The world of decentralized finance, as innovative as it is, has brought on a number of new words and concepts. Having to navigate through such unfamiliar and often incomprehensible ideas can be confusing, which is why we are here to do the heavy lifting for you. This week’s edition of DeFi Explained will cover the concept of decentralized exchanges, often abbreviated as DEX. Defined as a type of cryptocurrency exchange that allows peer-to-peer transactions to take place without any intermediary, decentralized exchange platforms are a core application of the DeFi space. How does this work? Why is it important? What are the benefits and risks associated with decentralized exchanges? These are all questions that will be answered in this article.
What Are Decentralized Exchanges (DEX)?
In layman’s terms, decentralized exchanges are an application of decentralized finance which allow the buying and selling of cryptocurrencies without the need of any broker. These exchange platforms instead rely on smart contracts that lie on the blockchain to manage the execution of orders without any intermediary.
This is in contrast to the traditional buying and selling of money which is usually overseen by some centralized authority such as banks, Examples of decentralized exchange platforms that dominate the decentralized cryptocurrency trading market are Uniswap, PancakeSwap, and Sushiswap
How Decentralized Exchanges Work
Trading on decentralized exchange platforms is a pretty straightforward process. Users just need to connect their crypto wallet to a platform such as Uniswap or PancakeSwap and the application will allow for direct trading. This is possible because the selected platform will have all this defined in its smart contracts that it has built on top of any leading blockchain. The most popular blockchain for DEX building is the Ethereum blockchain.
On the front-end, users simply need to select a particular pair of crypto tokens they wish to trade in, enter an amount, and click swap. The smart contract technology that is built on the back end handles this trade and records it on the blockchain. Every such trade generates both a transaction and trading fee which is also paid and recorded. Users are responsible for guarding their own funds in their wallets and must be vigilant to not misplace their private key or accidentally sending funds to an incorrect address.
Types of Decentralized Exchanges
There are three main types of decentralized exchanges, and each uses smart contract technology to trade directly.
Order Book DEXs
Modeled after the traditional trading model, order book-based decentralized exchange platforms were the first DEXs to enter the DeFi market. Unlike swap-based AMMs, order book DEXs compile all buy and sell orders of any asset in a single space, set by traders. The order book would then organize these orders by price. An example of an order book DEX application is dYdX.
Automated Market Makers
By definition, an automated market maker (AMM) is an autonomous trading mechanism that allows the trading of digital assets using liquidity pools. What this means is that AMMs automate the process of traditional market exchange. It is a type of DEX protocol that prices assets based on certain mathematical formulae in a pricing algorithm defined in their smart contracts. This is in construct to the use of order books done by traditional exchanges. The most recognizable AMM is Uniswap.
A relatively new blockchain-based service, DEX aggregators aggregate liquidity from different DEX platforms, allowing users to access multiple trading pools through one dashboard. This allows them to offer users better swap rates and token prices, minimize slippage, all in reduced time. Some leading DEX aggregators are 1inch, ParaSwap, and Open Ocean.
Benefits of Decentralized Exchanges
Decentralized exchanges have many advantages that traditional exchange platforms do not. Let us take a look at some of these benefits and see how they make trading in the crypto space more efficient.
With centralized exchange platforms, a set of legal regulations must be followed by all tokens before they can be listed. This is in contrast with DEX, where any token on the blockchain is eligible. As a result, a wider range of tokens are available for trading on decentralized exchange platforms.
With decentralized exchange, there is no need for disclosure of identity or formal registration such as KYC (Know Your Customer) which is employed by centralized platforms. DEX platforms allow users to stay anonymous while using their services.
Currently, the greatest to centralized exchange platforms is that of breach of security. Because they are governed by a single entity, centralized exchange platforms are often targets of hacking and theft. An example of such an event is the Coincheck theft of $530 million. WIth decentralized platforms, this is less common as users are the ones in charge of maintaining account security.
As with all decentralized platforms, DEX have no central authority and so users have full control over their funds. Threats of freezing of assets or blocking withdrawals is not common in decentralized exchanges, so users can be at ease when using their services that they are in full control of what they do with their funds.
Disadvantages of Decentralized Exchanges
Like all innovations, decentralized exchanges are not faultless. There are a few drawbacks and risks associated with decentralized exchanges, and it is important to be aware of them before using any platform.
Smart Contract Vulnerabilities
Although all DEXs are built with smart contracts on the blockchain and go through a rigorous auditing process, it is still code at the end of the day. A bug or vulnerability may be overlooked which can result in future exploitation and token theft.
On decentralized exchange platforms, trading calls must first be broadcasted to the network, then confirmed by a number of miners, and then it can e processed. This makes the overall processing of orders on DEX applications slow, and price slippage, or the delay in transaction execution due to sudden change in cryptocurrency values, can occur.
In conclusion, decentralized exchanges are a novel concept, essentially traditional exchanges optimized for decentralized finance. DEX is secure, private, and accessible, making it a great option for those with a decent amount of crypto holdings looking for a way to trade on their own terms. However, DEX is constantly evolving, with new updates and launches every year .it is important to be aware of the problems and benefits associated with such applications before making the leap.