What Is A DEX
A DEX stands for decentralized exchange, a peer-to-peer marketplace where transactions between crypto traders occur directly, without interference by an external party.
A primary focus of crypto is to foster financial transactions that aren't officiated or regulated by a centralized authority such as a bank. Most renowned DEXs today run on the Ethereum blockchain, contributing to the growing variety of DeFi tools on the network.
DEXs depend on smart contract technology that allows traders to execute transactions in the absence of an intermediary. Centralized exchanges differ from decentralized exchanges in that a financial institution is involved and offer services that generate a profit on their part.
The largest portion of the total trading volume in the cryptocurrency market is allocated to centralized exchanges in that they include regulated entities that make trading easier by offering user-friendly platforms. Insurance on assets is even included in some instances.
Centralized services can be likened to that of banks in that they provide security over a user's funds and make it easy to move assets around.
Contrary to this concept, decentralized exchanges enable users to trade directly from their crypto wallets, utilizing smart contracts in the process. Traders are entirely responsible for safeguarding and managing their own funds. If they lose their private key or send funds to the wrong address, the consequences are theirs alone.
Deposited assets or funds are given an IOU, which is essentially a token based on the relevant blockchain representing the same value as the assets.
Popular DEXs have been built directly on top of leading blockchain networks that support smart contracts.
How Do DEXs Work?
Traders use DEXs by interacting with smart contracts based on the blockchain. Every transaction includes a transaction fee and a trading fee.
There are three primary types of decentralized exchanges, namely automated market makers, DEX aggregators, and Order Book DEXs. All three allow trading through smart contracts.
Automated Market Makers (AMMs)
This type of decentralized exchange was originally created to provide a solution to the liquidity problem. AMM's inception was partly based on a paper on decentralized exchanges written by the co-founder of Ethereum, Vitalik Buterin. This paper explained how contracts holding tokens could be used to execute trades on the blockchain.
Automated Market Makers rely on services based on the blockchain that offer information about exchanges as well as other platforms to establish the price of assets called blockchain oracles. The smart contracts used in AMMs use pre-funded asset pools called liquidity pools instead of matching sell orders and buy orders.
The users who fund the liquidity pools are entitled to the transaction fees charged by the protocol for executing that trade. Liquidity providers often participate in a process called liquidity mining, where they deposit the same value of every asset involved in the trading pair to earn interest on their cryptocurrency holdings.
Traders can execute orders or, alternatively, earn permissionless interest due to the functions of liquidity pools. These exchanges are frequently ranked based on the amount of funds that are locked in the smart contract. These funds are called the total locked value, and when its value isn't high enough, "slippage" will occur.
Slippage is the result of a lack of liquidity, causing buyers to pay above-market rates on orders. Higher orders thereby create higher slippage. Wealthy traders are reluctant to trade on a platform that lacks deep liquidity because of the higher risk of slippage involved in their inevitably larger orders.
When liquidity providers deposit two assets for a particular trading pair, they run the risk of impermanent losses as the higher volatility of one asset will cause the trade on the exchange to lower the amount of the second asset in the liquidity pool.
If the amount that a liquidity provider holds decreases while the price of the more volatile asset increases, the provider may experience an impermanent loss. It is referred to as impermanent because the asset's price can rise again, and trades on the exchange can balance the pair's ratio once again. The proportion of each asset held in the liquidity pool is described by the pair's ratio.
Order Book DEXs
Order books consist of records of open orders to buy and sell assets for particular asset pairs. Sell orders signify that a trader is willing to sell an asset for a specific price. On the other hand, buy orders indicate that a trader wants to buy or bid on an asset with a certain price. The difference between the buying trader's price and the seller's price determines the depth of the order book and, thereby, the market price on the exchange.
There are two types of order book DEXs: on-chain and off-chain order books. When a DEX uses order books, the user's funds are typically kept in their wallets while open order information is held on-chain.
These types of exchanges can enable traders to leverage their stance by using funds borrowed from the platform's lenders. The earning potential of a trade is increased when leverage trading comes into play. However, the risk of liquidation is simultaneously increased because the size of the position is enhanced with borrowed funds, which the trader has to repay regardless of any losses they might have experienced.
Off-chain order books can aid in reducing costs and increasing the rate of transactions. Many DEX platforms will hold their order books off the blockchain and only settle trades on-chain.
These exchanges also let users lend funds to other traders to offer leverage. The lent funds earn interest and are secured by the liquidation mechanism of the platform. This ensures that lenders will get paid despite losses on the borrower's side.
