What are Swap Rates?
A Step-by-Step Guide to An Important Function in DeFi
By: Rahul Nambiampurath •DeFi Explainers
According to CoinMarketCap, there are more than 20,000 cryptocurrencies on offer. This is a function of blockchain’s core feature — monetizing decentralization through digital assets. Because of this, even tiny protocols (dApps) in a wider blockchain network have their own tokens.
Swap rate is an exchange of equal value between two cryptocurrencies. For example, let’s say we have $1,000 worth of Avalanche token and $1,000 worth of Ether.
The new 0.64 ETH denomination still represents $1,000 value. This means that we swapped AVAX for ETH at market exchange rate, which may vary from one centralized exchange (CEX) to another, and from one decentralized exchange (DEX) to another.
So, the swap rate refers to direct cryptocurrency exchange, without first exchanging it to dollars, and then into the other cryptocurrency. Theoretically, the token swap rate should result in $1,000 value. Nonetheless, there is friction involved to make the swap possible that reduces the final swap value.
What Is a Market Exchange Rate?
The value of a cryptocurrency rises and falls with demand. Likewise, if more people are willing to buy a cryptocurrency than is being supplied, the value of each coin, such as BTC or ETH, will go up. This is the battle between supply and demand. Cryptocurrencies with higher inflation rates will have higher inflow of new coins, which means that their demand will have to be higher to maintain value.
Case in point, after The Merge, Ether issuance rate was drastically reduced, going even under Bitcoin.
This is despite the fact that BTC has a forever-limited supply of 21M coins, while ETH supply is unlimited. Market exchange rates that follow the ebbs and flows of supply and demand are the most common, called floating rates.
In contrast, market exchange rates that are fixed to a value are called pegged. Typically, these are nations’ currencies, pegged to another nation’s currency such as the U.S. dollar.
In traditional banking, it can take businesses one to three days to settle cross border payments and consumers a few seconds. The cross-border payment system is still largely dependent on intermediaries, which can create friction and additional costs.
Blockchain networks have their own friction in the form of decentralized fees. For example, Ethereum validators and Bitcoin miners receive fees, paid by senders, whenever they process transactions as a new block to the blockchain’s public ledger.
Centralized crypto platforms, such as Binance or Coinbase, operate similarly to TradFi institutions. They compete with other CEXs, which determines their swap rates. On DEXs, swap rates are organically formed because they depend on users themselves supplying tokens into liquidity pools.
Moreover, token holders on DEXs, such as UNI tokens for Uniswap, can use those governance tokens to tweak swap rate fees.
Swapping on Centralized Exchanges (CEXs)
Just like stock exchanges, CEXs facilitate the exchange of assets. Because they rely on a clear ownership structure seeking profits, CEXs operate as companies. This means they have to register as such at respective government agencies.
In turn, those agencies set the rules by which CEXs operate. At the end of that centralized chain, CEXs impose condition on users, so they can swap tokens:
- ID verification
- Biometric verification
- Proof of name and address
- Payment ID proof
These know-your-customer (KYC) checks stem from a decades-long push to curb money laundering by criminals and terrorists. CEXs execute KYC and anti-money laundering (AML) evaluations to ensure customers are engaged in lawful financial practices. They must do so or face penalties from regulators.
Law enforcement agencies such as the U.S. Office of Foriegn Assets Control are increasingly targeting cryptocurrency ventures for review. In 2022, OFAC sanctioned the crypto mixer Tornado Cash for allegedly facilitating money laundering practices by suspected criminal organizations such as Lazarus Group, a suspected cybercrime entity linked to North Korea..
CEXs hold users’ private keys, which represents a central point of failure. If the exchange is hacked, all those digital assets are at risk of getting stolen. As a side effect of not being in direct custody of digital assets, users don’t swap cryptos on CEXs directly. Here is how that process works:
When a swap order (trade) is placed, the CEX takes control over the deposited swap funds.
In turn, the CEX issues IOUs equivalent in value, only exchangeable at withdrawal.
In the blockchain world, IOUs are smart contracts, recording deposit inflows and expected outflows — the swap rate.
The CEX then uses an order book to match asks with bids, such as xx AVAX for xx ETH, covering the spread with its own liquidity. Once matched, the CEX executes the swap at the present market exchange rate.
Swapping on Decentralized Exchanges (DEXs)
Unlike CEXs, DEXs empower users’ privacy and autonomy. There is no company or a CEO to govern a DEX because users themselves provide liquidity necessary to execute token swaps.
Moreover, users connect to DEXs with non-custodial wallets, so there are no KYC requirements to uphold. Here is how they work:
- A user connects to a DEX protocol with a non-custodial wallet like MetaMask.
- A user can then choose to provide either liquidity or swap tokens from existing token pair pools.
- Token pairs, such as BTC/USDC, are smart contracts pooling deposits from people who decided to provide liquidity. So, they are liquidity providers (LPs).
- When people who are just swapping tokens tap into liquidity pools, they give a small cut to LPs. This is the friction exerted by the DEX, in addition to paying the network’s gas fee.
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To match token swaps’ asks and bids, DEXs use automated market makers (AMMs). Nevertheless, because there is no central body providing liquidity, this means that a DEX is entirely reliant on its popularity. If it is less known, there will be fewer LPs providing necessary liquidity, which will grind token swaps to a halt.
Although DEXs can permissionlessly enlist any token, the ability for that token to be exchanged will then depend on the DEX’s popularity.
Do Swap Rates on CEXs vs. DEXs Matter?
Not really. Despite exerting more transfer fees, withdrawal fees and having a costly corporate structure, CEXs offer swap rates in range with DEXs. That’s because the crypto space is run by arbitrage bots.
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These computer programs hunt swap rate discrepancies between different platforms to maximize profits. For instance, if arbitrage bots find out a low liquidity ADA/ETH pool, traders could profit by buying the demanded tokens from CEXs. Then, they would deposit/sell them into the pool at a profit.
As this process continually repeats, both DEXs and CEXs even out their swap rates.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.