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How do Decentralized Exchanges work?

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Following the sudden collapse of FTX, more and more users have turned attention toward Decentralized Exchanges. This article aims to provide an overview of what DEX are, how they work and the kind of risks they pose vis-a-vis traditional, centralized exchanges.

What is a Decentralized Exchange?

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 funds.

DEXs use blockchain-based smart contracts to replace traditional intermediaries, such as banks, brokers, payment processors, and other organizations, to enable the exchange of assets.

DEXs provide complete 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 can lessen systemic centralization problems in the crypto ecosystem because user money don’t transit via a third party’s cryptocurrency wallet during trading.

Due to its permissionless composability, DEXs are a key “money LEGO” upon which more complex financial products can be built. DEXs are a cornerstone of decentralized finance (DeFi).

How Does a DEX Work?

There are various DEX designs, and they all have advantages and disadvantages in terms of feature sets, scalability, and decentralization. Order book DEXs and automated market makers (AMMS) are the two most popular varieties. Another popular type is DEX aggregators, which search across various 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 collected by the underlying protocol, its liquidity providers, token holders, or a combination of these organizations as stated by the protocol’s design, network fees refer to the gas cost of the on-chain transaction.

An end-to-end on-chain infrastructure with permission-less access, zero single points of failure, and decentralized ownership across a community of distributed stakeholders is the goal of many DEXs. This often means that a decentralized autonomous organization (DAO), made up of a community of stakeholders, governs protocol administrative rights 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 typically 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 decentralized governance structure.

OrderBook 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.

Due to the requirement that every interaction inside the order book be posted on the blockchain, fully on-chain DEXs have historically been less prevalent in DeFi. Significantly higher throughput than the majority of current blockchains can manage would be required for this, or network security and decentralization would 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 could support trading using smart contracts.

On-chain order book exchanges have grown more practical and now see a lot of trading activity thanks to scalability improvements 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 while trade settlement takes place on-chain, have also grown in popularity.

A few well-known order book DEXs are 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 always ready to propose a price between two (or more) assets. An AMM uses a liquidity pool instead of an order book where users can trade their tokens, with the price set by an algorithm based 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 can 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 post about how AMMs function for a more thorough investigation of AMMs.

AMMs could be used to support swaps 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 Pros of DEXs?

DEX trades contain strong guarantees that they will execute exactly 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 trading, 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 can 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 industry. Prior to its abrupt 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. Similar events occurred in 2022 with the demise of FTX.

DEXs contribute to wider financial inclusion. Accessing a DEX’s smart contracts just needs an Internet connection and a compatible self-hosted wallet, unlike some user interfaces that have restricted access based 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.

DEXs Risks and Factors to Consider

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:

  • Smart Contract Risk: Blockchains are thought to be extremely safe for carrying out financial transactions. The level 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 can 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 poor 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 work as follows: high liquidity draws more liquidity, low liquidity attracts less liquidity.
  • Frontrunning Risk: Since blockchain transactions are public, arbitrageurs or maximum extractable value (MEV) bots may attempt to frontrun DEX trades in an effort to steal value from unaware consumers. These bots attempt to take advantage of market inefficiencies by paying higher transaction fees and minimizing network delay, much like high-frequency traders do in traditional markets.
  • Centralization Risk: Although many DEXs strive to maximize their decentralization and censorship resistance, centralization points may still exist. These include, among others, using low-quality token bridging infrastructure and having the development team have administrative access to the DEX’s smart contracts.
  • Network Risk: Since a blockchain facilitates the exchange of assets, using a DEX may be prohibitively expensive or impossible if the network encounters congestion or downtime, leaving DEX users vulnerable to market movements.
  • 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 might prefer to entrust a third party with that responsibility. While accessing a sophisticated 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.

Conclusion

A key component of the cryptocurrency ecosystem, DEXs enable peer-to-peer exchange of digital assets between users without the involvement of middlemen. Due to its ability to supply new currencies with quick liquidity, their easy onboarding process, and the democratized access to trade and liquidity provision that offer, DEXs have seen an increase in use over the past few years.

It is unclear whether the majority of trading activity will move to DEXs and whether the present DEX designs will sustain institutional acceptance and long-term growth. However, DEXs are anticipated to continue to see advancements in transaction scalability, smart contract security, governance infrastructure, and user experience. They are predicted to remain an essential component of the cryptocurrency ecosystem. And the recent events definitely support the case for more users moving toward DEXs.

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