What is a Decentralized Exchange, and How Does it Work?

Centralized exchanges are the current dominating force in the crypto sphere. However, decentralized exchanges (DEXs) have been on the rise as they continue to grow in popularity. DEXs are responsible for facilitating peer-to-peer trading by relying on automated smart contracts to execute trades without an intermediary. Even though most DEXs execute this mechanism, not all employ the same infrastructure.

So, what exactly do we mean by decentralized exchanges, and how do they work?

Decentralized Exchanges (DEXs)

Decentralized exchanges are peer-to-peer marketplaces where crypto traders make transactions directly without handing over the management of their funds to an intermediary or custodian. The transactions happen through self-executing agreements written in code called smart contracts.

The reason behind the creation of DEXs is the removal of the requirement of any authority to oversee and authorize trades performed within a particular exchange. DEXs are a way of allowing peer-to-peer (P2P) trading of cryptocurrencies. P2P is a notion to describe a marketplace that connects buyers and sellers of cryptocurrencies. They are primarily non-custodial, meaning users keep control of their wallet’s private keys.

Additionally, decentralized exchanges rely on smart contracts to allow traders to execute orders without an intermediary. It allows traders to trade directly from their wallets by interacting with the smart contracts behind the trading platform. As such, traders are entirely responsible for their funds and losing them if they make mistakes.

How do DEXs Work?

DEXs are built on top of blockchain networks that support smart contracts. This is where users keep custody of their funds. Every trade incurs a transaction fee along with the trading fee. As such, traders interact with smart contracts on the blockchain to use DEXs.

There are three major types of decentralized exchanges;

• Automated market makers- Mainly a system relying on smart contracts to solve liquidity problems. The drive towards the creation of these exchanges was from Ethereum co-founder Vitalik Buterin’s paper on decentralized exchanges to describe how to execute trades on the blockchain using contracts holding tokens.

• Order books DEXs- Order books compile records of all open orders to buy and sell assets for particular asset pairs. Buy orders show one is ready to buy or bid for an asset at a specified price. On the other hand, a sell order indicates that a trader is ready to sell or ask for a special price for an asset under their consideration.

• DEX aggregators- DEX aggregators utilize different protocols and mechanisms to solve problems associated with liquidity. These platforms aggregate liquidity from several DEXs to minimize slippage on large orders. They also allow traders to optimize swap fees and token prices and offer traders the best price possible in the shortest possible time.

How do You Use Decentralized Exchanges?

Using decentralized exchanges does not entirely involve a sign-up process. In other words, you do not require an email address to interact with these platforms. However, traders only require a wallet compatible with the smart contracts on the exchange’s network. For every service DEXs offer, the fruits can be received by anyone with an internet connection or a smartphone.

When deciding on the DEX to use, you might want to decide on the network you want to use. The main reason for this is that every trade incurs a transaction fee. The next step would require you to choose a wallet compatible with your selected network and fund it with its native token. A native token entails a token that pays for transactions in a particular set network.

You can use a wallet extension to access your funds directly in your browsers. As such, you are making it easy to interact with decentralized applications (DApps) such as DEXs.

After picking a wallet, fund it with the tokens to pay for transaction fees on the chosen network. You have to buy these tokens on centralized exchanges, and they are easily identifiable through the ticker symbol they all use.

It would help if you took note of the network to avoid sending your funds to the wrong network.

Advantages of Using DEX

1. Token availability- The advantage of DEXs is that they can include any token minted on the blockchain they are built upon. As such, new projects will likely list on these exchanges before being available on the centralized counterparts.

2. Anonymity- When you engage in the exchange of crypto, your anonymity is preserved in the case of using a DEX. This comes differently with centralized exchanges, as you must go through a standard identification process, KYC.

3. Reduced security risks- You are at a reduced risk of hacks using DEXs, as the exchanges do not control your funds. However, traders guard their funds and only interact with the exchange when they wish to do so.

4. Reduced counterparty risk- Counterparty risk happens when the other party involved in a transaction does not fulfil its part of the deal and defaults on its contractual obligations.

Disadvantages of Using DEXs

1. There is a particular knowledge you need- To access DEXs, you need crypto wallets that can interact with smart contracts. As a user, you must know how to use these wallets and understand the security-related concepts associated with keeping your funds secure. You may commit different errors without the knowledge, leading to severe losses.

2. Intelligent contract vulnerabilities- Smart contracts on blockchains like Ethereum are publicly available, and anyone can review their code. However, to err is human. There can be several bugs that can slip past audits and other code reviews.

3. Unvetted token listings- Anyone can list a new token on a decentralized exchange and provide liquidity by pairing it with other coins. This leaves investors susceptible to scams such as rug pulls.

Final Thoughts

Although centralized exchanges account for the vast majority of market activity since they offer security, regulatory oversight, and, frequently, insurance, the growth of DeFi has created room for the development of decentralized crypto exchange protocols and aggregation tools.

Platforms like Uniswap, Curve, and Balancer display the potential for simple, user-friendly platforms that rely on liquidity protocols rather than order books. As the DEX market matures, the proliferation of new protocols and supporting mechanisms will likely only accelerate.