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Carla Moretti
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What is a DEX? Decentralized Exchange Explained
Carla Moretti
With almost two decades of experience in the fast-paced financial industry, Carla has established herself as a powerhouse and an innovative leader.
What is a DEX?
A decentralized exchange (DEX) is a peer-to-peer marketplace that allows users to directly exchange cryptocurrencies. Unlike its counterpart (a centralized exchange or CEX), a DEX does not act like an intermediary. Rather, a DEX uses computer algorithms to automate the cryptocurrency trading process.
A DEX represents a core aspect of decentralized blockchain networks in that anyone can join it and trade tokens without any regulation from banks or financial institutions. Two examples of famous decentralized exchanges are Uniswap and Sushiswap which are based on the Ethereum Blockchain. They make use of a suite of decentralized finance (DeFi) tools to help users conveniently trade digital assets. DEXs have seen impressive growth over the last few years. For example, in 2021, DEX trading totaled a massive $1 trillion, an 858% increase over the previous year. In the same year, the number of DeFi traders increased over tenfold. Many people are turning to DEXs to exchange their crypto holdings.
How do DEXs work?
A typical CEX allows users to trade cryptocurrency for fiat currency or crypto-crypto pairs. You can trade Bitcoin (BTC) for USD or you can exchange BTC for some ETH. The transactions will be handled by a centralized organization through an order book. Some exchanges also allow users to make advanced trades through margin trading. In a sense, these exchanges work like banks or brokers, but for cryptos.
DEXs execute trades through automated market makers. These are bots that are programmed to assign a rate to each cryptocurrency on the market with the help of smart contracts. The smart contracts utilize liquidity pools for cryptos and cash that are filled by users staking their cryptos into the DEX. Staking users receive staking rewards in the form of interest. These rewards incentivize users to stake their tokens in the decentralized exchange for providing liquidity to maintain a reserve of cryptocurrencies to stabilize their supply and price.
Transactions in a decentralized exchange are recorded directly on the blockchain. In contrast to a CEX, which records transactions in a database of orders.
DEXs are usually programmed with Open Source (freely available) code that can be copied and modified for commercial use. The Open Source nature of the code encourages developers to form communities that maintain it while testing new enhanced builds for public use. Exchanges like Uniswap, Sushiswap, and Pancakeswap are built on these principles and their names also reference this trend since they all use ‘swap’ in their names.
What are the advantages of using a DEX?
Decentralized exchanges offer several potential benefits over centralized exchanges. Here are some of the main advantages.
Anonymity
Decentralized exchanges do not require your personal information to use. Therefore, you can exchange cryptos privately without worrying about being monitored by banks or any other third party. This is a big difference in comparison to a centralized exchange where customers have to fill out detailed and lengthy KYC forms.
Crypto Variety
Decentralized exchanges are typically based on new blockchains that support DeFi and DAO capabilities. For example, if a DEX is based on Ethereum, anyone can mint new tokens for their Blockchain project through a custom smart contract and put them on the exchange. This makes DEXs a great place to look for new coins to buy. Entrepreneurs looking for funds tend to launch IPOs for blockchain projects on decentralized exchanges. The large variety of vetted and unvetted coins comes with the risk of losing your money, so we recommend every buyer be careful when looking for new tokens.
Reduced Exposure to Hackers
Unlike centralized exchanges, a decentralized exchange capitalizes on a distributed database to keep users and their data secure. Funds are stored in each user’s wallet, offering a primary layer of protection for a user. A secondary level of protection comes into play as the person you are trading with is less likely to be comprised by a hacker.
Boundless Trading for Developing Countries
Many people in developing countries are unbanked and have little access to fiat currencies. Restrictions such as political sanctions or local banking laws may also make cross-border payments difficult. Decentralized exchanges solve this problem for residents of these countries, allowing them to settle payments or transfer funds easily. Many DEXs have improved peer-to-peer technologies that facilitate secure and speedy money transfers. All that is needed is a smartphone and an internet connection.
Lower Transaction Fees
The advantage of self-executing smart contracts is that their transaction fees are lower to encourage higher trading volumes. You also do not have to pay any investment manager any fee that is typically paid in a financial institution.
What are the Disadvantages of Using a DEX?
As always, decentralized exchanges have their trade-offs in comparison to centralized exchanges as their counterparts. Here are a few potential problems you may face when trading through a DEX.
Complex User Interfaces
A DEX is built with functionality in mind but not ease-of-use, as is the case with many centralized exchanges. Therefore its UI is typically light and displays basic inputs and outputs. Advanced options are also loaded into menus that are intended for power users. Developers expect the average user to know about crypto assets and trading, and they do not prioritize the customer experience or journey when crafting a UI. Most of the UI is copied from existing freeware. Guides are available online, but you will have to go through technical documentation if you do not have the time to look up a video. You will also be expected to use unlabeled wallet addresses, so caution is advised to avoid sending funds to the wrong user.
Code Vulnerabilities
Since DEXs are based on smart contracts using open-source code, smart programmers can exploit weaknesses in the code to make unfair trades. Poorly configured smart contracts can have bugs that can be hacked through zero-day exploits, resulting in a loss of tokens for many users. Buyers and sellers are expected to understand these risks, and there is no guarantee of recovering any of your lost crypto assets if these exploits occur.
