A Decentralized Exchange Is Not Just a Place to Trade, It Is Infrastructure Anyone Can Build On

In the world of decentralized exchange, there’s an unobtrusive difference in the way people discuss them. Most discussions revolve around a DEX as a destination, or an exchange you go to get a token or another. That is a correct but not exhaustive statement. A decentralized exchange platform is also quite different. It is programmable code that any developer can construct over the top of, without permission, without an agreement to do so, without the exchange knowing in advance that their liquidity is being used in this way.

This is not as obvious as it may sound. It’s why decentralized exchanges are now the base layer that supports an overwhelming mass of the entire DeFi sector and why the quality of the infrastructure is impacting much more than just the people who use it directly.

The Difference Between Using an Exchange and Building on One

If one is trading on a centralized exchange, he or she is a customer of the exchange. You have an interface to interact with, you’re ordering through the interface, you’re using any automation you’ve created, a trading bot, a portfolio tracker, and you’re limited by how the company decides to expose an interface for it. Permissioned relationship at all layers.

This is reversed in a decentralized exchange platform for those who are willing to write some code. The trading logic is found within public smart contracts which can be interacted with directly by any developer, without being required to gain access from anyone or to use the trading interface of the exchange itself.

A developer can create a portfolio tracker that supports the reading of pool balances directly from the blockchain. A developer can create a trading bot that directly calls the functions of the smart contract and performs swaps. A developer can create a totally new application, such as a lending protocol, yield aggregator, or a derivatives platform that leverages the exchange’s liquidity as part of a larger application.

This is not something that the exchange has to actively turn on. It’s a direct result of operating financial logic on a permissionless, public blockchain. The decentralized exchange has no control over the relationship with each application that uses it. It cannot stop that building from occurring and in reality, the most effective platforms of the DEX space profit inordinately from the applications they never planned and they do not control.

What Gets Built on Top of DEX Liquidity

The diversity of DEXs built on top of the DEX layer underpinning the DeFi ecosystem illustrates the significance of the DEX layer in the DeFi stack.

The best-known example is aggregators. Instead of creating their own liquidity, aggregator platforms check prices and order books across multiple DEX platforms and route transactions through the venue offering the best execution price at that moment. Their role is to provide routing intelligence without taking on any liquidity themselves. They use the liquidity that already exists across the ecosystem and help users access the best possible trading experience.

Liquidations are often a requirement for lending protocols to rely on DEX liquidity. Once the borrower’s collateral value falls below the threshold, the protocol must sell the collateral in a timely manner, recovering the value of the loan. A lending protocol, instead of creating its own liquidity, will usually look to the existing liquidity on the decentralized exchange as a utility that can be utilized whenever the need arises for the protocol to conduct a liquidation.

YOPs create automated strategies that shift capital from one protocol to another based on changing market conditions and almost every rebalancing move within a strategy is a swap on a DEX. The value proposition for the optimizer is essential, find and capture the best yield throughout the ecosystem, and relies solely on the presence of liquid markets it can rebalance through when necessary.

This infrastructure is being leveraged in an increasing number of applications, not just in the field of pure finance. None of these use cases remotely resembles the typical crypto trading app, but they all share a common liquidity infrastructure, a dex trading platform.

Why Cross-Chain Infrastructure Multiplies What Can Be Built

The programmability of a single-chain decentralized exchange platform is powerful on its own. What changes the equation further is when that infrastructure extends across chains.

The power of programmability alone is enough to make one single-chain decentralized exchange platform powerful. The bigger factor is when that infrastructure becomes cross-chain.

Previously, a developer creating an app that required cross-chain token swapping as one of its primary functions would have to build a bridging feature or integrate with an existing one, which is a complex process that also raises the number of potential vectors for security breaches. If such a feature is implemented through a regular interface in a cross chain decentralized exchange, any developer working on the top of it automatically gains cross chain functionality without having to tackle the issue of chain-to-chain bridge on its own.

This has a multiplicative impact on what kind of applications can be made possible to build. It will be much easier to develop a multi-chain portfolio rebalancer, cross chain yield aggregator, a payment application that allows users to pay in any token on any chain and settle in the merchant’s chosen asset on their preferred chain, rather than having to develop a cross chain execution layer app for each of these features individually.

That underlying infrastructure is a determinant to the creation of the outer ecosystem. A deep liquidity, cross-chain decentralized exchange that has reliable routing and a developer friendly API makes the space of applications you can make much wider. If any of these is true, then it will severely restrict what can be built on top of it, even if it has a great user-friendly trading platform.

What This Means for How a DEX Should Be Evaluated

If decentralized exchange infrastructure is what others use, then trading venues are just a fraction of what it does and what it is worth.

This series has already covered extensively the aspects most relevant for traders trading directly on the exchange, namely liquidity depth, fee structure and execution quality. For developers and protocols that are relying on the exchange, the relevant factors are different. Is the exchange interface reliable and well documented for use in programs? Is liquidity consistent through periods of market stress when it is most needed? Is there transparency of changes to the smart contracts of the protocol that affect programs built on top of it?

A legitimate infrastructure-based decentralized trading platform will ensure that its smart contract interfaces are stable and well documented, that it communicates with advance warning of what upgrades are planned so dependent applications can adapt, and that it gives priority to the reliability of its core liquidity functions even when there is intense usage of its own trading platform. They are quite different priorities than optimizing for an actual trader clicking through a UI, and the platforms that manage to achieve both are doing something that is really hard, harder than what the platforms that only need to satisfy direct users are doing.

The Layer Beneath the Layer

So much of what people have as DeFi is really a layer of various applications, including a lot of applications built on top of the liquidity of decentralized exchanges. Many of these components rely invisibly on the correct functioning of the DEX infrastructure below.

This is the real definition of permissionless, composable infrastructure. It’s in service not just to the people who interact with it directly. It supports an entire ecosystem of applications, none of which ever asked for permission to build on it nor ever had to be.

Having a good exchange to do this is valuable not because they’re used this way, but because they are. A strong DEX becomes valuable because it enables an ecosystem to exist above it, creating opportunities and innovations that extend far beyond simple token trading.

A Decentralized Exchange Is Not Just a Place to Trade, It Is Infrastructure Anyone Can Build On was originally published in Coinmonks on Medium, where people are continuing the conversation by highlighting and responding to this story.