In May 2022, at the tail end of the cryptocurrency bull market, economist Eswar Prasad Wrote A Financial Times editorial arguing that the promise of DeFi as a way to democratize finance has been far fetched. In his words, “For all its promise of democratizing finance and expanding financial access, the emerging reality points to a concentration of economic power, while the risks lie largely with those investors least able to handle it.”

Prasad is right that early DeFi projects catered almost exclusively to cryptocurrencies, often called “degens” in Twitter parlance. However, he did not acknowledge that this is actually a common pattern for any emerging industry crossing the chasm from fringe to mainstream adoption. New transformative technology often begins Looks like a game. The Internet has gone through the same phase, as have many start-ups, such as Facebook, whose target audience has grown from college students to anyone in the world with an Internet connection.

This article explores how one of the building blocks of DeFi – a decentralized exchange – emerged and continued to evolve from being a game to a serious product that rivals traditional centralized exchanges.

The heart of DeFi – the decentralized exchange

At the core of any financial system, including DeFi, is the ability to exchange assets. For DeFi to rise from nothing to hundreds of billions of dollars, it required an easy way to trade tokens. This led to the emergence of decentralized exchangeor DEX. The best example of this is Uniswap, which is by far the most popular and successful DeFi DEX.

The idea behind the exchange adheres to the principles of DeFi: it serves as a transaction center where users can exchange a variety of different currencies without the need for an intermediary. However, Uniswap works as a Automated market maker (or AMM), where users can trade against a smart contract that acts as a counterparty.

While fulfilling these functions was enough for the platform to launch onto the global stage and extract the largest slice of emerging market share – a share held by the exchange today – Uniswap is not a perfect solution and the AMM model has many drawbacks.

The tradeoff with AMMs

AMM exchanges pool the liquidity they get from liquidity providers, and use algorithms to price the assets backed within this pool. This model proved very successful for Uniswap in its early days, as it allowed for easy access to and pooling of liquidity, against which trades were possible on Ethereum.

source: Twitter

AMMs work great in two use cases: stable swaps between two stablecoins or price-stable assets, and in the initial process of smoothing unauthorized liquidity for long-term assets. However, for use cases outside of these, AMM is not ideal for a liquidity provider or trader.

For liquidity providers, AMMs can be problematic due to toxic drawbacks as abundant liquidity can be taken advantage of by arbitrage and the risk of impermanent loss. For traders, on the other hand, AMM has another set of risks including MEV and slippage which can translate into huge losses.

On-chain settlement with off-chain pricing

The main issues with the AMMs described above are due to one simple fact: the AMM-style exchange rate assets are on-chain. This means that smart contracts on Ethereum (or other chains) are required to determine the fair value of an asset via mathematical formulas encoded on the chain. The beauty of this is that you don’t need additional infrastructure to facilitate trade. However, the trade-off is that price discovery becomes muddled and a host of problems caused by price manipulation via transaction orders affects users.

An alternative approach is the Request for Quotation (RFQ) form which allows users to get direct quotes from market makers and trade with no slippage and full MEV protection. Instead of pricing assets on-chain, RFQ-style exchanges handle the settlement and exchange of assets on the blockchain, but enable off-chain actors to price assets. This last distinction Enables much more capital efficiency In addition to helping to bring in market makers and traditional players who are unable to provide liquidity via AMMs.

Hashflow, one of the top 10 DEXs by transaction volume, has made it their goal to simplify the decentralized exchange experience while focusing on optimizing it for the retail user. Instead of using an AMM system, Hashflow uses the RFQ model described above, and has proven successful with over $11 billion handled in just over a year.

source: Hashflow trading metrics

Local and intersecting trade-offs and the way forward

In addition to its model, Hashflow also offers cross-chain native swaps. Hashflow was the first platform to introduce this technology and the end result is a trusted exchange model that is similar in practice to the more convenient experience offered by centralized exchanges, but carries with it all the benefits that come with decentralized finance. Looking to the future, after the recent addition of Wormhole’s messaging protocol, Hashflow will integrate more non-EVM threads and provide structured products along with specific requests.

If there is to be a true democratization of finance, DeFi as a whole needs to change and reorient itself with retail users as its focus. To achieve this, platforms such as Hashflow have taken steps to streamline and simplify the transaction process and make it less burdensome for the everyday user. Time will tell if the rest of the industry follows suit.