What’s an exchange?
An exchange refers to a market where users can buy and sell financial assets. There are countless exchanges worldwide that specialize in different products and services. Notably, the New York Stock Exchange (NYSE) focuses on selling shares in American companies. In contrast, the Foreign Exchange Market (FOREX) offers trading between fiat currencies.
Cryptocurrencies also have dedicated exchanges that offer digital assets like Bitcoin, Ethereum, and stablecoins. However, unlike traditional exchanges, crypto exchanges come in two varieties: centralized and decentralized. Currently, all major exchanges in traditional finance are centralized, meaning a third party always controls the order books.
What’s a DEX?
DEXs are decentralized crypto exchanges that offer access to digital assets without an intermediary. Instead of relying on a company to fill and record crypto trades, DEXs offer peer-to-peer (P2P) token swaps using blockchain technology. More specifically, DEXs use smart contracts to execute trades. Smart contracts automatically run orders once various predetermined features are met.
Since there aren't centralized authorities monitoring trades or supplying crypto, DEXs rely on average crypto investors to provide token liquidity. On most DEXs, anyone can put their crypto into liquidity pools, which provide the DEX with trading pairs. To incentivize more users to add their crypto to liquidity pools, DEXs usually offer a percentage of trading fees, providing a way for people to earn yield on their money that wasn’t previously possible.
What are centralized exchanges?
Unlike DEXs, centralized crypto exchanges (CEXs) don't require user funds to provide liquidity to crypto traders. Since companies control CEX platforms, executives always oversee the daily volume and transactions on the exchange. A few prominent examples of CEXs in the U.S. include Coinbase, Gemini, and Kraken. As for DEXs, the most prominent applications live on the Ethereum blockchain and include Uniswap, Curve Finance, and SushiSwap.
CEXs also submit to their jurisdictions' regulations to offer legal trading services. This often means CEXs require more ID paperwork from users versus DEXs. Indeed, most DEXs only need traders to connect their crypto wallets to make an exchange.
Another critical difference is that CEXs can accept fiat currencies. Since DEXs are based on their respective blockchains, they can only accept crypto funds for swaps. People must have crypto in a compatible wallet to interact with a DEX.
Lastly, it's worth mentioning that the trades on a CEX are custodial. In other words, the crypto people buy on a centralized exchange isn't 100% in their control. If investors leave their crypto on a CEX, the company is holding the crypto on their behalf. It's only when people transfer their crypto from a centralized exchange to a private wallet that they own their digital assets.
How do DEXs work?
Many DEXs use a combination of smart contracts and liquidity pools on top of a blockchain. The smart contract code helps fill trades without needing a third party to record order books. Any crypto investor could supply DEXs with their tokens in "pools," which allows users to trade these assets.
While that's the general way DEXs work, there are nuances among different DEX platforms. Three of the most common DEXs are automated market makers, on-chain order books, and off-chain order books.
Types of decentralized exchanges
Automated market makers (AMM): AMMs are DEXs that don't use order books to record transactions. Instead, they rely on autonomous smart contracts and liquidity pools to provide users with a decentralized trading experience. They also use oracles like Chainlink to provide information on current crypto prices.
On-chain order books: On-chain order books use a system of nodes and crypto miners to validate transactions and store this information on the blockchain. These order books are the same as those in centralized crypto exchanges, except they don't rely on a company to confirm transactions. Since these order books are publicly viewable on the blockchain, they’re considered more transparent than off-chain order books.
Off-chain order books: Although off-chain order books use a similar verification method to on-chain order books, they rely on external centralized servers to record trades. The benefit of this model is that off-chain order books typically offer lower fees than on-chain order book DEXs. However, off-chain order books don't have the same decentralization as competing DEXs.
What are the benefits of using DEXs?
- Anonymity: Many people prefer DEXs over CEXs because they don't require know-your-customer (KYC) or anti-money laundering (AML) documentation. People with a crypto wallet can use a DEX without giving away their identity.
- Transparency: There's no need to trust that a third party will execute trades on a user's behalf when using a DEX. All transactions are on a public ledger, which gives traders more certainty over their digital assets.
