Decentralized Exchanges (DEX)
Decentralized exchanges, also known as DEXs, have been gaining popularity in the cryptocurrency space as an alternative to centralized exchanges (CEXs). These exchanges offer a number of benefits over their centralized counterparts, including increased security, diverse trading pairs and more privacy for users.
In this article, we'll explore what decentralized exchanges are, how they work, and why they may be a good option for trading cryptocurrencies and other crypto assets.
What is a decentralized exchange?
Similar to foreign exchange markets where fiat currencies such as USD are traded continuously, cryptocurrencies need their own markets for users to buy and trade cryptocurrencies.
A decentralized exchange is a platform that allows users to buy and sell cryptocurrency and other digital assets without the need for a central authority or third party to facilitate the transactions. Instead of relying on a central server to hold users' funds and execute trades, decentralized crypto exchanges use smart contracts on a blockchain network to facilitate peer-to-peer crypto trading. This means that users retain control of their private keys and have full ownership of their assets, rather than trusting a third party to hold them.
The most common types of DEXs are order book DEXs and AMMs (automated market makers). DEX aggregators, which analyze multiple DEXs on-chain to find the best price and lowest transaction fees for the user's transaction are also widely used.
AMMs enable instant liquidity and in many cases, permissionless market creation for any token. An AMM is essentially a money robot which utilizes a liquidity pool that users can swap their tokens against. The price is determined by an algorithm based on the proportion of tokens in the pool. AMMs enable instant access to liquidity in markets that could otherwise have lower liquidity, and could also be used to facilitate swaps of NFTs, real-world assets, and more.
Order books allow an exchange's internal systems to match buy and sell orders in real-time. Fully on-chain order book DEXs are less common in DeFi, because they require every interaction within the order book to be posted on the blockchain. Over time, they have become more feasible thanks to the launch of layer-2s and new blockchains, and have been a compelling proof of concept for how a DEX could facilitate trading using smart contracts. Hybrid order book designs have also emerged, where management and matching processes take place off-chain, with the settlement of trades remaining on-chain.
How do decentralized exchanges work?
Decentralized exchanges typically have a different structure and functionality compared to centralized cryptocurrency exchanges. DEXs often use liquidity pools to facilitate trades. These pools contain a certain amount of each asset that is available for trade, and users can add or remove liquidity from the pool in exchange for a share of the trading fees.
Unlike centralized crypto exchanges (CEX) such as Coinbase, DEXs don't allow for exchanges between fiat currencies (think USD) and crypto (think Bitcoin). They only trade cryptocurrency tokens for other crypto tokens, for example some of your bitcoin for ETH.
When a user wants to trade one asset for another, the DEX uses an algorithm to determine the best price based on the available liquidity in the pool. This process is known as an automated market maker (AMM).
Decentralized exchanges often also offer other decentralized finance (DeFi) services, such as stablecoins, loans and staking. These services are made possible through smart contracts on the blockchain, which allow users to interact with DeFi protocols in a trustless and permissionless manner.
In addition to being decentralized, DEXs dApps are usually open-source, meaning that anyone can see exactly how they work and developers can adapt existing code to create new projects. That is how Uniswap's code was adapted by DEXs with "swap" in their names such as Sushiswap and Pancakeswap.
Why use a decentralized exchange?
Decentralized exchanges offer a number of benefits over centralized exchanges, including increased security and privacy for users. Because DEXs do not hold users' funds and do not require KYC (know your customer) information, they are less susceptible to hacks and scams. Most DEXs have no counterparty risk, meaning they don't have a risk of credit default, often have lower fees, and provide more flexibility in terms of the types of assets that can be traded.
One potential drawback of DEXs is that they may have lower liquidity and trading volume compared to centralized exchanges, which can lead to higher slippage (the difference between the expected price of a trade and the actual price) and difficulty finding the best price for a trade. However, as DEXs continue to grow in popularity, this is becoming less of an issue.
In summary, decentralized exchanges offer a secure and private alternative for trading cryptocurrencies and other digital assets. With a growing ecosystem of DeFi services and an increasing number of liquidity providers, DEXs are becoming a viable option for traders looking to trade cryptocurrencies without the need for a central authority.
Uniswap, which runs on the Ethereum blockchain and allows users to launch any ERC-20 token and list them for free as long as they can supply tokens to the liquidity pool, is a widely popular DEX. Other well-known AMM DEXs include PancakeSwap, which runs on the Binance Smart Chain (BSC), Curve, Bancor, Balancer, PancakeSwap and SushiSwap.
It is important that users do their research before starting going on their DEX adventure. Navigating DEXs can be tricky, as interfaces aren't always easy and specialized knowledge may be needed. Caution is required, as users may make mistakes such as sending coins to the wrong wallet, and impermanent loss can result from pairing more volatile cryptocurrencies with less volatile ones in a liquidity pool.