What is DEX? How does it work?
What is DEX? How does it work? – People looking to get involved in cryptocurrency need a place where they can securely buy and trade crypto tokens. While centralized crypto exchanges attract the majority of mainstream interest, traders can also benefit from decentralized crypto exchanges (DEXs).
DEXs have surged on blockchain networks like Ethereum in recent years. These exchanges provide a simple way to trade crypto assets without giving personal information to a central company. Before delving into what DEX is and how it compares to a centralized exchange, let’s first examine the concept of exchanges.”
People looking to enter the world of cryptocurrency need a place where they can securely purchase and trade crypto tokens. While centralized crypto exchanges attract the majority of mainstream interest, traders can also benefit from decentralized crypto exchanges (DEXs).”
In recent years, DEXs have experienced a surge on blockchain networks such as Ethereum. These exchanges offer a straightforward way to swap crypto assets without providing personal information to a central entity. Before delving into what DEX is and how it compares to a centralized exchange, let’s first take a conceptual look at exchanges.”
What is Exchange?
The term ‘exchange’ refers to a market where users can buy and sell financial assets. There are numerous exchanges worldwide specializing in different products and services. For instance, the New York Stock Exchange (NYSE) primarily focuses on selling shares of American companies. In contrast, the Foreign Exchange Market (FOREX) facilitates trading between fiat currencies.
Cryptocurrencies also have private exchanges that offer digital assets such as Bitcoin, Ethereum, and stablecoins. However, unlike traditional exchanges, crypto exchanges come in two types: centralized and decentralized. Currently, all major exchanges in traditional finance are centralized, meaning that third parties always control the order books.”
What is DEX?
DEXs are decentralized cryptocurrency exchanges that provide access to digital assets without intermediaries. Instead of relying on a company to facilitate and record crypto trades, DEXs offer peer-to-peer (P2P) token swaps using blockchain technology. More specifically, DEXs use smart contracts to execute transactions. Smart contracts automatically trigger orders when predefined criteria are met.”
As there are no central authorities overseeing trades or supplying crypto in decentralized exchanges (DEXs), they rely on average crypto investors to provide token liquidity. In most DEXs, anyone can contribute their cryptocurrencies to liquidity pools that support trading pairs on the platform. To encourage more users to add their crypto to liquidity pools, DEXs often provide a percentage of trading fees, offering people a way to earn returns on their funds that was not possible before.”
What are Centralized Exchanges?
Unlike DEXs, centralized cryptocurrency exchanges (CEXs) do not rely on user funds to provide liquidity to crypto traders. Since companies control CEX platforms, administrators always oversee the daily volume and transactions on the exchange. Some prominent examples of CEXs in the United States include Coinbase, Gemini, and Kraken. As for DEXs, the most notable applications reside on the Ethereum blockchain and include Uniswap, Curve Finance, and SushiSwap.”
CEXs are also subject to regulations in their respective jurisdictions to provide legal trading services. This often means that CEXs require more identity verification from users compared to DEXs. In fact, most DEXs only require traders to connect their crypto wallets to make a trade.”
Another critical difference is that CEXs can accept fiat currencies. Since DEXs are based on their own blockchains, they can only accept crypto funds for transactions. People need to have cryptocurrency in a compatible wallet to interact with a DEX.”
Finally, it is worth noting that transactions on a CEX are under supervision. In other words, the crypto purchased on a centralized exchange is not 100% under the control of the individuals. When investors leave their crypto on a CEX, the company holds the crypto on their behalf. People only truly own their digital assets when they transfer them from a centralized exchange to a private wallet.”
How Do DEXs Work?
Many DEXs utilize a combination of smart contracts and liquidity pools on a blockchain. The smart contract code assists in filling trades without the need for a third party to record order books. Any crypto investor can provide tokens to these ‘pools’ in DEXs, allowing users to buy and sell these assets.”
While this is the general operating mechanism for DEXs, there are nuances among different DEX platforms. Three common types of DEXs include automated market makers, on-chain order books, and off-chain order books.
Types of Decentralized Exchanges
Automated Market Makers (AMM): AMMs are DEXs that do not use order books to record transactions. Instead, they rely on autonomous smart contracts and liquidity pools to provide users with a decentralized trading experience. They also utilize oracles, such as Chainlink, to provide information about current cryptocurrency prices.
On-chain Order Books: On-chain order books use a system of nodes and crypto miners to verify transactions and store this information on the blockchain. These order books are similar to those in centralized crypto exchanges, except they do not rely on a company to confirm transactions. Since these order books are viewable by everyone on the blockchain, they are considered more transparent than off-chain order books.
