Cryptocurrencies, like foreign exchange markets where currencies are constantly exchanged, require their marketplaces for users to purchase, sell, and trade cryptocurrencies. However, since decentralization is such an essential feature of bitcoin trading, there was a demand for decentralized exchanges (DEX) – trading without the cost or manipulation of a third party, for exchanges without a centralized point of authority.
DEX allows for peer-to-peer transactions without the use of intermediaries and a plethora of additional advantages. As a result, everyone interested in the crypto world will undoubtedly be curious about the fundamentals of DEX, or decentralized exchange, and its capabilities.
This blog attempts to serve as a detailed overview of DEXs, the key differences between DEX & CEX, how they work, and how users can interact with them. In addition, you can also find an overview of the advantages and disadvantages associated with DEXs and their evolution.
Decentralized Exchange (DEX): Definition
One of the essential components of the decentralized finance (DeFi) ecosystem is decentralized exchanges. A decentralized exchange (DEX) is a platform that allows users to trade cryptocurrencies directly with one another without the use of a middleman.
Decentralized Exchanges are essentially a platform for investors to anonymously and securely purchase, sell, and exchange their crypto assets. To avoid cryptocurrency arbitrage, they employ Automated Market Maker methods to adjust the price of each coin.
Before we go any further, it’s crucial to understand the distinction between a decentralized exchange (DEX) and a centralized exchange (CEX). So let’s have a look at them!
Key differences between DEX and CEX
- DEXes are non-custodial (you have custody of your crypto at all times), whereas CEXs are custodial (they keep control of any funds you deposit on their platforms).
- DEXes are particularly well-suited to long-tail asset trading, which involves trading many small, low-volume cryptocurrencies because of their open and permissionless nature. CEXs are mainly ideal for short-tail asset trading, i.e., facilitating large volumes around the top cryptocurrencies, due to regulatory concerns.
- On the other hand, regulatory requirements allow CEXs to provide direct business-to-consumer safeguards such as deposit insurance, customer service guarantees, and more. DEXes aren’t businesses; thus, they don’t come with any of these standard safeguards.
How does Decentralized Exchange work?
A decentralized exchange facilitates trade between individuals by using smart contracts (automatically executed protocols), but it does not assume ownership of their currency.
DEXs use one of three methods to deal with this: an on-chain order book, an off-chain order book, or an automated market maker.
On-chain order book
Every transaction in an on-chain order book is recorded on a blockchain. This includes the transaction itself and the request to purchase or cancel an item. Although it is the pinnacle of decentralization, the requirement to place everything on a blockchain can make it more expensive and time-consuming.
Off-chain order book
All of this happens off-chain through off-chain order books, with just the final transaction being resolved on the blockchain. This solution can run into some security difficulties of centralized exchanges because orders aren’t stored on-chain, but it isn’t as sluggish or expensive as on-chain order books.
Automated Market Makers (AMM)
Automated Market Makers (AMM) do not use order books. If you have Chainlink tokens and wish to acquire Compound, you’ll need to find someone who has Compound and is prepared to trade at an agreed-upon price via order books.
AMMs eliminate counterparties and replace them with algorithms that determine the price, allowing you to trade Chainlink for Compound independent of who is on the other end of the exchange. They usually do this by using “liquidity pools,” which effectively pay users to hold some of their money in a smart contract that can later be used for trading. As a result, individual users play a crucial role in enabling exchanges.
User interaction with DEX
Unlike centralized exchanges, there are no accounts, Know Your Customer checks, or particular restrictions governing who may use a DEX. They are trustless and permissionless, allowing them to be used by anybody with a bitcoin wallet and funds.
As a result, users cannot keep any cryptocurrency on a decentralized exchange; instead, they must connect via various cold or hot wallets, such as MetaMask, a non-custodial browser wallet. Once a wallet is linked, the user may trade any cryptocurrency kept on the wallet anonymously or access dApps and associated protocols within the Decentralised Exchange, thereby turning it into a DeFi (Decentralized Finance) gateway.
Advantages of DEX
In recent years, decentralized crypto exchanges have emerged as one of the most promising channels for crypto trading. The following are some advantages that are seen in practically every inclusion on a decentralized exchange list:
Decentralized exchanges make tokens more accessible, especially those created on the blockchain on which they were created. As a result, new projects would publish their coins on the exchanges before listing them on centralized exchanges.
The second significant benefit of decentralized exchanges is that users may remain anonymous. With decentralized crypto exchanges, users are not required to undergo standard identification procedures such as Know Your Customer or KYC processes.
- Reduced counterparty risk
When one of either party fails to keep their end of the bargain during a transaction, it is known as counterparty risk. The basic definition of a decentralized exchange (DEX) demonstrates how smart contracts help DEXs enable transactions. As a result, you won’t have to rely on an intermediary for transactions, and you’ll be free of counterparty risk.
A decentralized exchange (DEX) is distinguished by the fact that it does not control its customers’ cash. On the other hand, traders retain custody of their funds and have complete control over how they engage with the DEX.
Disadvantages of DEX
Apart from the specific advantages of decentralized exchanges, it’s also critical to recognize the hazards that come with them.
- Specific knowledge requirement
Users should be familiar with security principles to protect their cash in a DEX crypto exchange. Furthermore, you must possess technical understanding in the choosing of wallets as well as the funding of the wallet with appropriate tokens.
- Unverified token listings
Any individual can issue a new token on a decentralized crypto market with the goal of increasing liquidity. For investors, however, this might lead to rug pull frauds. As a result, investors may buy tokens with the expectation of receiving another token. As a result, traders must conduct due research before investing in tokens.
Smart contract risks are the ultimate addition to the hazards connected with a DEX exchange. Exploitable defects in smart contracts might elude thorough audits and code inspections, resulting in more damage.
Final words: Evolution of DEX
The first decentralized exchange was launched in 2014, and its popularity has grown in tandem with the rise of DeFi. In addition, DEXs have progressed past their traditional order book hurdles thanks to the Automated Market Maker technology capabilities. On the other hand, decentralized crypto exchanges have proven to be crucial venues for users to borrow cash to leverage their holdings or provide liquidity to gain trading fees.
By placing their crypto assets in liquidity pools, DEXs have also enabled users to generate passive income on their crypto holdings. The usage of smart contracts in DEXs, on the other hand, continues to bring concerns.
More use cases may be generated in the future because these platforms are based on self-executing smart contracts. Flash loans, which are loans acquired and repaid in a single transaction, are an example of how decentralized finance innovation may enable the creation of previously unimaginable goods and services.
Decentralized Exchanges have the potential to become popular based on all of these facts. So how do you feel about this?
Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn’t represent any investment advice or WazirX’s official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.