What Is a DEX (Decentralized Exchange)?
DEFINITION
Without the use of a custodian or centralized middleman, users can trade crypto assets through blockchain transactions using a decentralized exchange (DEX).
Users can trade cryptocurrencies on a DEX (decentralized exchange) in a non-custodial setting without the requirement for a middleman to handle the transfer and custody of money. DEXs use blockchain-based smart contracts to replace traditional middlemen, such as banks, brokers, payment processors, and other organizations, to enable the exchange of assets.
DEXs provide total transparency into the movement of funds and the processes supporting exchange, in contrast to typical financial transactions, which are opaque and carried out through middlemen that provide very little insight into their actions. DEXs also lessen counterparty risk and potentially lessen systemic centralization problems in the bitcoin ecosystem since user money don’t transit via a third party’s cryptocurrency wallet while trading.
Due to its permissionless composability, DEXs are an essential “money LEGO” upon which more complex financial products may be constructed. DEXs are a cornerstone of decentralized finance (DeFi).
How Does a DEX Work?
There are several DEX designs, and they all have advantages and disadvantages in terms of feature sets, scalability, and decentralization. Order book DEXs and automated market makers are the two most popular varieties (AMMs). Another popular type is DEX aggregators, which search across several DEXs on-chain to get the best pricing or lowest gas cost for the user’s intended transaction.
The high level of determinism attained by employing immutable smart contracts and blockchain technology is one of the key advantages of DEXs. DEXs carry out deals utilizing smart contracts and on-chain transactions as opposed to centralized exchanges (CEXs), like Coinbase or Binance, which use their own matching engine to enable trading. DEXs also give customers the option to trade while maintaining full custody of their money in self-hosted wallets.
Network fees and trading fees are the two main types of expenses DEX users are normally expected to pay. While trading fees are paid by the underlying protocol, its liquidity providers, token holders, or a mix of these organizations as stated by the protocol’s architecture, network fees relate to the gas cost of the on-chain transaction.
An end-to-end on-chain infrastructure with permissionless access, zero single points of failure, and decentralized ownership across a community of dispersed stakeholders is the goal of many DEXs. This often implies that a decentralized autonomous organization (DAO), made up of a community of stakeholders, governs protocol administrative powers by voting on important protocol choices.
It is challenging to maximize decentralization while maintaining the protocol’s competitiveness in a crowded DEX market since the DEX’s core development team often has more knowledge about key protocol decisions than a dispersed group of stakeholders. To boost censorship resistance and long-term resilience, many DEXs choose a decentralised governance structure.
Order Book DEXs
An essential component of electronic exchanges is an order book, which is a live collection of open buy and sell orders in a market. The internal operations of an exchange use order books to match buy and sell orders.
On-chain order book in full Due to the need that every interaction inside the order book be put on the blockchain, DEXs have historically been less prevalent in DeFi. Either far higher throughput than the majority of current blockchains can manage is required for this, or network security and decentralization must be seriously compromised. Early order book DEXs on Ethereum as a result had poor liquidity and unsatisfactory user interfaces. Still, these exchanges provided a convincing demonstration of how a DEX might support trade using smart contracts.
On-chain order book exchanges have become more practical and now see a lot of trading activity thanks to scalability innovations like layer-2 networks like optimistic rollups and ZK-rollups as well as the introduction of higher-throughput and app-specific blockchains. Hybrid order book designs, in which the management and matching of orders take place off-chain but trade settlement takes place on-chain, have also grown in popularity.
A few well-known order book DEXs include Serum, Loopring DEX, 0x, and dYdX.
Automated Market Makers (AMMs)
The most popular sort of DEX is one with automated market makers since it allows for quick liquidity, democratized access to liquidity, and—in many cases—permissionless market creation for any token. A money robot in essence, an AMM is constantly ready to propose a price between two (or more) assets. An AMM uses a liquidity pool instead of an order book where users may trade their tokens, with the price set by an algorithm depending on the percentage of tokens in the pool.
AMMs allow rapid access to liquidity in markets that could otherwise have reduced liquidity since they can always quote a price for a user. A willing buyer must wait for their order to be matched with a seller’s order in the case of an order book DEX; even if the buyer puts their order to the “top” of the order book near to the market price, the order may never execute.
