What is a decentralized exchange (DEX)?
Summary:
- Decentralized exchanges (DEXs) are a variety of cryptocurrency exchange which allows direct peer-to-peer (p2p) transactions to take place online securely and without the need for a third-party intermediary.
- In transactions made through decentralized exchanges, the typical third-party entities which would normally oversee the security and transfer of an asset (e.g. centralized exchanges, stockbrokers, online payment gateways, etc.) are replaced by an application built directly on the blockchain.
- Some common methods of DEX operation include the use of smart contracts, order book relaying, or both.
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Trading cryptocurrencies can be a daunting task. With all the different exchanges, currencies, and trading pairs, it's easy to feel overwhelmed when trying to trade cryptocurrencies, especially if you're new to the scene.
A decentralized exchange (DEX) is a solution for anyone looking for a more straightforward trade of cryptocurrencies. DEXs are built on blockchain technology and allow users to trade directly without having to go through a third party. Read on to learn more!
What is a Centralized Exchange (CEX)?
Centralized cryptocurrency exchanges (CEXs) are like the traditional stock exchanges, but for cryptocurrencies. They are exchanges where users deposit their funds, and the exchange acts as a middleman to match buyers and sellers.
Centralized exchanges offer features such as an order book, charting tools, limit orders, and pretty much all the data is in one place. Centralized exchanges typically require users to undergo a Know-Your-Customer (KYC) verification process.
CEX also require the users to store their crypto assets in the exchange wallets, giving up control of the wallet’s private keys to the exchange.
What is a Decentralized Exchange (DEX)?
Decentralized exchanges differ greatly from traditional exchanges (like stock exchanges) and and also differ from centralized cryptocurrency exchanges. A DEX allows users to trade cryptocurrencies without entrusting their coins to the exchange.
How does DEX work?
A decentralized exchange (DEX) is an exchange where buyers and sellers trade cryptocurrency directly. There is no central authority controlling the order books or matching trades.
This makes DEXs more trustless and censorship-resistant than traditional exchanges, as there is no risk of the exchange being shut down or hacked.
DEXs uses a peer-to-peer system to match buyers and sellers. This is in contrast with centralized exchanges (CEXs), which require users to deposit their coins into the exchange's wallets. Centralized exchanges then match buyers and sellers and earn a commission on each transaction. When a trade is agreed upon, the funds are transferred between wallets directly, without going through a third party.
This makes DEXs much faster and cheaper trading fees than traditional exchanges or trading platform, as there are no middlemen to take a cut off the profits.
How are DEXs different from CEXs?
Here are some of the key differences between both types of exchange:
Traditional crypto exchanges: Traditional, centralized crypto exchanges are user-friendly, and all features and data are available in one place. However, since the user assets are stored in the exchanges, they are subject to hacks and theft. The centralized exchanges may also charge high fees and often impose limits on withdrawals and deposits. Users will have to go through a KYC process before trading.
Decentralized exchanges: Decentralized exchanges are fast catching up on the user-experience. They are peer-to-peer crypto exchanges are not subject to hacks, theft, or server downtime. Users have full control of their wallet’s private keys. DEXs typically charge low fees and rarely limit withdrawals and deposits. With DEXs, anyone can trade anonymously.
What are the benefits of DEX?
Decentralized exchanges are becoming more and more popular because of the benefits they offer as compared to centralized exchanges. Some of the key benefits of DEXs include:
Increased security
Because decentralized exchanges are built on blockchain technology, they are more secure than traditional centralized exchanges. This is because there is no single point of failure, and hence, no single point at which your funds can be stolen or lost.
Increased privacy
Centralized exchanges require you to provide personal information to create an account and trade currencies. Decentralized exchanges do not require you to provide any personal information, which means your identity remains anonymous.
Most decentralized exchanges are anonymous, meaning that they allow you to remain completely anonymous during all trades. However, certain DEXs require users to upload an ID before making a trade.
Increased variety
Decentralized exchanges allow you to trade over 50,000 different coins and tokens. Big-name centralized exchanges like Coinbase, Binance, and Kraken don’t support such variety.
