Crypto for Experts DeFi

What is a Decentralized Exchange? DEXs Explained

What are DEXs

DEXs or decentralized exchanges allow traders to swap one cryptocurrency for another in a peer-to-peer way, without a central authority to facilitate the process. DEXs are one of the core elements of Decentralized Finance (DeFi).

If you’ve already read something on crypto, you must have come across some funny food-themed names like SushiSawp, PancakeSwap and BakerySwap. They’re all DEXs. So, what do they do besides giving you cravings? Read on to learn everything about decentralized cryptocurrency exchanges. 

DEX – Decentralized Exchange Definition

A decentralized exchange (DEX) is a blockchain-based platform that allows for cryptocurrency exchange in a non-custodial, peer-to-peer way. DEXs use smart contracts to eliminate the need for an intermediary to guarantee liquidity and facilitate the trading process.

A DEX operates fully without the participation of a central authority. Unlike using a centralized exchange (CEX), crypto trading on DEXs relies solely on the blockchain network and its participants. That means that all digital asset trading takes place directly between the interested parties, without third-party interference. 

In practice this means that users don’t have to transfer their crypto assets to exchange servers to be able to trade. As a result, DEXs provide for better protection of user funds. DEXs can help eliminate systemic risks in the crypto ecosystem such as the single point of failure risk of centralized exchanges. 

How do Decentralized Exchanges Work?

To remain decentralized, DEXs rely on smart contracts. They allow cryptocurrency prices to be set using algorithms. To simplify transactions, some DEXs also use so-called liquidity pools (LPs), whereby investors stack their assets in exchange for rewards. LPs replace the order book. 

DEXs and DeFi

Now that you understand how DEXs work, you might have realized that decentralized crypto exchanges are essentially decentralized applications or dApps. As such, DEXs are one of the main elements of DeFi. Like with other DeFi products, communities in the DeFi space build DEXs with innovation and development in mind. Therefore, DEXs are mostly based on open-source code. 

Anyone can customize the code to create new competing designs. This is how the PancakeSwap, SushiSwap, and BakerySwap projects were created using the Uniswap code. As such, DEXs are one of the main types of building blocks thanks to the permissionless compostability principle.

What is Permissionless Compostability?

Composability, as a term, refers to the principle when a particular system permits a designer to combine its different elements to create new components in answer to various requirements. Unlike the traditional financial system, DeFi allows for a limitless combination of protocols. Therefore, we say that DeFi is characterized by permissionless compostability.

To easier understand permissionless compostability as a property of DeFi, think of the LEGO toy bricks. Anyone can use the existing open-source DeFi protocols to make new combinations, resulting in innovative and efficient financial products and services unlike anything seen in finance until now.

In fact, the parts of DeFi protocols are often called “money LEGOs” because developers can integrate and stack them just like everyone’s favorite LEGOs to create new DeFi products, use cases, and user experiences. This significantly cuts the time needed for creating a new DApp. 

However, each dApp requires thorough checks of its smart contract before it gets deployed on the blockchain. Individual protocol weaknesses can create systemic risk for the DeFi infrastructure as a whole.

DEX vs CEX – What kind of Crypto Exchange to Choose?

By now, you should have a clearer understanding of the differences between using a decentralized vs. centralized exchange. While you often hear DEXs being called “the exchange of the future”, centralized crypto exchanges still have advantages over their decentralized counterparts in some respects. 

Advantages of Using a DEX

  • Superior security of funds. The main advantage of using a DEX remains the fact that you keep all your assets in a private wallet, so you’re always in control of them.
  • Anonymity and full independence from regulators. The decentralized structure provides for the fact that user identity is protected against interference by local and international authorities and institutions. Of course, the lack of legal regulations can also be seen as a disadvantage.
  • Support for many different crypto coins and tokens. You’re not limited to the offering of a particular trading platform when using a DEX. However, DEXs work best for trading ERC20 tokens, but not necessarily for trading BTC or other tokens outside the Ethereum chain.

Downsides of Using a DEX

  • No fiat-to-crypto exchange option. DEXs don’t offer a fiat gateway, so users still need an account on a centralized exchange to buy their first crypto. Also, before you can spend your digital assets in the real world, you again need to convert your cryptocurrencies to fiat using a centralized exchange.
  • No margin trading option, which means that DEX users cannot borrow for investment purposes.
  • Lack of convenience. The well-known limited functionality and user complexity of most DEXs might deter beginner crypto traders. Yet, DEX user interfaces are improving and becoming more user-friendly by the day. 

