Decentralized exchanges are peer-to-peer cryptocurrency marketplaces. DEXs use smart contracts to enable trades directly between cryptocurrency wallets without the intervention of a third-party intermediary.
A DEX is simply autonomous software. Once a DEX is running on the blockchain, trades happen automatically and cannot be controlled by outside organizations. They also do not require you to create an account or provide personal information such as your name and address, which will appeal to those who value their privacy.
Many top decentralized exchanges run on the Ethereum blockchain, although this is starting to change as protocols like Avalanche, Solana, and Fantom rise in popularity.
How Do DEXs Work?
Private encryption keys are used to access a user’s cryptocurrency wallet. After logging into a DEX using their private key, users are able to see their asset balances and make trades.
Traders are responsible for managing their own assets, so it’s important to avoid careless mistakes like losing your private keys or transferring payments to the incorrect wallet addresses.
When a transaction is initiated, the user’s assets are automatically converted into an IOU (I Owe You) certificate and held in escrow so they can be exchanged on the network. An IOU is a blockchain token that has the same value as the underlying asset.
Since DEXs are built on blockchain networks, each transaction is subject to transaction fees, also known as gas. These fees are typically small and usually paid in the blockchain’s native token. Most exchanges also charge a small fee for each trade. Because of this, you will want to keep some additional cryptocurrency in your wallet to pay these fees.
Note: Ethereum has gained a reputation for having high transaction fees when the network is busy. This has led to the growth of many layer 2 solutions that run on top of Etherium and also competing blockchains. Always check the price of fees before submitting a trade. If they are high, try back later when the network is less busy and consider looking into other blockchains with lower fees.
The Three Main Types of Decentralized Exchanges are:
Automated Market Makers
Automated Market Makers were created to address issues related to low liquidity. AMMs determine the price of cryptocurrencies using oracles, which are blockchain-based data providers. Rather than trying to match buy and sell orders, DEXs use liquidity pools, which are simply collections of staked cryptocurrency.
Order Book Based DEXs
Order books are records of all open buy and sell orders for certain asset pairings. Buy orders show that a trader is willing to buy or sell an item at a specific price. Sell orders indicate that a trader is willing to sell for a specific price. The difference between these two amounts is called the spread.
These platforms use various protocols to address liquidity issues. They combine assets from multiple DEXs to reduce slippage on large orders. This also decreases trading fees and gives investors the best prices and quickest transactions.
DEX aggregators also utilize their deep liquidity to shield consumers against failed transactions.
Some DEX aggregators can even pull liquidity from centralized exchanges to provide a better experience for their customers. However, they are still able to retain privacy thanks to the way they interact with these platforms.
What are the Advantages of DEXs
Open source software ensures transparency by allowing the developer community to evaluate apps for vulnerabilities and verify that there is no hidden or dangerous code.
DEXs are a great option if you’re interested in purchasing new or less well-known cryptocurrencies. DEXs provide an almost infinite variety, ranging from top coins to obscure tokens. Since anybody can create their own token and build a liquidity pool for it, there is a great diversity of projects.
Diminished Hacking Risks
Since all of the assets are stored in users’ wallets instead of a central location, there is less risk of hacking.
The majority of DEXs do not require any personal information.
Inclusion of Developing Countries
Reliable financial services are not always available to people in emerging economies. This has led to an increase in the popularity of DEXs due to their ease of access and low cost, fast transactions.
What Are the Disadvantages of DEXs?
Interfaces are Not Always User-Friendly
Navigating decentralized exchanges involves a bit of knowledge and practice, since the interfaces are not always straightforward. Be patient and follow the advice of an experienced DeFi user until you get the hang of it.
Smart Contract Vulnerabilities
Defi platforms are only as safe as the smart contracts running on them. Despite extensive testing, the code could have defects that can be exploited to steal tokens. While smart contracts function properly under normal circumstances, developers can’t predict every possible scenario or vulnerability.
High Risk Coins & Tokens
Due to the enormous quantity of unvetted tokens accessible on DEXs, there is also an increased risk of fraud and schemes. It is not uncommon for new tokens to launch with hype and high prices, only to plummet in value as early investors sell all their tokens at inflated prices.
DEXs, such as Uniswap and Sushiswap, are part of a rapidly expanding toolset known as decentralized finance (Defi). These applications provide access to a wide range of financial services, which are available directly from your cryptocurrency wallet.
DEXs give users more control over their assets, allowing them to avoid frustrating and time-consuming account setup and approvals to exchange their cryptocurrencies. At the same time, many DEXs also offer lower trading fees than their centralized counterparts.
Decentralized exchanges are still a fairly new concept, which will surely transform and improve over time. However, they already offer many opportunities and benefits to early adopters.