A decentralized exchange (DEX) is a peer-to-peer marketplace where you can trade cryptocurrencies directly without a custodian overseeing funds transfer and holding. DEXs replace traditional intermediaries like banks, brokers, and payment processors with smart contracts on the blockchain, which facilitate the exchange of assets.
In contrast to traditional financial transactions, which lack transparency and involve intermediaries who reveal very little about their operations, DEXs provide complete visibility into the movement of funds and the processes behind exchanges.
Since user funds aren't routed through a third-party wallet during trading, DEXs diminish the risk of counterparties. They can mitigate centralization concerns in the cryptocurrency ecosystem.
Thanks to their permissionless access, DEXs play a fundamental role in decentralized finance (DeFi) and function as a vital building block for more complex financial products.
This article outlines how decentralized exchanges DEX work, the various types of DEX, and the advantages and drawbacks they introduce to the cryptocurrency space
CEXs vs. DEXs
Centralized Exchanges (CEXs) and Decentralized Exchanges (DEXs) represent two distinct approaches in cryptocurrency trading.
CEXs function as third-party intermediaries, acting as centralized platforms where users deposit their funds, and the exchange facilitates trades on their behalf. They often provide a user-friendly interface, advanced trading features, and high liquidity. However, users relinquish control of their private keys and funds to the exchange, which can pose security risks.
On the other hand, DEXs operate directly on blockchain networks, enabling peer-to-peer trading without an intermediary. Users retain control of their private keys and funds, enhancing security. While DEXs may have lower liquidity and a less intuitive user interface than CEXs, they offer a decentralized and censorship-resistant approach to trading, aligning with the core principles of blockchain technology.
How does a DEX work?
There are different types of DEXs, each with its own advantages and trade-offs in terms of features, how much it scales, and how decentralized it is. The most common types are order book DEXs and automated market makers (AMMs). Another widely used category is DEX aggregators, which scan multiple DEXs on-chain to find the optimal price or lowest gas cost for the user's intended transaction.
DEXs offer a significant level of determinism by leveraging blockchain technology and immutable smart contracts. Unlike centralized exchanges like Coinbase or Binance, which rely on the exchange's internal matching engine, DEXs execute trades through smart contracts and on-chain transactions. Additionally, DEXs allow users to control their funds through their self-hosted wallets while trading.
Users of DEXs typically encounter two types of fees—network fees and trading fees. Network fees involve the gas cost of the on-chain transaction, while trading fees are gathered by the underlying protocol, its liquidity providers, token holders, or a combination of these entities as outlined by the protocol's design.
The vision for many decentralized exchanges is to establish permissionless, end-to-end on-chain infrastructure without central points of failure and with ownership distributed among a community of stakeholders.
This often involves governance by a decentralized autonomous organization (DAO).
However, striking a balance between maximizing protocol decentralization and ensuring competitiveness in a crowded DEX landscape is a challenging task. The core development team behind the DEX usually possesses more in-depth knowledge about critical protocol functionality than a distributed set of stakeholders. Nevertheless, many DEXs opt for a distributed governance structure to enhance censorship resistance and long-term resilience.
Types of Decentralized Exchanges?
Order Book DEXs
Order book decentralized exchanges (DEXs) provide a real-time record of active buy and sell orders. They rely on order books to match "buy" and "sell" orders from different users and the exchange's internal systems to pair these orders effectively.
History of order book DEXs
Historically, fully on-chain order book DEXs were less prevalent in DeFi. This was due to the necessity of recording every interaction on the blockchain, demanding exceptionally high throughput or compromising network security and decentralization.
Consequently, early Ethereum-based order book DEXs experienced lower liquidity and less-than-optimal user experiences. Nonetheless, they served as compelling proofs of concept, demonstrating how a DEX could facilitate trading through smart contracts.
Why Order Book DEXs are popular
Advancements in scalability, including layer-2 networks like optimistic rollups and ZK-rollups and introducing higher-throughput, application-specific blockchains, have made on-chain order book exchanges more viable.
They now attract a significant volume of trading activity. Additionally, hybrid order book designs, wherein order book management and matching processes occur off-chain. At the same time, trade settlement remains on-chain and has gained popularity.
Notable examples of order book DEXs include 0x, dYdX, Loopring DEX, and Serum.
