Updated: Apr 14
Cryptocurrencies have turned the entire world of finance and technology upside-down.
Before the creation of the Bitcoin protocol, one of the biggest problems in the financial world was a centralized system controlling the flow of money. Cryptocurrencies were the solution to decentralize power. The central authority was replaced by an automated system based on mathematical algorithms which can carry out transactions. Decentralized exchanges are born to make it possible.
What exactly is a DEX?
"A decentralized exchange (DEX) is a type of exchange specializing in peer-to-peer transactions of cryptocurrencies and digital assets. Unlike centralized exchanges (CEXs), DEXs do not require a trusted third party, or intermediary, to facilitate the exchange of crypto assets."
DEXs became so popular thanks to the Ethereum network, the first blockchain on which they have run, but now they are widespread on many blockchains that use ERC-20. In a few words, DEXs are how you swap into and out of crypto assets.
This type of exchange doesn’t have a central authority or a single entity with control, this feature is replaced by code and algorithms and the process brings with it many advantages and disadvantages.
Pros and Cons of a DEX
Using a DEX has a lot of benefits, primarily when you work in the DeFi ecosystem:
No KYC (know your customer) is required. You do not have to provide personal data, pictures, or fingerprints. The management of a DEX takes place thanks to a smart contract and lines of code that should be more reliable than a human. The open-source code allows everyone to look, search, and resolve possible bugs.
However, DEXs also have weaknesses and downsides:
No support. If you have an issue, nobody can help you. You can only ask in a community forum where people generously could help you.
You must use a hot storage device (so-called hot wallet). That means your wallets function on the net. Pay attention.
Low liquidity; means that if you buy a lot of tokens, the prices of coins/tokens should go up. Vice versa, selling tons of tokens can crash the price.
Code is open for anyone, but this is a double-sided sword. Those who find the vulnerability could also exploit it.
How a DEX works?
Like all decentralized applications (dApps), DEXs are hosted on a smart contract blockchain. Technically, all blockchains are smart contract platforms, including Bitcoin, but not all are suitable for dApp development and deployment. This is why Ethereum, Solana, Avalanche, and Fantom are so-called smart contract platforms. Traders interact with smart contracts on the blockchain to use DEXs. This also connects DEXs directly with non-custodial wallets, such as Trezor, MetaMask, Trust Wallet, Ledger, and others.
There are three types of decentralized exchanges: Automated market makers (AMM), Order books DEXs, and DEX aggregators.
1) Automated Market Maker
These platforms use algorithms to match buyers and sellers and do not need a central authority. Smart contract technology helps AMMs resolve liquidity concerns by obtaining information from other exchanges and platforms to determine the price of assets on crypto exchanges and split all assets into liquidity pools. Each liquidity pool can be rebalanced whenever users carry out transactions. Automated Market Makers depend on blockchain-based services, known as blockchain oracles, to obtain information from other exchanges and platforms to determine the price of assets traded on the platform.
AMMs are currently the most popular type of decentralized exchange; the best commonly used are Uniswap, Balancer, Sushiswap, Bancor, and Curve.
2) Order book DEX matches buyers and sellers who work like open-air markets: they allow participants to place their best bid or ask prices on assets and wait for somebody else to come along and fill their orders. Simply put, the same method as the US Stock Market. The most common are DDE and dYdX.
3) DEX aggregators are platforms that allow users to trade on multiple DEXs simultaneously. They have high trading volumes and low fees but offer less security.
The most crucial aggregators are ParaSwap and 1Inch.
Follow-up materials: cointelegraph.
Decentralized exchanges’ transaction fees vary by platform. The highest fees are Ethereum’s gas fees. However, they will soon be lowered as ETH goes through the Merge. Each DEX runs on different networks. Therefore, before choosing which DEX to operate on, it is essential to understand which coin is used to pay the gas fees and its price!
Decentralization has always been at the core of cryptocurrencies, and DEX will always be a cornerstone in DeFi.
Join our community on Discord