Off-chain Order Books: Off-chain order books employ a verification method similar to on-chain order books but rely on external centralized servers to record trades. The advantage of this model is that off-chain order books often offer lower fees than on-chain order book DEXs. However, off-chain order books do not have the same degree of decentralization as their counterparts among competing DEXs.
Benefits of Using DEXs
Anonymity: Many individuals prefer DEXs over CEXs as they do not require Know Your Customer (KYC) or Anti-Money Laundering (AML) documents. People with cryptocurrency wallets can use DEXs without disclosing their identities.
Transparency: When using a DEX, there is no need to trust a third party to transact on behalf of a user. All transactions are recorded on a public ledger, providing traders with greater precision over their digital assets.
Access to Private Keys: When people trade on DEXs, tokens go directly to their cryptocurrency wallets. Individuals who value self-custody do not have to worry about centralized exchanges holding their tokens.
Wider Altcoin Selection: Cryptocurrency traders often find it easier to discover new, small, or obscure altcoins on DEXs. As CEXs are heavily regulated, traders may be less inclined to take on significant risks with unproven crypto projects that you might encounter on DEXs.
Disadvantages of Using DEXs
Smart Contract Vulnerabilities: Since AMMs are code-based, traders on DEXs need to trust that there are no flaws in the protocol. There is always a possibility of malicious actors exploiting a vulnerability in a DEX.
Lack of Customer Support: DEXs do not have dedicated customer service departments like CEXs. If users encounter an issue with DEX usage, finding reliable assistance can be challenging.
Liquidity Risk: DEXs rely on average users for liquidity, and while many DEXs have expanded their liquidity pools, they are not as liquid as CEXs. DEX users may have to pay higher prices if the desired trading pair lacks substantial liquidity.
Weak UI/UX for Beginners: Individuals not familiar with using a crypto wallet may find it challenging to interact with a DEX. These decentralized platforms do not necessarily have the same streamlined user interface found in many centralized exchanges.
Often Limited to a Single Chain: While some Web3 developers may attempt to create a multi-chain DEX, most of these exchanges are available only on a single blockchain. If you are dealing with tokens on multiple blockchains, you would need to interact with various DEXs.
Prone to Token Scams: Since DEXs are not centrally regulated, they lack as robust screening standards as major altcoins. This makes DEXs more susceptible to scams, so users should exercise extra caution when dealing with low-volume DEX tokens.
How to Use DEX’s?
To use a DEX, traders need to first download a compatible software crypto wallet for the exchange. For example, individuals wanting to use an Ethereum-based DEX should have an Ethereum-compatible wallet, such as MetaMask.
After setting up a crypto wallet, users need to deposit cryptocurrency into this specific account. Traders can either transfer crypto from a centralized exchange to their wallet or purchase directly from their wallets.
Regardless of the cryptocurrency you want to trade on a DEX, keep in mind that you will need the native cryptocurrency of your blockchain to pay for fees. For example, on Ethereum, you will need additional ETH to complete a transaction.
After depositing funds into your crypto wallet, you can visit the desired DEX and open the application. Typically, you will find the ‘Open App’ button on the top right corner of the site’s homepage.
While in the trading portal of a DEX, you should see a button to link your crypto wallet and two default cryptocurrencies ready for trading. After logging in with your crypto wallet, the DEX should recognize your wallet address and allow you to start trading.
You can switch between the two cryptocurrencies on your DEX until you find the pair you want to trade. Enter the crypto you want to exchange and confirm the transaction in your crypto wallet. Make sure to closely examine all fees associated with this trade before confirming. Depending on network congestion, it may take a few minutes to see the desired tokens in your crypto wallet.
What are the most popular DEXs?
As of the current writing, some of the top DEXs include:
Uniswap: Built on Ethereum, Uniswap is by far the largest DEX in the cryptocurrency space. Recent estimates indicate that Uniswap holds roughly 50% of the total volume for all DEXs and consistently manages over 1 billion dollars in daily transactions. Due to its size and reputation, Uniswap provides the highest liquidity and security for DEX trading.
PancakeSwap: PancakeSwap is the largest DEX on the Binance Smart Chain and follows a similar structure to Uniswap. However, being on the BSC, PancakeSwap tends to have lower fees compared to Ethereum-based DEXs. The lower fee structure has attracted many individual investors who prefer not to pay higher fees for interacting with Ethereum.
Curve Finance: Curve is an AMM DEX specialized in stablecoin pairs on Ethereum. Unlike many competing DEXs, Curve does not offer a multitude of speculative altcoins. Instead, it employs an algorithm prioritizing low fees and low slippage among supported digital assets.
