Definition

A decentralized exchange (also known as a DEX) is a peer-to-peer marketplace where traders trade directly with one another without the need for an exchange. DEXs, which are decentralized exchanges, enable non-bank financial transactions that aren’t regulated by banks or brokers. 

Many well-known DEXs, such as Uniswap and Sushiwap, operate on the Ethereum blockchain. This is achieved using self-executing agreements called “smart contracts” that employ code. DEXs were created to eliminate the need for any external regulation or control over trades conducted on a certain exchange. Cryptocurrency P2P trading is possible using decentralized exchanges.

In a nutshell, a P2P market is one in which buyers and sellers of cryptocurrencies connect through the internet. They’re generally non-custodial, so customers retain control of their wallet’s private keys.

A cryptocurrency’s private key is a form of advanced encryption that allows users to access their funds. After logging in to the decentralized exchange with their private key, users can check their crypto balances straight away. They will not be asked for any personal information, which is ideal for those who value their privacy.

The growth of the decentralized finance (DeFi) industry can be attributed, in part, to several inventions that addressed liquidity issues such as automated market makers. The creation of DEX aggregators and wallet extensions helped attract users to the decentralized finance space by lowering costs.

How does decentralized exchange work?

DEXs, which stands for decentralized exchanges, are cryptocurrency trading platforms that don’t allow fiat currency to trade with cryptocurrencies. Instead of allowing fiat and cryptocurrency to be exchanged, they solely deal in crypto token trades.

You can exchange fiat for crypto (and vice versa) or crypto-crypto combinations, such as some of your bitcoin for ETH, through a centralized market. You may also execute more complex transactions like margin trading and placing limit orders frequently.

All of these exchanges, however, are managed by the exchange itself via an “order book,” which establishes the price for a specific cryptocurrency based on current purchase and sales orders — the same technique employed by stock exchanges like Nasdaq.

In other words, decentralized exchanges are simply a collection of smart contracts. They set the rates of various cryptocurrencies against each other using “liquidity pools” — in which investors lock funds in exchange for interest-like returns – to make transactions easier.

Transactions on a centralized exchange are kept on the exchange’s internal database, but settlements for DEX transactions are made directly on the blockchain. The majority of DEXs is written in open-source software, which allows anyone with an interest to examine how they operate.

Developers can also use the framework to modify existing software and introduce new competing projects, as seen with Uniswap, which has been adapted by a host of DEXs with “swap” in their names such as Sushiswap and Pancakeswap.

Order books

All open orders to buy and sell assets for specific asset pairs are recorded in a book. Buy orders indicate that a trader is ready to purchase or offer an asset at a certain price, while sell orders imply that the same trader is prepared to sell or request a specific price for the item being considered.

The spread between the bid and ask prices determines the depth of the order book and market price on the exchange. A DEX, like a regular cryptocurrency exchange, is an online marketplace that allows users to trade cryptocurrencies using its own internal currency. On-chain order books and off-chain order books are the two types of DEXs. Users’ funds remain in their wallets while order information is kept on the chain.

Many cryptocurrency exchanges provide leveraged trading, which allows traders to use borrowed money to enhance their bets. Leveraged trading increases the earning potential of a trade, but it also adds a risk of liquidation since it magnifies the size of the position employing borrowed funds, which must be repaid even if the traders lose their wager.

The liquidity of order book DEXs is frequently an issue. Traders generally stick to centralized platforms because they compete with centralized exchanges and incur additional costs owing to the activities that must be completed on-chain. While DEXs with off-chain order books decrease these expenses, smart contract risks increase as a result of the need to deposit funds in them.

DEX aggregators

DEX aggregators employ a variety of solutions to address issues with liquidity. Platforms that aggregate liquidity from multiple decentralized exchanges to avoid slippage on big transactions, minimize swap costs, and provide traders with the best price possible in the quickest time are known as DEX platforms.

One of the main objectives of DEX aggregators is to prevent users from being defrauded by charging them different prices for varying cryptocurrency amounts. Another major goal is to decrease the risk of failed transactions by protecting customers from the pricing effect. 

Some DEX aggregators also integrate with specific centralized exchanges to provide a better user experience while remaining non-custodial by leveraging integration with particular platforms.

How are decentralized exchanges used?