Automated market makers (AMMs)
AMMs are the dominant form of decentralized exchanges (DEXs) due to their ability to provide instant liquidity, offer inclusive access to liquidity provision, and often permit unrestricted market creation for any token.
Essentially, an AMM functions like an automated trader, always ready to quote a price for a pair of assets. Instead of relying on an order book, AMMs operate using a liquidity pool where users can exchange their tokens, and the price is determined by an algorithm based on the ratio of tokens in the pool.
Why AMMs are popular
AMMs are particularly advantageous as they provide immediate access to liquidity in markets that might otherwise have limited liquidity. Unlike order book DEXs, where a buyer must wait for their order to match a seller's, an AMM's smart contract instantly sets the exchange rate. This benefits users in terms of speedy transactions and allows liquidity providers (those who deposit into the AMM's liquidity pool) to earn passive income through trading fees.
This combination of instant liquidity and accessible liquidity provision has led to a surge in creating new tokens through AMMs, focusing on specific use cases like stablecoin swaps. For a more comprehensive understanding of AMMs, you can explore this detailed guide on their operation.
While current AMM models primarily deal with cryptocurrencies, they have the potential to facilitate exchanges of various assets, including NFTs, tokenized real-world assets, carbon credits, and more.
Popular AMM DEXs include Bancor, Balancer, Curve, PancakeSwap, Sushiswap, Trader Joe, and Uniswap.
Advantages of Decentralized Exchanges
Precise order execution
Decentralized exchanges (DEXs) operate through deterministic smart contracts, providing strong assurances that trades will execute precisely as intended by the user without the interference of centralized entities.
Enhanced transparency
Unlike the potentially opaque execution methods and exposure to censorship seen in conventional financial markets, DEXs offer robust execution guarantees and enhanced transparency into their trading mechanics.
Eliminates counterparty risk
Since DEXs eliminate the need for custodians and allow users to engage through their self-hosted wallets, they mitigate counterparty risk. Additionally, DEXs can help mitigate some of the systemic risks associated with the blockchain industry by reducing the concentration of capital in the wallets of a small number of centralized exchanges.
For instance, in 2014, the centralized exchange Mt. Gox managed a significant portion of all Bitcoin trading volume before abruptly ceasing operations, resulting in the loss of thousands of Bitcoins.
Combating financial exclusion
Furthermore, DEXs contribute to promoting financial inclusivity. While specific CEXs have restricted access based on geographic location, accessing a DEX's smart contracts requires an internet connection and a good self-custodial crypto wallet. The onboarding process for a DEX is also seamless and quick compared to a centralized exchange.
Risks and factors to consider in DEXs
Decentralized Exchanges (DEXs) have opened up trading and liquidity provision to a wider audience, ensuring enhanced transparency and unrestricted entry. Still, DEXs do come with their own set of potential risks, which include the following.
Smart contract vulnerability
While blockchains are generally recognized for their high level of security in executing financial transactions, the quality of a smart contract depends on the expertise and experience of the team that developed it.
Smart contract bugs, hacks, weaknesses, and exploits can expose DEX users to financial losses. Developers can mitigate this risk by conducting security audits, subjecting the code to peer reviews, and employing rigorous testing practices.
Liquidity concerns
Despite the growing popularity of DEXs, some markets within them suffer from poor liquidity. This leads to significant slippage and an unsatisfactory user experience. Consequently, DEX trading pairs often experience lower liquidity.
Frontrunning
Given the transparent nature of blockchain transactions, DEX trades are susceptible to being front-run by arbitrageurs or MEV bots seeking to exploit users. Like high-frequency traders in traditional markets, these bots capitalize on market inefficiencies by paying higher transaction fees and optimizing network speed.
Centralization risk
Despite efforts to maximize decentralization, some points of centralization may persist in DEXs. For example, the DEX's matching engine might be hosted on centralized servers, or the development team might have administrative access to the DEX's smart contracts and potential use of subpar token bridging infrastructure.
Network vulnerability
Exchanging assets relies on a blockchain network. Therefore, using a DEX might become costly or even infeasible during network congestion or downtime. This leaves DEX users exposed to market shifts.
Scam token risk
Many DEXs allow permissionless market creation, meaning anyone can create a market for any token. This elevates the risk of acquiring low-quality or potentially malicious tokens compared to centralized exchanges. When using DEXs, you must be mindful of the risks of engaging in early-stage projects.
