What is a decentralized exchange?
What is a decentralized exchange? You can use centralized and decentralized exchangers to trade cryptos. The former may be preferable when you are starting out or want to trust a well-known company. But the latter is the only option if you want to trade lesser-known cryptos and have full control over your crypto wallet.
Cryptocurrency exchanges are platforms that allow users to trade cryptocurrencies. They are usually distinguished as centralized exchanges (CEX) or decentralized exchanges (DEX).
Most people invest in crypto on a centralized exchange. This is perhaps the most accessible and safest option for average users. But it is also important to understand decentralized exchanges, which you should use if you want to buy certain types of crypto and participate in different parts of the crypto ecosystems. In this article, we will mainly talk about decentralized exchanges. We will see what they are and what they are not, how they work, their advantages and disadvantages. Let's go.
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What is a decentralized exchange?
Decentralization is one of the core values of the crypto movement. Crypto transactions are conducted freely without the approval, regulatory oversight, or high fees of banks and other financial institutions. This is one of the benefits of using and investing in cryptocurrencies. Each DEX is intended to bring the benefits of decentralization to the buying, selling, and portfolio management of crypto.
A DEX is therefore a peer-to-peer market. A market where users can exchange cryptocurrencies in a non-custodial manner without the need for an intermediary to facilitate the transfer and custody of funds. DEXs replace traditional intermediaries like banks, brokers with smart contracts. These smart contracts are based on blockchain technology which facilitates the exchange of digital assets.
Compared to traditional financial transactions, which are opaque and go through intermediaries that offer extremely limited insight into their actions, DEXs offer complete transparency on the movements of funds and the mechanisms facilitating exchanges. Therefore, counterparty risk and systemic risk are reduced unlike centralized or classic systems.
Following this logic, DEXs are considered a cornerstone of decentralized finance (DeFi). They serve as a “ lego monetary » key on which more sophisticated financial products can be built through permissionless composability. The most popular DEXs, such as Uniswap and Sushiswap, use the Ethereum blockchain and are part of the growing DeFi toolkit.
How does a decentralized exchange work?
At a centralized cryptocurrency exchange, you start by creating an account and meeting the site’s KYC requirements. After depositing funds or connecting your existing crypto wallet, you can buy, sell, and trade cryptocurrencies, making a quick trade, or building a long-term portfolio. CEXs like Coinbase allow you to trade fiat for crypto (and vice versa) or crypto pairs. DEXs, on the other hand, do not allow trading between fiat and cryptocurrencies. Instead, they exclusively trade cryptocurrency tokens for other cryptocurrency tokens.
On a decentralized crypto exchange, you connect your cryptocurrency wallet to software on the exchanger’s website. If you want to buy or trade crypto assets, you simply specify what you’re looking for. The decentralized application tells you the price, and if you approve, you accept the transaction. You never log in, provide a name or email address, or create an account.
DEXs don’t connect you with an individual seller. Instead, they employ automated market makers (AMMs), to offer you coins and tokens from a liquidity pool.
This liquidity pool is an amount of cryptocurrency that other users have made available for a specified period of time. When you buy crypto on a decentralized exchange, you are buying from a liquidity pool. Those who have a wallet on Trust Wallet for example can buy their cryptocurrency from the liquidity pool of PancakeSwap, UniSwap or many others.
What are the advantages of a decentralized exchange?
Most of the strengths of decentralized exchanges come from their distributed architecture. Here are some key advantages (although some of them are also disadvantages):
Wide variety of tokens
If you want to find a hot coin right at the beginning of its launch, exchanges are the perfect place to get it. DEXs offer a virtually unlimited range of coins, from the most well-known to the most bizarre and completely random. In fact, anyone can create a coin based on the Ethereum network and create a liquidity pool for a crypto or token. For this reason, in a decentralized exchange you will find a greater variety of projects: “verified” projects and " unverified ».
Low risk of hacking
Since all funds from a DEX transaction are stored in users’ wallets, these movements are theoretically less likely to be hacked. This is quite relative, as DEXs also reduce what is known as the “ counterparty risk ". This risk is the probability that one of the parties involved, including potentially the central authority in a non-DeFi transaction, will default on the transaction.
