Readings
The readings for this lecture will mostly consist of whitepapers to fully understand the largest application layer of blockchain technology, i.e., decentralized finance. It is actually quite amazing that these documents are available for everyone to read, imagine if the similar documents were available for the traditional financial industry, that would be very interesting.
Readings:
Note that the Uniswap v1 whitepaper is a “website” and not a pdf file, however this is often the case in the blockchain space. For example, if you want to read how the idea about automated market makers initially was discussed you can read the following reddit post from 2016 by Vitalik Buterin Let’s run on-chain decentralized exchanges the way we run prediction markets. Two years later, in 2018, Vitalik Buterin made a post on ethresearch (a forum for Ethereum research) Improving front running resistance of x*y=k market makers.
Supplementary readings:
When comparing cryptocurrency exchanges to traditional stock brokers, there are significant differences in how funds are held and how trading is facilitated. These differences have important implications for risk management, regulatory oversight, and user trust.
In the traditional brokerage model, client funds and assets are typically held in a separate deposit or custody account by a financial institution or a central depository. The broker acts as an intermediary, connecting clients to external stock exchanges where trades are executed. The client’s assets are safeguarded, and the brokerage has limited access to funds beyond facilitating transactions.
In contrast, cryptocurrency exchanges often serve as both custodian and trading platform. When users deposit fiat or cryptocurrency into the exchange, these funds are held in internal wallets controlled by the exchange itself. Rather than being segregated by client, funds are usually pooled together with other users’ assets. This structure allows for fast, seamless transfers within the exchange but also exposes users to different risks, as the exchange is responsible for the security and management of the funds.
In traditional stock brokerage systems, the broker facilitates the execution of trades by routing orders to an external exchange. These stock exchanges are independent entities responsible for price discovery, order matching, and trade execution. The broker’s role is to provide clients access to this external marketplace, with the exchange handling the core trading functions.
In the cryptocurrency exchange model, the platform itself functions as the marketplace. When users place buy or sell orders, these are matched directly within the exchange’s internal order books. The exchange determines prices, matches orders, and executes trades without involving any external marketplace. While this integration allows for lower latency and operational efficiency, it also concentrates risk within the same entity that holds users’ funds.
Traditional stock exchanges and brokers are typically regulated by financial authorities, with clear rules governing asset custody, trade reporting, and client protection. Client assets are often protected by insurance schemes, and there are strict requirements to segregate client funds from the broker’s operational accounts.
Cryptocurrency exchanges, however, operate in a more varied regulatory landscape. Oversight can differ significantly by jurisdiction, and the protections for users may be less well-defined. Additionally, since user assets are often pooled rather than segregated, the risk to individual users could be higher in the event of exchange insolvency or a security breach.
In the traditional broker-exchange model, trust is distributed between separate entities. The broker facilitates the transaction, and the exchange handles trade execution and price discovery. Assets are typically held by a third-party custodian, providing a layer of protection in case the broker faces operational issues.
In contrast, cryptocurrency exchanges consolidate both custody and trading functions. Users must place greater trust in the exchange, as it holds their assets and facilitates their trades. Any operational or security failures—such as hacking or mismanagement—can simultaneously affect both the ability to trade and the safety of user funds, since they are all managed within the same entity.
The following this lecture, these questions are useful for the reader to think about and try to understand. They are also an aid for the students in studying for the exam:
What statements are true and false: