Financial advisors are very familiar with traditional finance and how the industry works. Registered investment advisory firms are clients of custodians like Fidelity, Schwab and IBRK that have relationships with exchanges like the New York Stock Exchange and Nasdaq.
Individual securities transact on exchanges, and portfolios of securities are held with custodians. Clients of firms have log-in access to the platforms built by custodians, and the advisors can manage those assets through the custodian. This is how the traditional financial system has worked for decades.
This article originally appeared in Crypto for Advisors, CoinDesk’s weekly newsletter defining crypto, digital assets and the future of finance.
At the core of DeFi sit decentralized exchanges, or DEXs for short. (I wrote about the importance of DEXs in last week’s newsletter, for the second part of this continuing series on understanding DeFi.) DEXs facilitate the trading of digital assets for users around the world.
Unlike centralized exchanges like the NYSE, DEXs don't use the order book system, which has been used for decades and, to be quite honest, continues to work well today. The reason that DEXs don't use the time-proven order book system is because it requires a team of centralized individuals and technology to run. Instead, DEXs use smart contracts to facilitate trading. The smart contract that governs the trading on a DEX is called a liquidity pool.
A liquidity pool is simply a pool of locked assets governed by a smart contract (or a piece of software code) that is used by the DEX to trade – often called “swapping” – crypto assets. Liquidity pools are crowdsourced, meaning the paired assets in the pool are not pledged by one single person or institution. True to the decentralized and grassroots style of crypto, liquidity pools come into existence from contributions made by the crypto community. Liquidity pools can be thought of as a giant pot of paired assets that facilitates swapping between currencies.
Liquidity pools are governed by automated market makers, or AMMs, software code that governs and automates the process of swapping assets and providing liquidity and that allows digital assets to be traded on a DEX by using the liquidity pool. On platforms with AMMs, users don't trade with another counterparty (think of buyer and seller in the traditional order book system); instead, they trade against the pool of paired assets.
In a liquidity pool of two paired assets, if the price of X increases, the price of Y decreases, and therefore the constant, k, remains the same. Only when new assets are pledged to the liquidity pool does the total pool volume increase. This formula governs the liquidity pool and creates a state of balance between the prices of the tokens. Buying Token A will increase the price of Token A, and selling Token A will decrease the price of Token A. The opposite will happen to Token B in the liquidity pool.
Another component of AMMs is the arbitrage feature. These smart contracts are able to compare the prices of paired assets in their own pools with those across the DeFi ecosystem. If the price varies too much, the AMM will incentivize traders to take advantage of the mispricing in the native liquidity and the outside pools, and with this incentive, the native AMM reaches equilibrium once again.
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