Anonymity of users and transactions
No personal information is required to use the most popular exchanges/DEXs. On Trust Wallet for example, you are only asked for your password when creating the wallet.
Decentralized exchangers: for the finance of tomorrow
There are many economic movements that in the future could be transferred to the blockchain and sooner or later could be managed through exchanges. For example: Peer-to-peer lending.
Fast transactions and anonymity are making DEXs increasingly popular in developing economies, where a robust banking infrastructure may not be necessary over time. Anyone with a smartphone and an internet connection can trade through a DEX. However, DEXs don’t just have advantages. They also have disadvantages. Here are a few.
What are the disadvantages of a decentralized exchange?
DEXs have democratized access to trading and liquidity provision through robust smart contracts. However, they also come with a set of risks:
Smart contract risk
Blockchains are considered highly secure for executing financial transactions. However, the quality of a smart contract’s code still depends on the skill level and experience of the team that developed it. Smart contract bugs, hacks, vulnerabilities, and exploits can occur, leaving DEX users vulnerable to loss of funds. Developers can mitigate this risk through security audits, peer-reviewed code, and good testing practices. Diligence is always required.
Liquidity risk
As DEXs become more popular, some DEX markets have poor liquidity conditions. These conditions can lead to large amounts of slippage and a suboptimal user experience. Due to how liquidity network effects work, a significant portion of trading activity is still conducted on CEXs. This often results in less liquidity on DEX trading pairs.
Risk of centralization
While many DEXs aim to maximize their resistance to decentralization and censorship, points of centralization can still be present. These include the DEX’s matching engine being hosted on centralized servers, the development team having administrative access to the DEX’s smart contracts, and the use of low-quality token bridging infrastructure, among others.
Network risk
Since asset trading is facilitated by a blockchain, using a DEX can be prohibitively expensive or downright impossible if the network experiences congestion or downtime, leaving DEX users susceptible to market movements.
Token risk
Since many DEXs offer permissionless market making—the ability for anyone to create a market for any token—the risks of purchasing low-quality or malicious tokens can be higher than in CEXs. DEX users should consider the risks associated with participating in early-stage projects.
Other disadvantages of DEXs include the fact that:
- The platform may be more difficult to navigate and use
- You could lose your money if someone hacks the DEX
- There may be possible additional fees for each transaction
- You could be alone in case of trouble
Examples of decentralized exchange
Uniswap
Launched in 2018, Uniswap is the largest decentralized exchange in the world. It allows the decentralized exchange of many ERC-20 tokens on the Ethereum blockchain, without an intermediary. Its model is automated thanks to smart contracts. Uniswap has no central entity and is managed by its community.
PancakeSwap
PancakeSwap is a decentralized exchange similar to Uniswap but built on the Binance Smart Chain blockchain. It therefore allows for easy and low-cost trading of various BEP-20 tokens. PancakeSwap uses an AMM (Automated Market Maker) based liquidity model rather than a traditional order book.
CurveFinance
Curve Finance focuses on decentralized exchanges of stablecoins or cryptoassets whose value is pegged to traditional fiat currencies. Its algorithmic liquidity pool model is optimized for low slippage exchanges between stablecoins like USDT, USDC, DAI etc.
dYdX
dYdX is a decentralized trading platform offering high leverage on popular crypto assets like Bitcoin. Its unique model allows for peer-to-peer borrowing without an intermediary while keeping the borrowed assets in custody.
Conclusion
DEXs are a fundamental pillar of the cryptocurrency ecosystem. They allow users to exchange digital assets in a peer-to-peer manner without the need for intermediaries. DEXs have seen increasing adoption in recent years due to the instant liquidity they can enable for newly launched tokens, their seamless onboarding experience, and the democratized access to trading and liquidity provision they provide.
It remains to be seen whether the majority of trading activity will migrate to DEXs. However, DEXs are expected to remain a vital infrastructure for the cryptocurrency ecosystem and will continue to see improvements in transaction scalability, smart contract security, governance infrastructure, and user experience.
If you know more about how DEXs work, Leave us a comment so that we can improve this article.
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