What is a Decentralized Exchange? (DEX)

This is a primer on Decentralised Exchanges (DEX) that includes how they work, why they are important, how you can use them, and potential investment opportunities.

What is a Decentralised Exchange?

DEXs have emerged as a new way to trade cryptocurrencies and other digital assets. As the name suggests, these are online platforms that aim to provide a decentralised and potentially much more secure way to trade.

The key difference between a decentralised and a traditional exchange is that on a DEX the interaction is directly peer-to-peer, with limited or no involvement from a third party. This contrasts with a traditional exchange, which acts as a middleman to every trade.

 

CEX vs. DEX: What's the Difference Between the Crypto Exchanges - MikiGuru

Source: Mikuguru.com

 

As such, DEXs can be seen as taking the decentralised approach so central to the crypto project and applying it to the way that cryptocurrencies actually change hands. In fact, the back-office operations of a DEX are actually themselves run on a blockchain, and this brings the well-known benefits of decentralised ledger technology to the process of exchanging digital assets.

This means that a trade mutually agreed to on a DEX is a direct trade taking place between the wallets of two private users. There is no ‘middleman’ who takes custody of your funds and then forwards them to the other party, and this overcomes the trust and reliability problems that have plagued so many online exchanges.

Why do they matter?

The main driver for the emergence of DEXs is that whilst interest in crypto has spiked dramatically in recent years, so has the amount of fraudulent crypto activity carried out on the main exchanges.

For instance, Crypto.com admitted in early 2022 that over $30 million worth of cryptocurrencies had been stolen by hackers, comprised of 4,836 Ether (ETH) and 443 Bitcoin (BTC). Going back a little further, a landmark investigation by Reuters uncovered that a staggering over $4 billion worth of cryptocurrencies were stolen from crypto exchanges between 2011 and 2017 alone.

Accordingly, DEXs have the potential to overcome one of the last remaining hurdles preventing the mass adoption of cryptocurrencies – that trust in the security of digital money is still low for large parts of the population.

 

CEX vs DEX|Is Defi taking over? - YouTube

Source: AAX Exchange

 

Finally, DEXs represent a means to avoid the possibility that tighter crypto regulations will impede this rapidly evolving sector. For instance, the outright ban on the use of cryptocurrencies in China and the possibility that other regulators will move in this direction poses a major threat to the whole industry.

The availability of DEXs is therefore a great resource for crypto users in territories with currently hostile regulations in place. In addition to this, DEXs also safeguard users against the possibility that governments or other central authorities could seize your crypto holdings. Their decentralised nature would make this impossible to execute.

How do traditional crypto exchanges work?

On a traditional cryptocurrency exchange, you deposit your funds either in the form of fiat or cryptocurrency. In terms of crypto, after this you have technically given up control of your funds in the sense that you can withdraw it, but while it is deposited you can’t send it on the blockchain. You no longer hold the private keys to the funds, and therefore to withdraw our money you need to ask the exchange to sign the transaction on your behalf.

This means transactions are relatively easy to do, as everything is taking place within the system of the exchange in question, and there are many trading analysis tools available to you to help you decide how, when and what to buy and sell.

The cost of this approach is simply that you have handed over your money to a third party, and you may be at risk of the funds disappearing, as outlined above.

Most of the time this risk is considered acceptable by most users and is the same risk you face when you deposit your money with any kind of online exchange, be it crypto or not. However, for many users, this risk is still too high, and they prefer a more decentralised approach.

How do DEXs work?

Make no mistake – DEXs are much more complex to navigate than traditional exchanges!

There are several types of DEX, but the common theme is that orders are executed on-chain via the use of smart contracts and that users are not required to hand over custody of their funds to a centralised exchange at any point.

 

What Is a DEX?

Source: Cryptorobin.com

 

The most popular type of DEX uses an on-chain order book. Put simply, this means that everything is done on-chain in the sense that all orders are coded onto the underlying blockchain the DEX is using. This means all transactions are fully transparent, and you don’t need to rely on an intermediary to act between you and the other party in each trade.

This approach is, however, quite cumbersome and resource-intensive. The requirement for every node on the network to record each transaction means fees are often needed to incentivise users to offer their processing power to the blockchain.

Examples of on-chain order book models include the Stellar and Binance DEXs.

In addition to this, there are also so-called off-chain DEXs, where the operation is more centralised than is the case in an on-chain DEX. Essentially, instead of every order being posted to the blockchain, they’re hosted somewhere, and this makes the exchange much closer to the traditional model outlined above.

Finally, there are Automated Market Makers, which are effectively complex algorithms reducing the need for intermediaries in online exchanges. Although the back-end mathematics may be quite complicated, the front-end user experience is often quite smooth, a notable example being Trust Wallet.

What are the advantages?

A major advantage of DEXs is that KYC/AML regulations are much simpler here. Instead of individuals having to submit identity documentation and proofs of address, DEXs are essentially permissionless environments, so these checks are not needed. This solves serious privacy and data-sharing concerns for some, as well as accessibility issues for other users. All you need to make an exchange is an active cryptocurrency wallet, and this ease of access is a major appeal for some.

Secondly, there is no counterparty risk . This means that DEXs don’t hold customers’ funds, so hacking and other forms of external interference aren’t a threat. The not-so-distant collapse of Mt. Gox back in 2014 is still fresh in many crypto users memory, and therefore DEXs offer the promise of a more secure option.

Finally, the availability of unlisted tokens attracts many to DEXs. Highly specialised tokens that aren’t listed on centralised exchanges can be found on DEXs, and this makes them a hot spot for serious blockchain and crypto aficionados. One top DEX, Uniswap, for example, has more than 5,000 tokens available on its platform.

What are the drawbacks?

As may already be apparent, DEXs couldn’t be described as user-friendly. Those new to the crypto space will almost certainly find any DEX takes more time to get used to than the interface at a traditional exchange.

Secondly, there are some issues around trading volumes and the liquidity of various digital assets. The highly specialist nature of some of the tokens available on DEXs necessarily means limited liquidity. Buying and selling may take longer than anticipated, and prices can move very sharply in either direction.

Finally, fees may be higher on DEXs, simply because when the network is congested or if you’re using an on-chain order book there might be limited processing power available to complete your order.

Best known DEXs to explore

  1. Curve (CRV)

Curve runs on Ethereum, and is an on-chain DEX. It currently has a total value of assets listed is around $21 billion.

  1. Uniswap (UNI)

Uniswap is another on-chain DEX for Ethereum, with a lower total asset value of $9 billion.

  1. PancakeSwap (CAKE)

PancakeSwap is an automated market maker running on the Binance Smart Chain with assets totalling around $7.7billion.

  1. SushiSwap (SUSHI)

SushiSwap is a decentralised protocol for providing automated liquidity on Ethereum. It currently has listed assets of nearly $5.5 billion.

  1. Balancer (BAL)

Balancer is a decentralised automated portfolio manager and trading platform for cryptocurrencies with total assets standing at $3 billion.

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