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Blockchain technologies like cryptocurrency are based on a philosophy of decentralization. So it should be no surprise that decentralized exchanges (DEXs) have risen to compete with the more traditional centralized exchanges (CEXs).
The Short Version:
- DEXs are peer-to-peer crypto marketplaces that let traders make direct transactions on the blockchain through a system of smart contracts, order books and/or liquidity pools.
- On a DEX, users can remain anonymous and have access to more cryptocurrencies, while enjoy more security than traditional exchanges.
- While there are numerous benefits to trading on a decentralized exchange, doing so requires an intermediate level of experience and knowledge of how crypto works.
Over the past few years there has been a steady rise of altcoins and DeFi (decentralized finance) technologies. These new advancements created a truly unique environment for crypto assets, an environment with a solid and expanding base of traders and investors.
What makes DEXs unique is that they’re peer-to-peer marketplaces that let cryptocurrency traders make direct transactions — without an intermediary managing their funds. Instead, DEXs use smart contracts that self-execute their agreements and innovative solutions have been devised to solve liquidity-related issues.
But how does it actually work? Read on to find out how DEXs operate, their pros and cons, and which platforms you can consider using.
How Do Decentralized Exchanges Work?
Unlike CEXs, DEXs enable transactions to be executed and cleared without an intermediary. This is possible because DEXs are built directly on the blockchain. And this allows users to freely trade their assets and keep custody of their funds through self-executing smart contracts.
There are three main DEX frameworks: automated market makers (AMMs), order books and DEX aggregators.
First-generation DEXs use order books to log all open buy and sell orders for an asset. The spread between the bid and ask prices determines the depth of the order book and the prevailing market price. There are two types of order book DEXs: on-chain order books and off-chain order books.
- On-Chain Order Books — Typically, an on-chain order means the order is processed and verified by the blockchain. Miners validate the transaction and then it is recorded on the blockchain. These records are maintained through a network of nodes.
- Off-Chain Order Books — “Off-chain orders” generally refers to transactions that are processed off the blockchain. These orders can be executed with an agreement between two parties or with a third party being a guarantor. The advantages of off-chain orders include enabling execution of trades at prices closer to those desired by users through increased speed and reduced costs.
Automated Market Makers
An automated market makers system solves liquidity issues through the use of smart contracts to form liquidity pools.
Liquidity pools are basically reserves of assets that help mitigate market swings or other moments of illiquidity. Users fund these liquidity pools to help cover transaction fees that would normally be charged upon the execution of a trade.
AMMs pull information from blockchain-based services in order to set the price of traded assets. In short, AMMs allow transactions to be executed without intermediaries or order books.
A DEX aggregator can be thought of as a search engine. It searches the rates on the various DEXs to find the best rate.
These aggregators typically pool liquidity from various DEXs in order to minimize slippage on larger orders while enhancing token prices and swap fees. Additionally, DEX aggregators increase the chances of successful transactions and protect users from the pricing effect.
Decentralized Exchanges: Pros & Cons
While DEXs are well known for security, user control and anonymity, they are not without disadvantages.
- Diversity of Tokens — Because CEXs vet tokens to ensure compliance with local regulations, there are typically fewer tokens available. In contrast, DEXs may include any token minted on the blockchain.
- Anonymity — DEXs allow users to remain anonymous, while CEXs must provide information (photo ID, full legal name, etc.) for the Know Your Customer (KYC) process before they can trade.
- Reduced Security Risk — DEXs reduce the risk of funds being hacked because users custody their own funds. Only liquidity providers are at risk if a DEX platform is hacked.
- Reduced Counterparty Risk — Since DEXs operate through smart contracts, there is no risk of other parties failing to uphold their end of the deal and defaulting on their obligations.
- Steep Learning Curve — Users must be familiar with using crypto wallets and have a working knowledge of digital security. Wallets must have native tokens of each specific network. If a user does not have the native token to pay fees, their funds may become locked. Furthermore, user interfaces are not always intuitive, and users may need some time and study before they can navigate them comfortably.
- Smart Contract Vulnerabilities — Smart contracts are built with code that can potentially have exploitable bugs, resulting in the loss of tokens. And human error is still a factor, despite automation.
- Unvetted Token Listings — As stated in the Pros sections, DEXs allow a greater diversity of tokens. But this diversity can expose DEX users to the many scams associated with newly minted tokens.
Decentralized Exchanges (Swaps)
As mentioned, many first-gen DEXs use order books to facilitate trades and set prices. But the next generation of decentralized exchanges does not. Rather, these next-gen DEXs use liquidity pools to set asset prices. Below is a list of DEX platforms you can begin with.
- Uniswap — Through the Uniswap platform, users swap any two Ethereum-based assets. Uniswap eliminates intermediaries and unnecessary forms. And this makes it safe, accessible and efficient. Furthermore, the Uniswap protocol was designed to be censorship resistant and is non-upgradable.
- Curve — Curve uses a liquidity pool while specifically allowing stablecoin trading. This lets users trade between stablecoins with low slippage and fees.
- Pancake — This platform has never been hacked and has a swap function that lets you easily swap between any available assets with a simple interface and reasonable trading fees.
- SushiSwap — This DEX offers liquidity providers a native token called SUSHI, which Uniswap now offers with its UNI token. SushiSwap is an Ethereum based AMM and its original protocol is based on Uniswap’s code. In fact, aside from notable community-oriented features, the source code for SushiSwap and Uniswap are nearly identical.
- Kyber Network — Kyber operates a stack of smart contracts that can run on any blockchain; therefore, unlike other platforms, it is not limited to Ethereum. Like other platforms, Kyber operates with liquidity pools to facilitate peer-to-peer swaps.
- Bancor — ERC-20 tokens are exchangeable for the native Bancor Network Token (BNT). These BNT tokens can then be exchanged for others on the ERC-20 token platform. Bancor deployed AMMs on Ethereum before anyone else, back in 2017, even before DeFi hit the mainstream.
We’re still in the early stages of DeFi. For now, DEXs still have a high learning curve for the layperson and there scammy altcoins still abound. But as blockchain technologies become more widely used and sophisticated, we’re likely to see the emergence of new DEXs and hopefully greater stability in the altcoin space.
Disclaimer: The content presented is for informational purposes only and does not constitute financial, investment, tax, legal or professional advice. If any securities were mentioned in the content, the author may hold positions in the mentioned securities. The content is provided “as is” without any representations or warranties, express or implied.