What is a Decentralized Exchange?
A decentralized exchange, or DEX, uses smart contracts to enable cryptocurrency trading directly between users, without the need for an intermediary.
Unlike a centralized exchange, a DEX uses smart contracts and algorithms as the central authority, relying on the trustless nature of open-source code to reliably execute trades.
How does a DEX work?
Most DEXs use either an order book or Automated Market Maker (AMM) design, with AMMs being the most popular of the two. Using an order book design requires a lot of work to be done on the DEX, even with the use of smart contracts, which can slow things down or even compromise security.
A DEX using an AMM design, however, is much faster because it uses liquidity pools that allow traders to swap tokens, instead of waiting for a specific order to match and execute. The math behind liquidity pools is complex, but the most important thing to know is simply that they allow for simple, fast trading of tokens within a DEX.
Users who contribute their assets to a liquidity pool are called liquidity providers. Becoming a liquidity provider means that you can expect to earn rewards for helping to provide capital to the pool, and is a way to earn passive income in a DEX.
Benefits of using a DEX
There are several reasons for using a DEX that are beneficial on their own, but when combined, DEXs become increasingly appealing.
While centralized exchanges require customers to go through a formal Know-Your-Customer (KYC) process, DEXs allow users to retain privacy. DEXs are able to do this because they’re non-custodial — users retain their private keys, so the DEX isn’t responsible for those funds.
Trading on a DEX is done using smart contracts, liquidity pools and Automated Market Makers (AMMs), which means no central authority manually validating and processing transactions. Users can access a DEX and place orders any day or time, and every transaction is recorded on the blockchains being used.
DEXs are able to offer much lower fees for transactions (and are often faster) than a centralized exchange. This is because there are no intermediaries involved in the process, just smart contracts that perform their coded functions extremely reliably.
Not only is the code for most DEXs open-source, but all of the transactions are visible since they exist on their respective blockchains. Having open-source code means that anyone can verify the processes and rules that the DEX and its smart contracts will follow.
Limitations of using a DEX
While a DEX offers many features that a centralized exchange does not, there are some criticisms of DEXs.
It’s important to note that as the technology continues to improve and becomes more readily adopted, some of these weak points could disappear.
Decentralized exchanges were designed with the advanced DeFi user in mind.
As a user, you’ll need to perform a good deal of research before using a particular DEX or purchasing niche tokens to make sure you’re getting involved with a legitimate product. If you use a fly-by-night DEX or purchase scam coins, those funds are gone.
If you have issues connecting to or using the DEX, you’ll need to rely on community resources such as forums to solve your problem — there’s generally no customer support team ready to help you if you run into an obstacle.
This is one of those areas that could change over time as DEXs become more mainstream.
Decentralized exchanges were created to replace centralized exchanges, which have had decades to build out easy-to-use websites and interfaces for their customers.
DEXs have been around for a much shorter period of time, and were purpose built to accomplish very complex tasks. This means the technology came first, resulting in a less-than-ideal user interface that can be a challenge for new users to overcome.
However, like the previous point, the usability of DEXs will continue to improve as more people and institutions begin using them. There are usually many articles and videos that can help new users navigate a DEX though, and this is especially true for the most popular DEXs.
Most decentralized exchanges work with smaller pools of funds than a mainstream exchange, resulting in lower overall liquidity across the DEX.
This means that prices within the liquidity pools can shift drastically, subjecting users to volatility that they wouldn’t experience in a centralized exchange.
As a DEX grows and the asset inventory is increased, volatility is stabilized since large transactions become less impactful on the liquidity pools.
At this point, DEXs only facilitate crypto-to-crypto transactions. For example, there’s currently no way to use USD to buy ETH on a DEX, or liquidate your crypto on a DEX into a fiat currency to withdraw funds.
Stablecoins are providing something of a workaround for this, though. Since stablecoins like USDC are a cryptocurrency, you can use them as an on- or off-ramp into DEXs.
Depending on where you are, you may be able to use stablecoins for real world purchases or withdraw it into fiat currency.
Does using a DEX make sense?
You should have a better understanding of what a DEX is and how it works now. DEXs are an important part of DeFi, and offer some unique tools that might not be found in centralized or TradFi exchanges.
If you’re interested in crypto but not ready to dive into DEXs just yet, the first place to start is by creating a wallet. Having a wallet allows you to buy, sell, swap and store cryptocurrencies.
Blockchain.com allows you to have a custodial and non-custodial wallet in the same place, so you can self-custody your crypto without having to switch services or apps.
This information is provided for informational purposes only and is not intended to substitute for obtaining accounting, tax or financial advice from a professional advisor.
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