Imagine a world where you can trade fractions of Apple or Tesla stock 24/7, from anywhere in the world, with near-instant settlement. This isn’t only a far-off dream of the future. It’s a scary prospect and one that is coming closer to reality as decentralized finance (DeFi) meets traditional stock markets. The key to unlocking this potential lies in applying the Automated Market Maker (AMM) model, pioneered by platforms like Uniswap, to tokenized stocks.
What are Automated Market Makers (AMMs)?
Automated Market Makers (AMMs) are the underlying technology of decentralized exchanges (DEXs). They mark a radical break even from order book-based exchanges, where humans still serve as market makers in the order book, replaced here by algorithmic “money robots”. Li Wei, a blockchain content strategist with roots in China’s tech sector, explains that AMMs facilitate cryptocurrency trading through automated means, providing liquidity through algorithms.
How AMMs Work
Rather than depending on buyers and sellers to fill orders like a traditional exchange, AMMs utilize something called liquidity pools. These pools have different pairs of assets. An algorithm sets the price of each asset so that a stable overall balance is always kept. This mathematical equation illustrates the unchanging equation, balance = x * y = k. Here, ‘x’ and ‘y’ are the balances of the two assets, and ‘k’ is the constant.
Types of AMMs
There are several types of AMMs, each with its own unique mechanism:
- Constant product market makers (e.g., Uniswap): These maintain a constant product of the quantities of the two tokens.
- Constant sum market makers: These maintain a constant sum of the quantities of the two tokens.
- Constant mean market makers (CMMMs): These enable the creation of AMMs with more than two tokens and weighted outside the standard 50/50 distribution.
With AMMs, traders directly trade on-chain and prices are set algorithmically depending on the liquidity pool. By speculating over the future price of these tokens, liquidity providers can earn passive income through the fees generated from these trades.
Tokenizing Stocks: Bridging the Gap
The concept is simple: tokenize traditional stocks, representing ownership as digital tokens on a blockchain. These tokenized shares can then subsequently be traded on DEXs, fueled by AMMs. This creates a universe of opportunities, providing numerous benefits compared to conventional stock exchanges.
Benefits of Tokenized Stocks on DEXs
- 24/7 Access: Unlike traditional stock exchanges with limited operating hours, tokenized stocks can be traded around the clock, even on weekends, depending on the trading platform and token structure. DeFi enables round-the-clock access to stock trading, unlike conventional platforms that operate within restricted hours.
- Global Access: Investors worldwide can participate more easily, as tokenized stocks can be traded on blockchain platforms that are accessible globally. DeFi enables users to access stock trading from anywhere with an internet connection, without the need for intermediaries or geographical restrictions.
- Fast Settlement: Trades can clear in seconds, not days, thanks to smart contracts that settle transactions on the blockchain.
- Increased Liquidity: Tokenized stocks can be traded on DEXs, which can provide enhanced liquidity due to the ability to trade on a global, 24/7 market.
- New Trading Models: Tokenized stocks can enable new trading models, such as fractional ownership and synthetic tokens, which can track the prices of real-world assets without holding or being backed by the actual asset.
- Democratization of Finance: DeFi provides financial services to anyone with internet access, keeping millions of potential investors from being excluded from stock markets. DeFi opens the door for those who have been excluded in the past to invest and grow their wealth in ways they could have never imagined.
- Reduced transaction time and cost: DeFi can settle trades faster and cheaper, taking up to four days for cross-border trades in traditional systems.
Navigating the Risks
Though the promise is great, it’s important to recognize the dangers of this approach.
Potential Risks and Challenges
- Impermanent Loss: A unique risk in AMMs, impermanent loss occurs when the price of assets in a liquidity pool diverges, leading to a potential loss for liquidity providers.
- Liquidity Risk: Investments in private unlisted securities, including tokenized securities, are highly illiquid.
- Volatility Risk: Tokenized assets can experience significant price drops, with a potential decline of 70-80% in value.
- Regulatory Hurdles: The legal aspects of tokenization of securities are debated in some jurisdictions, including Switzerland, and regulatory actions by governments restricting the use of tokenized securities cannot be excluded.
- Smart Contract Risk: Investors should review the functioning of the smart contract underpinning the tokens and seek advice from third-party experts to understand it before acquiring tokenized securities.
- Blockchain Risk: Blockchain technology is new and untested, subject to known and unknown risks, including the risk of updates, amendments, alterations, or modifications to the blockchain source code.
The Future of Finance
The use of AMMs on tokenized stocks is still early. The ability to change finance as we know is certainly there. Li Wei's innovative stock trading will be more accessible, more efficient, more democratic in the future. This evolution will be guided by the creative force of DeFi, as regulatory frameworks change and technology progresses.