A decentralized exchange does not need a sign-up process since you don’t need an email address to use them. Traders will instead require a wallet that supports the smart contracts on the network of the exchange. Anyone with a smartphone and access to the internet can use the decentralized exchange to take advantage of their financial services.

The first step in adopting DEXs is to choose a network for the user. Each trade will incur a transaction fee, and each of these fees must be paid in the native currency of the network. The next stage is to acquire a wallet that works with the selected network and fill it with its native currency. A native token is used to cover transaction expenses in a specific network.

Users may engage with decentralized apps (DApps) such as DEXs easily by utilizing browser-based wallet extensions that enable them to directly access their money. These are typically added in the same manner as other plugins and require users to either import an existing wallet using a seed phrase or private key or create a new one. Password protection ensures further security.

Smart wallets, on the other hand, have a lot of features that are incompatible with any other category. These wallets may also include mobile apps for traders to utilize DeFi protocols on the go, as they come preinstalled with browsers that can interact with smart contract networks. Users may synchronize their wallets between devices by transferring from one to the next.

After selecting a wallet, it must be loaded with the tokens necessary to pay transaction costs on the chosen network. These tokens must be purchased on centralized exchanges and are easy to identify by their ticker symbol, such as ETH for Ethereum. Users only have to withdraw the tokens they bought to wallets they control after acquiring them.

It’s critical to move funds to the correct network. As a result, users must take their money out of the incorrect network. Users may either connect their wallet through a pop-up message or press the “Connect Wallet” button on one of the top corners of a DEX’s website to fund it.

Benefits and downsides of decentralized exchange

Benefits

• Variety: If you’re looking for a hot cryptocurrency in its infancy, DeFi is the place to go. DEXs provide a virtually limitless variety of tokens, from well-known to obscure and completely random. That’s thanks to the fact that anybody can mint an Ethereum-based token and establish a liquidity pool for it, so you’ll find more projects, both vetted and untested.
• Hacking risks: Because all of the assets in a DEX trade are kept in the traders’ personal wallets, they are theoretically less vulnerable to a hack. Relatedly, because DEXs eliminate “counterparty risk,” which is the chance that one of the involved parties, including potentially the central authority in a non-DeFi transaction, will default, they help reduce this risk.
• Anonymity: Most popular DEXs do not need any personal information to operate.
• Utility in the developing world: In emerging nations with poor banking infrastructure, peer-to-peer lending, rapid transactions, and anonymity provided by DEXs have grown increasingly popular. Anyone with a smartphone and access to the internet may trade on a decentralized exchange.

Downsides

• Trickier user interfaces: Dealing with decentralized exchanges necessitates some specialized knowledge, and the interfaces aren’t always simply prepared to do a lot of research, and don’t expect the DEX itself to provide much assistance. You’ll generally need to go offsite for a walk-through or an explanation. Caution is advised since it’s possible to make an irreversible mistake, such as sending cash to the incorrect wallet. Another frequent problem is known as “impermanent loss,” which can occur when two more volatile cryptocurrencies are combined in a liquidity pool.
• Smart contracts are vulnerable to attack: Any DeFi protocol is only as secure as the smart contracts that power it and code may contain exploitable bugs (despite extensive testing) that can result in the loss of your assets. While a smart contract may function normally in most cases, not all uncommon events, human factors, or hacks can be anticipated by developers.
• Riskier coins: With the wide variety of cryptocurrencies accessible on most decentralized exchanges, there are more frauds and ploys to be wary of. When a creator creates a lot of new tokens in an attempt to flood the liquidity pool and damage the currency’s value, it’s known as a “rug pull.”

Because there is no central entity verifying the sort of information provided to centralized platforms, it’s difficult for these platforms to enforce Know Your Customer and Anti-Money Laundering checks. Regulators may still attempt to apply these checks on decentralized systems.

Because custodians are not required, the regulations that apply to them would not apply to these platforms. They still require users to sign messages on the blockchain in order to remove funds from their platforms, which is why they aren’t affected by any rules.

Decentralized exchanges now enable users to borrow funds, leverage their positions, lend funds to earn interest passively, or provide liquidity in order to receive trading fees.

Because these platforms are based on self-executing smart contracts, new use cases may emerge in the future. Flash loans, for example, are a form of decentralized finance innovation that enables the creation of goods and services that were not conceivable before.