Why Choose a CEX over DEX?

  • CEXs offer a superior user experience. By design, CEXs greatly rely on user satisfaction, which is why they invest in providing more user-friendly interfaces. Beginner investors usually find it much easier to use a CEX rather than a DEX, where you have to do everything yourself.
  • CEXs have better customer support. In fact, many DEXs have no customer support whatsoever. So, once again, centralized exchanges’ 24/7 technical support for its users may be much more convenient for beginner crypto traders. 
  • CEXs offer low transaction fees. In most cases, you have to take into account slightly higher costs when trading on a DEX.

Directly comparing the advantages of decentralized and centralized exchanges can’t give you a clear answer as to which kind is better. When choosing an exchange, it’s worth focusing on your personal preferences, needs, and expectations.

Types of Decentralized Exchanges

Many different kinds of DEXs exist on the market. We may identify three main categories of DEXs.

Order Book Decentralized Exchanges

DEXs that use the order book model are the original type of decentralized exchanges that operate most similarly to a traditional exchange. They organize trading pairs according to transaction prices and external information. This type of DEXs also require users to deposit their crypto assets on the exchange before using it for transactions.

Automated Market Maker (AMM) exchanges

DEXs with AMM protocols are also known as swap exchanges. Most of the top DEXs today are AMM exchanges. As a fully automated platform, AMM exchanges rely on a valuation algorithm rather than external information for determining asset price. 

Additionally, AMM protocol DEXs allow for instant crypto exchanges with low trading fees and don’t require the user to deposit their assets on the exchange before transacting. The time saved thereby can make a huge difference to traders in the fast-moving cryptocurrency market.

DEX Aggregators

This type of DEXs use their technology to monitor cryptocurrency prices in all markets to offer the buyer the best possible exchange rate. They’re called DEX Aggregators because they provide the user with access to many trading tools simultaneously from a single dashboard. 

DEX aggregators have appeared recently, with the advent of DeFi and decentralized exchanges. Their main point is to address the problem of low liquidity on DEXs by using complex mechanisms based on more than one protocol. 

Top DEXs for Cryptocurrency Trading

Uniswap

This is the top decentralized exchange on the market currently. Uniswap operates on the Ethereum blockchain and as such, it’s especially useful for trading ERC20 tokens. Crypto traders can exchange tokens directly via their Ethereum crypto wallet.

Uniswap provides a relatively superior user-friendly interface for a DEX, while allowing investors to exchange tokens without having to create an account and undergo the Know Your Customer (KYC) process.

PancakeSwap

PancakeSwap is the leading platform for trading BEP20 tokens on the Binance Smart Chain (BSC). Besides giving you sugar cravings, this automated protocol also serves to support decentralized crypto trading. Instead of a central authority to provide liquidity, other users stack their tokens in the liquidity pool and receive a share of the rewards generated by the transactions. All transactions on PancakeSwap are performed automatically with the use of smart contracts based on BSC, thanks to which all activities on the exchange are much cheaper than Uniswap.

SushiSwap

This is another one of the largest decentralized exchanges that operates on Ethereum. SushiSwap allows you to buy and sell virtual assets and, as befits DEXs, it’s operated by the users themselves. It was created as a fork of the Uniswap code, but after a while it gained functionalities that users won’t experience on Uniswap.

1Inch

Developed only in 2019, this relatively young DEX is an aggregator protocol that collects dispersed liquidity from various exchanges, selecting the most convenient ones per context. This means that 1Inch is able to split a single trading transaction into multiple DEXs to ensure the best price. 

1Inch, along with others like Matcha, operates on the Ethereum blockchain. Similarly, ZeroSwap is a DEX Aggregator for the  Binance Smart Chain.The 1Inch network also includes the 1inch Liquidity Protocol. This is a next-generation AMM DEX that protects users from market manipulation, such as front-running attacks.

Was this post helpful?

Related posts

Exchange Tokens Explained
As a separate digital asset class, crypto exchange tokens have evolved to serve different functions...
DAOs explained: What is a Decentralized Autonomous Organization?
Crypto and the DeFi infrastructure have eliminated the need for intermediaries and central governing authority...
DApps – Decentralized Applications Explained
In a world of booming internet applications, DApps or decentralized applications offer an alternative way...