High Risk
Because DEXs feature a large variety of coins, there is a higher risk of losing your funds from failed cryptocurrency projects. Sometimes token issuers can become the main liquidity provider and flood the market with many coins decreasing their value. We advise you to read whitepapers, check blockchain audits and read credible reports to make an informed decision.
Staking Requirements
If you are a simple user, you may end up paying slightly higher trading fees if you have not added any cryptocurrency fund into their respective liquidity pools. It’s no secret that liquidity providers have the upper hand in this space. Therefore be prepared to spend some tokens to lower trading fees and provide liquidity in a liquidity pool.
How Can you Interact with a DEX?
To get started, you will need a crypto wallet. You will have to make sure that your wallet is compatible with the corresponding blockchain. For example, if you want to connect with Uniswap, you need an Ethereum wallet. A useful list of Ethereum wallets is available here. Interacting with a DEX will also require you to have a small amount of cryptocurrency to pay for initial transaction fees. In the case of Ethereum, this is usually in the form of ‘gas’ fees.
How do the DEX fees Work?
The fee is different for every exchange. This is also true for centralized exchanges. The fee can be structured. For example, both Uniswap and Sushiswap charge a fee of 0.3% which is split between you can the liquidity providers. Pancakaswap has a lower fee (0.25%) and liquidity gets a lower proportion of the split. Blockchains also have additional ‘Layer2’ solutions that can settle trades off the main blockchain, scaling up the network and speeding transactions. Layer2 solutions can offer lower transaction costs. Examples are Polygon, Optimism, and xDai.
FAQ
Most frequent questions and answers
The best DEX exchanges are Uniswap, Sushiswap, Pancakeswap, and 1inch. Besides these, there are many other DEXs like dYdX, AstroSwap, WagyuSwap and Kyber. Each type of change has different pros and cons and is typically build on different blockchain networks.
A DEX exchange works by allowing users to directly trade crypto exchange with each other with the help of automated market makers and liquidity pools. This type of exchange uses computer algorithms to run smart contracts and trade cryptocurrency based on available demand and supply. Financial transactions do not require centralized counterparts and you keep in control of the private keys of your coins and tokens.
DEX is the short form of decentralized crypto exchange.
Yes, the IRS can track decentralized exchanges that send reports to it. Each crypto-crypto transaction is a taxable event in the US. Therefore, you should study the taxation requirements of cryptocurrency trading so that you can complete your tax documentation according to the law.
Yes, PancakeSwap is a DEX. It is used to exchange BEP20 tokens and tokens pegged to BEP20.
A DEX makes money from taking a portion of a direct cryptocurrency transaction as trading fees. Part of the fee is added to a liquidity pool, while part of it is given to market makers. A DEX also makes money with the help of smart contracts that allow parties to make money based on a fixed set of terms and conditions.
Uniswap is the biggest decentralized crypto exchange.
No, Metamask is a cryptocurrency wallet. It is used to store cryptocurrency coins and tokens. You can use Metamask to connect to either a decentralized exchange or centralized exchange.
Binance is one of the biggest CEXs in the crypto world. It has its centralized order book. Binance offers a wide variety of cryptocurrencies for trading.
Yes, Uniswap is a DEX. It is based on the Ethereum blockchain.
Yes, it is legal to trade in DEXs in the US. You may be required to report your transactions in a DEX for capital gains taxes.
Yes, you can buy Bitcoin on a DEX, among many other cryptocurrencies. You can also buy different cryptocurrency pairs on a DEX.
There is no definitive answer to this question. However, there are many options to choose from. The real answer will depend on the type of coin you want and the blockchain that the DEX is based on.
Yes, DEXs are made for crypto trading.
You first create a cryptocurrency wallet (like Ethereum wallet, or Metamask) that is compatible with the blockchain of the DEX. You then connect your wallet to the decentralized platform of your choice.
A DEX is a decentralized cryptocurrency exchange that allows users to trade cryptocurrencies directly without any intermediary. A CEX is a centralized cryptocurrency exchange that acts as a central point for trading different cryptocurrencies.
DEXs and Dapps are decentralized computer applications that work on blockchain technology. They are also referred to as Web3 Apps. While DEXs are cryptocurrency exchanges, Dapps can be of different types, such as services (healthcare, content streaming), metaverses (games and VR social apps), and Decentralized Finance (DeFi) tools.
The major downsides of decentralized exchanges include:
- High-risk cryptos
- A potentially vulnerable smart contract
- Confusing user-interfaces
- Poor user experience
- Often high trading fees
- Potential rug pulls from creators of new tokens
Skrumble.com provides all its content for informational purposes only, and this should not be taken as financial advice to buy, trade, or sell any investment instruments or products, including but not limited to cryptocurrencies, or use any specific exchange. Please do not use this website as investment advice, financial advice, or legal advice, and each individual’s needs may vary from that of the author. Investing in financial instruments, including cryptocurrencies, carries a high risk and is not suitable for all investors. It is possible to lose the entire initial investment, so do not invest what you cannot afford to lose. We strongly advise conducting your own research before making any investment decisions. This post includes affiliate links with our partners who may compensate us.
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