In the case of an AMM, a smart contract controls the exchange rate. Users may instantly access liquidity, and liquidity providers—those who deposit funds into the liquidity pool of the AMM—can profit passively from trading commissions. AMMs have seen a huge increase in the number of new token launches thanks to the combination of rapid liquidity and democratized access to liquidity provision. This has also allowed for the development of novel designs that concentrate on specific use cases, such as stablecoin swaps. Read this page on how AMMs function for a more thorough investigation of AMMs.
AMMs might be used to support exchanges of NFTs, tokenized real-world assets, carbon credits, and much more, even though the majority of existing AMM designs focus on cryptocurrencies.
Bancor, Balancer, Curve, PancakeSwap, Sushiswap, Trader Joe, and Uniswap are a few examples of well-known AMM DEXs.
What Are the Benefits of Decentralized Exchanges?
DEX trades contain strong guarantees that they will execute precisely as the user intended, free from the interference of centralized parties, because they are made possible by deterministic smart contracts. DEXs offer robust execution assurances and enhanced transparency into the underpinnings of trade, in contrast to the opaque execution techniques and possibility for censorship inherent in traditional financial markets.
DEXs lower counterparty risk because there are no custodians involved and consumers may participate using self-hosted wallets. By lowering the amount of cash concentrated in the wallets of a limited number of centralized exchanges, DEXs can help lessen some of the systemic risks associated with the blockchain sector. Prior to its unexpected closure and the loss of hundreds of thousands of bitcoins, the Mt. Gox controlled exchange managed a sizeable part of all Bitcoin trade volume in 2014.
DEXs contribute to wider financial inclusion. Accessing a DEX’s smart contracts just needs an Internet connection and a suitable self-hosted wallet, unlike certain user interfaces that have restricted access depending on a user’s location or other criteria. In contrast to a centralized exchange, the onboarding procedure for a DEX is simple and nearly immediate because users can sign in easily using their wallet address.
DEX Risks and Considerations
Through better execution guarantees, more transparency, and permissionless access, DEXs have democratized access to trade and liquidity provision. DEXs do, however, come with a number of dangers, including but not limited to:
- Blockchains are thought to be quite safe for carrying out financial transactions, however there is a smart contract risk. The degree of expertise and experience of the team that created a smart contract does, however, have an impact on the code quality of the project. DEX users may experience a financial loss as a result of smart contract faults, hacks, vulnerabilities, and exploits. By using peer-reviewed code, good testing procedures, and security audits, developers may reduce this danger, but they must always exercise caution.
- Liquidity risk: Although DEXs are gaining popularity, certain DEX marketplaces have inadequate liquidity, resulting in significant slippage and a bad user experience. Significant sections of trading activity are still undertaken on centralized exchanges, which frequently results in reduced liquidity on DEX trading pairs because to the network effects of liquidity, which operate as follows: high liquidity draws more liquidity, low liquidity attracts less liquidity.
- Frontrunning risk—Because blockchain transactions are public, arbitrageurs or bots seeking to extract the most extractable value (MEV) from unknowing users may attempt to frontrun DEX deals. These bots attempt to take advantage of market inefficiencies by paying higher transaction fees and minimizing network delay, just like high-frequency traders do in traditional markets.
- Risk associated with frontrunning: Because blockchain transactions are public, arbitrageurs or bots seeking to extract the most value possible from unaware users may attempt to frontrun DEX deals. These bots aim to take advantage of market inefficiencies by optimizing network latency and paying higher transaction fees in order to profit from the DEX transactions of regular users, just like high-frequency traders do in traditional markets.
- Even though many DEXs strive to increase their decentralization and censorship resistance, centralization points may nevertheless exist. These include, among other things, the use of subpar token bridging infrastructure, the hosting of the DEX’s matching engine on centralized servers, and administrative access granted to the DEX’s smart contracts by the development team.
- Network risk—Because a blockchain facilitates the exchange of assets, utilizing a DEX may be prohibitively expensive or completely impractical if the network encounters congestion or outage, leaving DEX users vulnerable to changes in the market.
- Token risk—Since many DEXs allow anybody to develop a market for any token, the likelihood of purchasing a subpar or harmful token may be higher than it would be on a controlled exchange. Users of DEX should think about the dangers of taking part in projects in their early stages.
In addition to the aforementioned, some users could find the idea of having complete control over their private keys to be unsettling. One of the key advantages of the Web3 vision is having complete control over one’s assets, yet many users would choose to entrust a third party with that responsibility. While accessing a complex ecosystem of open-source financial services, more users may be able to take advantage of the advantages of preserving total control over their assets by adhering to proper security and key management procedures.
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