DeFi and Automated Market Makers

By Zain Jaffer

The original 2008 Bitcoin white paper abstract opens with the sentence: “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.” That last clause is particularly of note — “without going through a financial institution.”

The 2008 invention of Bitcoin was a product of its time. Specifically, it was a reaction to the public outrage against Wall Street and big banks in general, and how these almost brought down the global economy because of the subprime mortgage crisis. Those old enough to remember may recall the Occupy Wall Street protests. People started to ask, why do we need these banks anyway?

If you are in front of someone, like if you want to pay for takeout coffee or food and the cashier is in front of you, you simply hand over the payment and take possession of the items. That is called a peer-to-peer transaction, where there is no middleman like a bank, a broker, or a wire service between your transactions.

Things are more complex when you are not in front of the other party. In most instances, you need “trusted third parties” like banks. These institutions have been around for hundreds of years. The problem some people have is that these third parties can often betray your trust, or at the very least cause delays in the transaction or charge excessive fees. That is what Bitcoin has solved.

What Bitcoin failed to solve is how to trade between various types of crypto tokens such as converting Bitcoin to Ethereum, to Solana, or US or other fiat currency stablecoins. To swap between crypto tokens, you still needed third-party Centralized Exchanges like Binance, Coinbase, and the infamous FTX.

In the Summer of 2020, something called Decentralized Finance Summer or “DeFi Summer 2020” happened. This was due to the release a few months earlier by Uniswap Labs of their Decentralized Exchange (DEX). In a DEX, instead of people in a company like Binance or Coinbase facilitating your swap between Bitcoin and Ethereum or Ethereum and Solana, you had a set of software called “smart contracts” that basically did what humans in a centralized exchange did. This allowed people around the globe to trade or swap their tokens with no third-party human in the loop.

Unlike centralized exchanges, DEXs allow liquidity (fund) providers to loan the exchange a pair of tokens, or trading pairs, in exchange for the trading fees. So someone who has both Ethereum and Solana can upload these in a particular ratio that determines the price using a formula called x*y = k, and earn from the trading fees.

Centralized exchanges often rely on what is called orderbooks. These are the sequential set of orders from buyers and sellers, and these are matched so that both sides are filled as much as possible.

In DEXs, if there are no buyers or sellers, someone has to create these. These are created by Automated Market Maker (AMM) software. If someone wants to sell Ethereum at a certain price for US dollar stablecoin, the AMM will draw from the pool of loaned trading pairs from investors and match that order and get it filled. All of this is automated by software and uses the x*y = k ratio and your Economics 101 price curves of supply and demand to determine the price.

This April 2024, the US Securities and Exchange Commission (SEC) served Uniswap a Wells notice which usually indicates a threat of future legal action, under the guise of protecting investors. DEX transactions, unlike centralized exchange transactions, do not have Know-Your-Customer/Anti Money Laundering (KYC/AML) procedures and are often done using self-custodial digital wallets identifiable only by their hexadecimal public addresses.

However, this threatened SEC vs Uniswap case is vital to the industry because many crypto tokens do not really trade in centralized exchanges and are purely traded on these DEXs. To say that an entire industry and ecosystem, along with the economics it provides to millions of people globally is under threat is an understatement. After the announcement, the global crypto markets dived.

The US can either choose to be the home of innovative technologies in blockchain or it can choose to be the laggard in this technology that is superior to traditional finance methods. Already these types of harassment by the SEC are convincing some innovative blockchain startups to seek friendlier jurisdictions globally.

Understandably there are millions of people in traditional finance and powerful interests in Wall Street. However just like anything else, when a technology appears that can disintermediate these powerful legacy industries, sooner or later it normally does.

Author Bio

Zain Jaffer is an accomplished entrepreneur and investor, actively involved in a range of investments including real estate, technology start-ups, private equity, and digital assets through his family office, Zain Ventures. He also supports underrepresented causes and underserved communities through the Zain Jaffer Foundation.