What are the drawbacks of DEX?
DEXs do have their drawbacks. Some of them are:
Specific knowledge is required
Since decentralized exchanges are built with blockchain technology, users need to know how the blockchain works to make trades. Using a DEX can be confusing if you don't fully understand how this technology works.
Smart contract vulnerabilities
Since decentralized exchanges are built on a blockchain, they usually include a smart contract in the system. Poorly written smart contracts are vulnerable to attacks and, if an attack is successful, it can lead to stolen funds.
Unvetted token listings
Centralized exchanges usually vet the tokens and coins they allow on their platforms. Decentralized exchanges do not carry out this vetting, so users may be exposed to unauthentic or scammy tokens when using these exchanges.
What are the types of DEXs?
There many different implementations of DEXs, but the most common ones are:
Automated market makers (AMMs)
Automated market makers (AMMs) are the most common type of DEX. AMMs allow users to trade tokens directly. The buyers and sellers of a certain token trade against an algorithm. This eliminates the challenges of an order book market – AMMs can function 24x7 with no middlemen. AMMs are also known as "algos" (short for algorithms).
AMMs usually work by detecting a trade imbalance (when more people want to sell a crypto asset than want to buy it or vice versa). Using algorithms, the AMMs stabilize the stock price and keep the markets running smoothly. The most common algorithm used is the Constant Product Formula. However, newer AMMs with improved and variants of the Constant Product Formula are coming up. Saddle’s AMM uses the Stableswap algorithm.
Order book DEXs
Order book DEXs are decentralized exchanges that use an order book to match buyers and sellers.
An order book is a list of buy and sell orders for a particular security or asset. When you place a buy order, your order is added to the bottom of the buy order book. When you place a sell order, your order is added to the top order book.
If there's a match between a buyer's ask price and a seller's bid price, the trade will execute immediately. If there's no match, then your orders will remain in the order book until they are cancelled or filled.
While order book DEXs are decentralized, they may not be as private or censorship-resistant as AMMs. Buyers and sellers must publicly display their orders for other users to see, and anyone can see how much trading volume there is for a particular coin.
DEX Aggregators
With many DEXs sprouting, for traders, keeping track of prices across exchanges and arbitrage opportunities becomes complex. Liquidity is also spread across DEXs, resulting in massive slippages for high-volume trades. DEX aggregators emerged as a solution to the problem, while retaining the benefits of DEX.
DEX aggregators are growing in popularity thanks to their many benefits, including security, speed, and convenience. Aggregators also offer users more control over their trading experience, as they can choose which DEXs they want to use and can easily switch between them. Overall, DEX aggregators provide an excellent way for users to trade tokens safely and efficiently.
How do you use a Decentralized Exchange?
Decentralized exchanges are still a new technology, and there is no one-size-fits-all answer to this question. Each decentralized exchange has its own unique set of instructions on how to use it.
Some DEXs allow you to trade directly without depositing funds into an account. Others require you to deposit funds into a "smart contract" before beginning trading. Still others have unique user interfaces that require a different level of technical knowledge to use.
The best way to learn how to use a decentralized exchange is by reading the instructions on their website or watching one of their instructional videos.
Top Decentralized Exchanges (2022)
Saddle.Finance
A decentralized exchange for digital assets that offers low fees, fast transactions, and high liquidity providers.
Curve
A decentralized exchange that allows users to trade cryptocurrencies and fiat currencies.
SushiSwap
A decentralized exchange for digital assets that allows users to trade without depositing funds on the exchange.
Balancer
A decentralized exchange for digital assets that is built on the Ethereum blockchain.
Final Thoughts
Decentralized exchanges are becoming more and more popular because they offer several benefits over centralized exchanges. Anyone with a smartphone and an internet connection can trade via a DEX.
However, there are also drawbacks to using these new technologies. When balanced with the pros and cons, DEXs provide users with an added layer of customer funds security, best price, privacy, anonymity, lower transaction fees, and availability.
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