How Does a Decentralized Exchange (DEX) Manage Counterparty Risk Using Smart Contracts?
A DEX eliminates counterparty risk by using smart contracts to hold collateral and automatically execute trades and settlements. The contract acts as a trustless escrow, ensuring that if one party fulfills their side of the trade (e.g. depositing collateral), the other party is obligated to perform, or the contract automatically liquidates.
Glossar
Collateralization
Security Deposit ⎊ Collateralization is the process of securing a financial obligation, particularly in margin trading or lending protocols, by locking up an asset of greater value than the liability being assumed, thereby providing a buffer against potential loss.
Impermanent Loss
LiquidityRisk ⎊ Impermanent Loss quantifies the temporary divergence in value between holding assets in a decentralized liquidity pool versus simply holding those same assets in a non-interest-bearing wallet, resulting from price movements between the deposited pair.
Smart Contracts
Function ⎊ Smart contracts are self-executing agreements with the terms of the agreement directly written into lines of code, residing on a decentralized ledger.
Counterparty Risk
Exposure ⎊ Counterparty risk represents the potential loss incurred when a trading partner defaults on their contractual obligations.
Decentralized Exchange (DEX)
Platform ⎊ A Decentralized Exchange (DEX) is a cryptocurrency trading platform that operates without a central intermediary, allowing users to trade digital assets directly from their non-custodial wallets.
Automated Market Maker
Architecture ⎊ Automated Market Makers (AMMs) represent a paradigm shift in decentralized exchange (DEX) design, moving away from traditional order book models to a constant function market mechanism.