Furthermore, some users may find having full control over their private keys overwhelming. Although complete control over assets aligns with the Web3 vision, some users may prefer to entrust a third party with the custody of their assets.
However, sticking to sound security and key management practices can empower more users to retain control over their assets while accessing a diverse ecosystem of open-source financial services.
The importance of liquidity in DEXs
Insufficient liquidity in a trading pair can disproportionately impact the value of the involved cryptocurrencies. When liquidity is low, it diminishes the accuracy of the value for one or both assets. It also leads to slower trades and greater slippage. Slippage occurs when the anticipated trade price differs from the actual execution price.
Decentralized exchanges (DEXs) sustain vigorous liquidity levels by rewarding individuals who contribute liquidity with a portion of the trading fees.
The process of providing liquidity
Each DEX trading pair maintains its reservoir of liquidity, commonly referred to as "pools" or sometimes "liquidity pools." For instance, on the Uniswap DEX, the popular trading pair ETH-USDT possesses a substantial reservoir of liquidity, composed equally of ETH and USDT.
While the technical specifics may differ, they generally follow a similar structure. A smart contract accepts specific deposits of assets, although the criteria for acceptance and the ratio may vary.
For instance, most DEX liquidity pools represent trading pairs, meaning that depositing into the pool requires an equal value of the two crypto assets constituting the pair. In the case of the ETH-USDT pool, it requires an equal value of ETH and USDT based on the DEX's current market price.
After the deposit, your funds may or may not be subject to a locking period. The smart contract generates and dispatches a token, serving as a receipt. This token is used to collect any outstanding rewards from your position and to retrieve your initially deposited crypto.
The ratio of the returned crypto assets may differ from the initial deposit. DEXs typically offer an overview of the yield potential in their pools.
How to provide liquidity on a DEX
To ensure liquidity on a decentralized exchange, you'll require three essential components:
- Crypto wallet: Often called web3 wallets, they store cryptocurrencies and digital assets. The most reliable wallets, like the Tangem Wallet, are self-custodial. This means you have complete control over the wallet's contents, unlike custodial wallets, where a third party has ultimate control.
- Cryptocurrency: Your wallet must have cryptocurrency to cover transaction fees and for swapping. Transaction fees are payments made for actions that modify a blockchain. They are paid in the native currency of the blockchain.
For instance, on the Ethereum blockchain, ETH is used for transaction fees. Since pools typically consist of a pair of cryptoassets, you'll need an amount of these two cryptoassets that are of equal value. For example, if 1 ETH is equivalent to 1468 USDT, providing .25 ETH would also require 367 USDT.
- DEX platform: We recommend using a reputable decentralized exchange with substantial trading volume.
Liquidity Pools in DEX
When you contribute funds to a trading pair in liquidity pools, you can receive a portion of the fees generated from that pair's trading activity. For example, 0.25% of the total trading volume is distributed to liquidity providers (LPs). If you were the sole liquidity provider for the ETH-USDT pool, and the pool facilitated $50,000 in trades, you would receive $125 in fees.
You can monitor your LP position in the DEX Pools section to track track of your earnings.
Key terms
Liquidity: This is a crucial metric for evaluating the vitality of any market, whether cryptocurrencies or traditional assets. It gauges how easily you can trade two assets without causing significant price fluctuations in either.
Liquidity pool: It refers to a collection of funds for a specific trading pair on a decentralized exchange (DEX). Users contributing liquidity to a pool receive a portion of the fees generated from trades, which is known as Yield.
Liquidity holds such significance that DEXs often offer incentives and a share of trading fees to encourage participation in liquidity pools.
The exchange fee constitutes a small percentage of every swap, which is paid to the exchange for facilitating the trade.
How to contribute to DEX liquidity pools and earn Yield
Adding liquidity to a DEX is a simple process. First, review the APY offered on the different pools available. Once you've identified a pool you're interested in, deposit the specified cryptocurrencies for that pool. The DEX will offer a feature to monitor your rewards.
Conclusion
Decentralized exchanges (DEXs) are a fundamental cornerstone within the cryptocurrency landscape, allowing users to trade digital assets directly, bypassing the need for intermediaries. Over the past few years, DEXs have witnessed a surge in popularity, primarily attributed to their ability to provide instant liquidity for newly launched tokens, their user-friendly onboarding process, and the inclusive access they offer to trading and liquidity provision.