What is a Decentralized Exchange (DEX)?

A decentralized exchange (DEX) allows you to trade directly with other users, eliminating the need for a central third party.

DEFINITIONS

Crypto1earn

10/9/20224 min read

Decentralized Exchange
Decentralized Exchange

What is a DEX?

Definition

A decentralized exchange (or DEX) is a marketplace that provides peer-to-peer transactions between crypto buyers and sellers directly through a peer-to-peer network. Cryptocurrencies offer one of the most fundamental benefits of the technology: the ability to facilitate financial transactions that do not require the intervention of banks, brokers, or any other third party. Ethereum is used by many popular DEXs, like Uniswap.

Crypto traders will transact directly with one another on a DEX (or decentralized exchange). Unlike banks, brokers, payment processors, or any other intermediary, DEXs enable crypto's core promise: financial transactions without intermediaries. There are a lot of DEXs out there, and the most popular ones (such as Uniswap and Sushiswap) operate on the Ethereum blockchain, which enables them to offer a huge range of financial services directly to their users. It's a boomtime for DEXs - $217 billion worth of transactions flowed through them in the first quarter of 2021. DeFi traders grew tenfold from May 2020 to April 2021.

How do DEXs work?

The key difference between DEXs and centralized exchanges such as Coinbase is DEXs offer no option to exchange fiat currency for cryptocurrency - instead, they solely trade cryptocurrency tokens against other cryptocurrencies. If you trade fiat for crypto (and vice versa) on a centralized exchange (or CEX), you can trade crypto for crypto. In addition to margin trades and setting limits, you can also make more advanced moves. Unlike stock exchanges like Nasdaq, cryptocurrencies are priced by the exchange itself based on recent buy and sell orders through an "order book".

Smart contracts, on the other hand, are what make up decentralized exchanges. Using algorithms, they determine the price of various cryptocurrencies in relation to each other and facilitate trades with "liquidity pools" - in which investors lock funds in exchange for interest-like rewards.

DEX settlements are directly on the blockchain, while centralized exchanges use an internal database.

In general, DEXs are open-source applications, so anyone can review the code in detail. There are in fact a number of DEXs which have borrowed Uniswap's code to create new competing projects, which is how we became familiar with the fact that several DEXs named after "swap" or "pancakeswap" have adapted the code to create new projects.

What are potential benefits of using a DEX?

It's the place to go if you're looking for an in-fancy token. From well-known tokens to the strange and completely random, DEXs offer almost limitless choices. You'll find a more diverse array of projects, both vetted and unvetted, due to the fact anyone can make an Ethereum token and create a liquidity pool.

Due to all the funds in a DEX trade being stored on the traders' wallets, hacking risks can be reduced. In non-DeFi transactions, DEXs can also reduce the risk of a default by a party, such as the central authority.

Most popular DEXs don't require any personal information.

In developing economies - where banking infrastructure might not be strong - DEXs are becoming increasingly popular because of their peer-to-peer lending, speedy transactions, and anonymity. Trading via a DEX can be conducted by anyone with a smartphone and an active internet connection.

What are some potential downsides?

You should expect to do a lot of research on DEXs and don't expect them to give much guidance. Decentralized exchanges require some specialized knowledge and the interface isn't always simple - be prepared to do plenty of research and don't expect much assistance from DEXs themselves. For a walk-through or explanation of how things work, you will generally have to look off-site. There is a risk of making an unrectifiable error, like sending coins to the wrong wallet, so you should take caution when using this method. Adding a volatile cryptocurrency to a liquidity pool can also cause "impermanent loss." Is that what you're trying to say?

Any DeFi protocol is only as safe as the smart contracts that power it - and even though the smart contracts may have been heavily tested, they may still contain exploitable bugs that can lead to your tokens losing their value. The developers of smart contracts are not able to anticipate all rare events, human factors, and hacks, even under normal circumstances.

Scams and schemes are more prevalent on DEXs because of the large, unvetted tokens available. Suppose you have a hot token, and it starts to rise in value. Then your token's value plunges as soon as its creator mints a whole bunch of new tokens, flooding the liquidity pool and tanking the coin's value.

Whenever you purchase a new cryptocurrency or experiment with a new protocol, it's important that you do your research before buying. Read white papers, visit the developer's Twitter feeds or Discord channels, and check out audit reports of any specific project that interests you.

How do you interact with a DEX?
  • Use a crypto wallet like Coinbase Wallet or your web browser to access a DEX like Uniswap. We recommend using Coinbase's dapp wallet, which you can access directly from your Coinbase app if you're just getting started.

  • An exchange like Coinbase sells Ethereum, which is essential to trading on most DEXs. On the Ethereum blockchain, you need some ETH to pay transaction fees (called gas). In addition to these fees, there is a fee that is charged by the DEX itself.

How do DEX fees work?

There are different fees. It charges 0.3% to liquidity providers, and it could add a protocol fee. However, it is imperative to note that DEX fees are ordinarily dwarfed by Ethereum network gas fees. Transaction fees are expected to decline and transaction speeds will increase as ETH2 upgrades.