relationship between price and supply of an asset, such as a currency or a token. For example, when a person purchases an asset that is available in a limited quantity, such as Bitcoin, each subsequent buyer’s cost will be slightly higher, as the number of available coins decreases. Consequently, the earliest investors generate the greatest amount of profit.
In developing decentralized exchanges, the cryptocurrency industry implemented bonding curves into smart contracts, to create a fair exchange of assets. Bonding curve contracts sell tokens to users by calculating the token price in an underlying asset, such as Ethereum, and quoting prices in the same underlying asset. In both cases, the smart contract calculates the average price and provides a transparent rate to its user.
“Our economic research team proposed the idea of a bonding curve when looking at market operations done by central banks, especially those in developing countries who try to manage their currency’s exchange rate. We were able to utilize the same concept for a token exchange, creating transparency for all market participants on future pricing based on liquidity available, and in a completely autonomous and decentralized way,” says Makoto Takemiya, CEO of Soramitsu and one of the contributors to SORA.
Concepts similar to bonding curves have historically been used by central banks to manage the fiat currency exchange rates. For example, the central bank of Hungary commonly intervenes in HUF/EURO markets in order to maintain FX rates within a targeted volatility band. They do this by selling Forints for Euros when the price is too high, or by using reserves of Euros to buy Forints when the price is too low. Sovereign currency states can conduct such open market operations successfully, because they have a high degree of centralization over their currencies and keep significant financial assets in reserve. In cryptocurrency markets, however, centralized players are frowned upon.
Polkaswap was launched to create a solution that doesn’t rely on any human involvement. The project was launched with a grant from the Web3 Foundation, the non-profit foundation that contributes to the technology in the Polkadot and Kusama ecosystem, founded by Dr. Gavin Wood, a co-founder of both Ethereum and Polkadot.
As cryptocurrencies continue to become mainstream, traditional financial infrastructure has come under scrutiny for centralization and self-dealing, often leaving the retail investor to pick up the pieces of financial experiments gone wrong. Decentralized exchanges provide valuable lessons for the financial architecture of the future, where access to value is democratized and can make a meaningful financial impact on the lives of ordinary people.