- Access to private keys: When people trade on DEXs, the tokens go directly into their crypto wallets. People who value self-custody don't have to worry about centralized exchanges holding their tokens.
- Wider altcoin selection: Often, crypto traders have an easier time finding new, small, or obscure altcoins on DEXs. Since CEXs are heavily regulated, they typically don't take as many risks with unproven crypto projects that you may see on DEXs.
What are the disadvantages of using DEXs?
- Smart contract vulnerability: Since AMMs rely on code, traders on DEXs need to trust that there are no bugs in the protocol. It's always possible that bad actors could hack a DEX.
- Lack of customer support: DEXs don't have dedicated customer service divisions like CEXs. If users have an issue using a DEX, it can be challenging to find reliable help.
- Liquidity risk: DEXs must rely on average users to deposit funds for liquidity. Although many DEXs have grown their liquidity pools, they aren't as fluid as CEXs. DEX users may have to pay higher prices if the trading pair they want doesn't have a ton of liquidity.
- Poor UI/UX for beginners: People who aren't already familiar with using a crypto wallet may struggle to interact with a DEX. These decentralized platforms don't have the same simplified UI found on many centralized exchanges.
- Often limited to one chain: Although some Web3 developers are trying to create a multi-chain DEX, most of these exchanges are only available on one chain. If you're interested in tokens on multiple blockchains, you’ll have to interact with various DEXs.
- More prone to scam tokens: Since DEXs aren't centrally regulated, there aren't as robust screening standards as for altcoins. This makes DEXs more prone to scams, so users must be extra careful when dealing with low-cap DEX tokens.
How to use DEXs
To use a DEX, traders must first download a software crypto wallet compatible with their exchange. For instance, people who want to use an Ethereum-based DEX must have an Ethereum-compatible wallet like MetaMask.
After setting up a crypto wallet, users must deposit crypto funds into this private account. Traders can either send crypto from a centralized exchange into their wallet or buy directly in their wallet.
No matter what cryptocurrency you intend to swap on a DEX, remember that you'll need your blockchain's native cryptocurrency to pay for fees. On Ethereum, you'll need extra ETH to complete a transaction.
After you've funded your crypto wallet, you can visit your desired DEX and open the application. Typically, you'll find the "Open App" button on the top right side of the site's homepage.
When you're on a DEX's trading portal, you should see two default cryptocurrencies ready to swap and a button to connect your crypto wallet with the DEX. After you sign in with your crypto wallet, the DEX should recognize your address and allow you to trade.
You can toggle the two cryptocurrencies on your DEX until you find the pair you want to exchange. Enter the crypto you want to swap and confirm the transaction on your crypto wallet. Just be sure to closely look at all the fees involved in this trade before submitting it. Depending on network congestion, it may take a few minutes before you see your desired tokens in your crypto wallet.
What are the most popular DEXs?
At the time of writing, following are some of the top DEXs:
Uniswap: Built on Ethereum, Uniswap is by far the largest DEX in the cryptocurrency space. Recent estimates suggest Uniswap holds roughly 50% of the total volume for all DEXs and regularly handles more than $1 billion in daily transactions. Due to its size and reputation, Uniswap offers the greatest liquidity and security for DEX trading.
PancakeSwap: PancakeSwap is the largest DEX on the Binance Smart Chain and has a similar layout to Uniswap. However, since PancakeSwap is on the BSC, it tends to have lower fees than Ethereum-based DEXs. The lower fee structure has attracted many retail investors who don't want to pay the higher prices for interacting with Ethereum.
Curve Finance: Curve is an AMM DEX on Ethereum that specializes in stablecoin pairs. Unlike many competing DEXs, Curve doesn't offer a ton of speculative altcoins. Instead, it has an algorithm that prioritizes low fees and low slippage between supported digital assets.
Wrapping up
DEXs still aren’t as straightforward as CEXs, but they are a significant innovation in the crypto space. People who prioritize core crypto values like decentralization and anonymity most appreciate what DEXs are trying to accomplish. As more investors enter the crypto space, DEXs will likely play a more significant role in the future of finance.
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