Osmosis DEX Explained
|– DEXs are an essential feature of DeFi, allowing users to exchange their different cryptos via decentralized protocol |
– But until now, DEXs have been limited by their underlying blockchain: only tokens native to that network could be exchanged by the protocol.
– Osmosis DEX – built on Cosmos’s multichain foundation – is leveraging advanced technology to offer blockchain interoperability within the same exchange protocol.
– Multi-chain DEX Osmosis introduces novel features that set it apart from other DEXs; here, we unpack them.
DeFi has been experiencing tremendous growth since 2020, thanks to the juicy opportunities it brought to crypto in terms of yield farming, decentralizing lending and borrowing, stablecoins, synthetic assets, and much more.
Decentralized exchanges (DEXs) are among the most promising segments of DeFi, but their utility has until now been limited by their underlying blockchain.
That’s where Osmosis comes into the picture – a new generation of DEX trying to overcome the problem that single-blockchain DEXs face.
In this article, we’ll explore the unique contribution Osmosis is making to the DeFi space. But before we proceed, we need to start with a quick recap of the core component of DEXs: the automated market maker.
Automated Market Maker: The engine of any DEX
Exchanges do exactly what they say on the tin – they enable users to exchange one asset for another.
Traditional exchanges, and in fact centralized crypto exchanges, achieve this by using something called an order book system. This is a system in which individual “buy” and “sell” orders come in from users (in effect, exchange liquidity) and are organized and displayed to you in order via the exchange’s central mechanism.
Decentralized exchanges, on the other hand, do not use order books. Instead, they use smart contracts to create liquidity pools for different tokens, something known as an Automated Market Maker or AMM.
Automated market makers reward the users who are providing liquidity to their pools (Liquidity Providers) with a fraction of the fees paid on transactions executed within the protocol, and this relationship is what incentivizes the liquidity provision and keeps the whole thing turning.
The Limitations of AMMs
One of the biggest limitations to the existing AMMs is that they lack cross-chain interoperability.
In the blockchain space, interoperability is when two more blockchain systems can interact with each other and share data and digital assets.
Existing DEXs, however, currently don’t have this capability because each blockchain is built with different standards and code bases. This means users can only trade tokens native to the underlying AMM network. For instance: Uniswap only supports Ethereum tokens, Timechain is Fantom exclusive, Pancakeswap is based on BSC, and Dexlot is native to Avalanche.
This lack of interoperability in DEXs means users are limited to swapping/earning liquidity for only tokens hosted on a given blockchain which translates to less composability. Additionally, users cannot take advantage of the benefits of different networks.
Besides limiting users, this causes a problem for the wider system in terms of centralization of the ecosystems as it revolves only around one network instead of being multi-chain.
Osmosis DEX: An interoperable DEX built on Cosmos
As “the largest interchain DEX,” Osmosis seeks to compete directly with the user experience of centralized exchanges, such as Coinbase and Binance.
Established in 2021, Osmosis is a multi-chain AMM built for the Cosmos ecosystem. The DEX offers interoperability between blockchains using Inter-blockchain Communication Protocol (IBC) and Axelar, which facilitate the connection of blockchains within a decentralized infrastructure.
What is Cosmos – and how does it relate to Osmosis?
Cosmos Network consists of a “Hub”, which is the central Cosmos blockchain allowing all subsidiary blockchains to communicate; and “zones” which are autonomous and independent blockchains connected to the Hub.
Thanks to the main hub, all of these different Zones (ie blockchains) can communicate, exchange assets and swap data.
By using Cosmos and its cross-chain communication capabilities as a base, Osmosis can offer far broader swapping options to its users, despite having no centralized entity to manage the platform.
Let’s check out the unique features of Osmosis that sets it apart from other DEXs.
Huge Composability and Interoperability
By leveraging the Cosmos blockchain, Osmosis enables communication and composability between tokens from different blockchains.
It can handle trades between any of the 47 separate blockchains within Cosmos, all within the same DEX protocol. For users, this means a vastly bigger market for trading: the market cap of all the projects in the Cosmos ecosystem provides a potential marketplace of $58.7 billion.
Here, you can put tokens from different blockchains to work. From Ethereum-based USDC, MKR, and LINK tokens, Secret Network’s SCRT tokens, and BandChain’s BAND tokens to Moonbeam-based DOT tokens, all of them are supported on Osmosis DEX.
Customizable Liquidity Pools for Stable Liquidity
Another exciting feature of Osmosis DEX is its the way its liquidity pools are governed.
One fundamental problem faced by all DEXs is volatile liquidity. Liquidity is often referred to as “mercenary” because users will logically stake their tokens in whichever pool offers the highest rewards – this results in extreme volatility across the AMM space as pools compete to maintain their supply of liquidity. This is one area where Osmosis is different.
It allows users to create their own liquidity pools with customizable parameters. Liquidity providers use the native token Osmosis (OSMO) to vote on changes to the make-up of specific pools.
- Flexible Rules for Competitive Pools
By deciding swap fees, token rates, reward incentives in a flexible way, liquidity pools can respond to changes in the market in a way that ensures their success – combatting the notorious instability that has plagued liquidity pools until now.
Through this additional layer of customization, Osmosis helps developers tweak optimal strategies and respond to changing market conditions to ensure the success of their liquidity pool.
There is no one-size-fits-all solution. Osmosis addresses a problem by providing tools to allow market participants to self-identify opportunities and react by adjusting the various parameters.
Superfluid Staking with OSMO Token
When it comes to staking, Osmosis uses a unique superfluid staking process. This novel process allows users to simultaneously provide assets in a liquidity pool and stake assets to secure the network.
What it means is when users deposit any two Osmosis-supported tokens into a liquidity pool, they are also staking their liquidity shares on both tokens’ chains. This way, they earn a share of transaction fees for providing liquidity to the Osmosis AMM as well as rewards for securing the chain of the token they are staking. In superfluid staking, LP tokens are basically able to secure the network while being part of a liquidity protocol.
OSMO token distribution is heavily skewed towards staking rewards and liquidity mining. 70% of the OSMO supply, capped at 1 billion with a 9-year distribution schedule, is allocated as rewards for these two endeavors to help bootstrap the network and gain traction.
Third-Gen Blockchain, New-Gen DeFi
The adoption curve for DeFi has been phenomenal. However, as the system gained traction, it also confronted its own limitations, and unsurprisingly, interoperability was one of the main issues.
Solutions like Osmosis DEX are leveraging advanced blockchain technology to overcome these limitations and bring users better options and increase the decentralization of the DeFi space – and they are achieving this by using third-generation blockchain technology.
Osmosis is just the beginning of a new chapter in DeFi, so make sure you understand this extremely interesting new technology in order to take advantage of the new things it offers users like you and me.