It is worth noting that order book DEXs often experience issues with liquidity. Traders frequently pursue centralized platforms more readily because of the extra fees involved in decentralized on-chain transactions. Off-chain order books solve this problem to a certain extent but give rise to new risks relating to smart contracts.
DEX Aggregators
DEX aggregators strive to solve liquidity issues via various mechanisms and protocols. These platforms accumulate liquidity from a few DEXs in order to minimize the slippage on larger orders, offer traders the best possible price rapidly, and optimize token prices and swap fees.
The two chief goals of DEX aggregators are to decrease the chances of a transaction failing and protect users from the effects of pricing as far as possible. Some platforms make use of the liquidity of centralized platforms to ensure a better user experience while preserving its noncustodial nature. They remain noncustodial because they leverage integration with certain centralized exchanges.
Decentralized Exchanges vs. Centralized Exchanges
Crypto exchanges are crucial in providing liquidity to the cryptocurrency market as a whole and facilitating massive trading volumes daily. The market is continuously expanding, and leading exchange platforms evolve accordingly, ensuring they scale appropriately and offer new functionality and features to adapt to the ever-growing number of digital assets.
Decentralized exchanges offer an entirely different approach to financial dealings by operating without an intermediary entity that verifies and clears transactions. Instead, they rely on smart contracts to assist trading.
The features of decentralized exchanges often entail lower costs and transactional activity at a higher speed than centralized exchanges.
DEXs key feature of being noncustodial simply means that the traders themselves are responsible for managing their private keys and wallets. This is an attractive property for traders who prefer having full control over their assets.
However, being solely in charge of your dealings also entails a higher risk of your key getting lost, destroyed, or stolen. The decentralized nature of DEXs also means that no Anti-Money-Laundering or Know-Your-Customer regulations are implemented.
Various distinct segments of the DEX market have originated with the evolution of the crypto market. Liquidity pools, order books, and many other decentralized finance tools and mechanisms have become prevalent in the continuous development of the DEX market.
How To Use Decentralized Exchanges
No sign-up process is required in the interaction with DEX platforms. A wallet that is compatible with the exchange network's smart contract is essential, but virtually anyone with an internet connection and a capable device can participate.
The first step entails choosing a network you want to use keeping transaction fees in mind. Next, choose a wallet compatible with the network's smart contract and fund it using its native token.
Wallet extensions make it much easier to access your wallet directly from your browser, additionally allowing you to interact with the DEX regardless of your location. The installation process is comparable to any other extension. You will be required to import an existing wallet through a private key or create a new wallet.
Many of these wallets include mobile applications, allowing users to use decentralized finance protocols on the go. These applications are created with built-in browsers to readily interact with smart contract networks.
When you have chosen an appropriate wallet, you will need to fund with the tokens used for transaction fees. You can purchase said tokens on centralized exchanges. The tokens you bought need to be transferred to your wallet.
Now that your wallet is funded, you can connect by selecting "Connect Wallet" on the DEXs website.
Advantages Of Using DEXs
Token Availability
Tokens offered on centralized exchanges have to adhere to regulations before being listed. Decentralized exchanges have the freedom of minting any token on the blockchain on which it is built. This means that new projects can be listed on decentralized exchanges before becoming available on centralized exchanges.
Traders can get involved at the earliest possible point but are advised to be wary of scams such as rug pulls.
Anonymity
There are no identification verification procedures involved in decentralized exchanges, meaning that traders can exchange cryptocurrencies anonymously. This is intriguing to traders who value their privacy and do not wish to be identified by a central authority at any point in their dealings.
Reduced security risks
Users with extensive experience in cryptocurrency trading run a low risk of being hacked. Traders can secure their funds and only interact with the relevant exchange when necessary. When the network suffers from a cyber attack, only liquidity providers will have to endure the risks.
Reduced counterparty risk
Counterparty risk occurs when one of the two parties involved in a transaction fails to fulfill their role as described by a contract. This risk is completely eliminated as decentralized exchanges' operations are based on smart contracts.
The Continuous Evolution Of DEXs
Decentralized exchanges first came to be in 2014 but truly gained their popularity when decentralized financial services and blockchain technology started making headlines.
Innovative developments have ensured that borrowers can leverage their positions, lenders can earn interest on their funds, and liquidity providers earn trading fees.
The opportunities for growth and application have no limits. Due to the versatility of smart contracts, more functionalities are bound to arise. An appropriate example of the potential of DEXs is flash loans. Users can borrow and repay a loan in a single transaction with flash loans.
Only time will tell the direction in which this technology is moving, but we can be sure it will be astounding and excite even the most conservative of traders.
