What is a Decentralized Exchange (DEX)?

On Oct 7, 2022

COVERED:

What is a Decentralized Exchange?
How do they Work?
Automated Market Makers
Order Books
DEX Aggregators
Benefits of using a DEX
Concerns

WHAT IS A DECENTRALIZED EXCHANGE?

A Decentralized exchange, also known as a DEX is a peer-to-peer marketplace, in which crypto traders make transactions directly, without the need of an intermediary or third party. DEXs allow financial transactions that aren’t officiated by banks, brokers, or any other third parties. Some of the popular DEXs include Sushiswap and Uniswap which both utilize the Ethereum blockchain. Similarly, PancakeSwap is also a popular DEX, built upon the Binance Chain. These decentralized financing tools enable a huge range of financial services directly from a compatible cryptocurrency wallet.

The transactions in DEXs are facilitated through the use of self-executing agreements written in code called smart contracts. Compared to traditional financial transactions which are opaque and run through intermediaries who offer very limited insight into their actions. On the other hand, DEXs offer complete transparency into the movement of funds and the mechanisms facilitating exchange. Similarly, since there is no involvement of a third party, DEXs reduce counterparty risk and can reduce systematic centralization risk in the cryptocurrency ecosystem.

HOW DO THEY WORK?

Since DEXs are built on top of blockchain networks that support smart contracts. Hence, DEXs establish the prices of various cryptocurrencies against each other algorithmically and employ the use of “liquidity pools”. In these pools, investors lock funds in exchange for interest-like rewards. DEXs are built on open-source code which means that anyone interested can see its code and how it works. It also means that the existing code can be adapted by the developers to create new competing projects which is how Uniswap’s code has been adopted by a host of DEXs with “swap” in their names like “Pancakeswap” and “Sushiswap” etc.

DEXs were created to remove the requirements for any authority or third party to oversee trades performed within a specific exchange. DEXs allow P2P cryptocurrency. P2P or Peer-to-Peer means a marketplace where sellers and buyers are in direct contact. Their transactions are non-custodial which means that the users keep control of their wallet’s private keys. A private key represents a form of advanced encryption which enables users to have access to their cryptocurrencies. By logging into a DEX with their private keys, users can immediately access their crypto assets. They won’t be required to submit any personal information like name or address etc.

There are three main types of decentralized exchanges.

Automated Market Makers
Order Books DEXs
DEX Aggregators

All of these allow direct trade through smart contracts.

AUTOMATED MARKET MAKERS

An automated market maker system reliant on smart contracts was created to solve the liquidity problem. Popular decentralized exchanges have been built on top of prominent blockchains that support smart contracts. The most popular DEXs are built on the Ethereum blockchain. Similarly, these AMMs rely on blockchain-based services which provide information from exchanges and other platforms to set the price of traded assets called “blockchain oracles”. These smart contracts then use pre-funded pools of assets known as liquidity pools. These pools are funded by other users who are then entitled to the transaction fees that are charged by the protocol for executing a trade on that pair. These liquidity pools allow traders to execute orders or to earn interest in a permissionless and trustless way.

ORDER BOOKS

Order books compile the records of all open orders to buy and sell for specific asset pairs. It allows an exchange’s internal systems to match buy and sell orders. There is an On-chain order book and an Off-chain order book. In the On-chain order book, every transaction is written onto a blockchain. This includes not only the actual purchase but also the request to purchase or cancel an order. With Off-chain order books, all of this happens elsewhere, with only the final transaction settled on the blockchain. Since orders aren’t stored on chain, this matter can run into some of the security issues of the centralized exchanges but isn’t as slow or costly as on-chain order books.

DEX AGGREGATORS

They use several different protocols and mechanisms to solve the problems associated with liquidity. The two significant objectives of the DEX aggregator are to protect users from the pricing effect and to decrease the likelihood of failed transactions.

BENEFITS OF USING A DEX

Because DEX trades on facilitated by smart contracts, they carry strong guarantees that they will be executed in exactly the same manner that the user intended, without any interference from centralized third parties. So DEXs offer strong execution guarantees and increased transparency into the underlying mechanics of trading.

DEXs offer a potentially limitless range of tokens from the well-known, to the weird and even totally unknown tokens. This is because the Ethereum-based tokens can be minted by anyone, who can then create a liquidity pool for it. Furthermore, the coins aren’t being held in any centralized exchange but in the user’s wallet with their private keys. So DEXs are theoretically less susceptible to a hack.

Anonymity is again a plus point here because no personal information is required to use most of the popular DEXs. Similarly, DEXs also help in increasing financial inclusion. As users can sign in, straightforwardly with their wallet address, the onboarding process for a DEX is seamless and practically instant compared to a centralized exchange.

CONCERNS

DEXs also carry a set of risks. For example, DEXs only work with crypto assets and not fiat currencies like the US Dollar or the British Pound. So a person needs to have cryptocurrency assets in advance to use a decentralized exchange. Their user interfaces are also much trickier because navigating DEXs requires some specialized knowledge and the interfaces aren’t always easy or beginner friendly.

A DeFi protocol is only as safe and secure as the smart contracts that power it. And the code can have exploitable bugs, which can result in a loss of assets. Similarly, some DEXs have poor liquidity conditions which can lead to a large amount of slippage and a miserable user experience. There is also the risk of fraud because many DEXs feature permissionless market creation (the ability that anyone can create a market for any token) So the risks of buying malicious or low-quality tokens or even fake tokens can be much higher than in centralized exchanges.