Decentralized Exchange (DEX) Explained

Decentralized Exchange (DEX) Explained Clearly

Table of Contents

What is a decentralized exchange (DEX)? First, you’ll first need to understand how cryptocurrencies work. You see, many cryptocurrencies are mined in one way or another. After they are mined, they can be used for a variety of functions, from voting rights to consensus, and most importantly, they can be traded, sold, or bought. 

The process of trading cryptocurrencies involves transferring them from one cryptocurrency wallet to another cryptocurrency wallet. Now, when we look at this from a traditional standpoint, this was done through the usage of a centralized cryptocurrency exchange. These are known as CEXs for short, and these match the orders of someone who wants to buy cryptocurrencies with someone who wants to sell cryptocurrencies. 

Furthermore, thanks to the amazing returns of investment on altcoins throughout the bull run of 0218, as well as the DeFi boom throughout 2020, a lot more users have been interested in trading cryptocurrencies, and as such, a lot of new, innovative exchange platforms have popped up which provide their own set of benefits for their user-base.

While centralized exchanges were popular, they carried a lot of risks when it came to investors, with billions of dollars in BTC and ETH lost through hacks and scams. Many of them have also drawn the attention of regulators who are impacting the privacy of their users. To address many of these issues, we saw the rise of decentralized exchanges which try to solve many of the issues involved. Before we dive too deep into decentralized exchanges, however, let’s compare them briefly.

  • Decentralized Exchanges allow for a much higher level of security and user-privacy
  • Their level of liquidity depends on the number of users they have
  • The transactions occur through the usage of smart contracts
  • Users have full control over their cryptocurrencies

Centralized Exchange vs Decentralized Exchange (DEX)

However, throughout time, users have seen disadvantages in regard to traditional and centralized exchanges. They are owned privately, and what this means is that there is always a third party involved that has its own motives, and they are in the middle of every single transaction that is made on the platform.

What this means is that these private companies are allowed to see everything about those transactions, and they can gain as well as hold the details across all of their customers. Now, given the fact that cryptocurrencies became vastly popular due to the level of anonymity and privacy they provide to the end-user, this might not be the most appealing way of purchasing, selling, or trading cryptocurrencies for many. Transactions that are conducted on centralized exchanges are also custodial, and this means that the platform holds the asset which is being exchanged.

Discussing a custodial setup, this is one in which the private keys, that are a requirement when it comes to accessing a customer’s funds, are actually held by the service provider. The service provider offers a login account instead. 

These offer ease of use and are extremely efficient, however, they do have risks associated with them. For example, by storing the funds of many customers in a single location, they can become a target for hackers, government censorship, or accidents such as hardware malfunctions which, well, could ruin the day for a lot of users of the centralized exchanges.

Then you have decentralized exchanges, which tackle many of the issues that are imposed by centralized exchanges. They offer complete anonymity, in theory, and non-custodial transactions. In other words, the actual assets which are transferred never pass through the hands of an intermediary.

In fact, non-custodial is a service where the funds, or assets, are not in the custody of a platform or a third party. The whole process occurs through trustless smart contracts instead.



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This is the process through which a complex, self-executing series of code is executed and powers the blockchain network. This gives non-custodial exchanges the ability to be trustless, censorship-resistant, quick, less complex, and generally have a lot fewer risks involved with it.

You see, a custodial exchange can be confiscated, however, a non-custodial one cannot.

Decentralized Exchange (DEX) In-Depth Review

Decentralized Exchanges or DEXs are these autonomous decentralized applications or dApps that allow people who buy or sell cryptocurrencies to do so without using an intermediary or custodian to manage this for them.

They were initially thought of as methods through which any authority that attempts to supervise and prove the trades can be eliminated within an exchange. They would instead be replaced by smart contracts, which is how DEXs operate automated market makers and trades. This allows them to be peer-to-peer. 

A smart contract is this self-executing program with the terms of the buyer’s as well as seller’s agreement which is directly embedded within the code. This program, alongside the agreement that it contains, is distributed across a decentralized blockchain network. Most of the time, this will be done through Ethereum. A smart contract is one that is automatically executed when specific conditions are met, and once this code is executed, it is impossible to reverse or modify. 

These smart contracts essentially enable transactions as well as agreements to be anonymously executed across two or more parties that do not really trust each other, without a reliance on a third-party authority or any external mechanism. 

Moving along, there are multiple types of decentralized exchanges. Each of these has its own specific function, so let’s cover each of them.

First, you have on-chain order books. In these, there are network nodes that are assigned to maintain the record across all of the orders. In other words, miners need to confirm each of the transactions. Then you have off-chain order books, which differ in the fact that the records of the transactions are hosted in a centralized entity. These utilize relayers which help manage the order books. Off-chain order book decentralized exchanges are not fully decentralized as a result. 

Then you have automated market makers (AMM) which do not require order books and utilize smart contracts to form liquidity pools that automatically execute trades based on parameters that are pre-specified. 

Discussing liquidity pools, they are pools of tokens that are locked in smart contracts that provide liquidity within a decentralized exchange. Many decentralized exchanges that end up leveraging liquidity pools make use of automated market maker systems, where on these types of trading platforms, the traditional order book is replaced by pre-funded, on-chain liquidity pools for the assets of the trading pair. 

The main advantage here is the fact that these do not require a buyer and neither a seller to decide to exchange two assets for a specific price and instead they leverage a pre-funded liquidity pool which allows for trades to occur with limited slippage, as long as there is enough liquidity.

Another noteworthy thing here is the fact that the funds which are held in these liquidity pools are actually provided by other users who can earn passive income on their deposits through trading fees. This is based on the percentage of the liquidity pool which they provide.

Decentralized Exchange Advantages

Obviously, one of the main reasons why many cryptocurrency traders opt-in to use decentralized exchanges is due to the vast advantages they provide over centralized exchanges as previously discussed. As such, let us dive a little bit deeper into each of the advantages so you can learn exactly what each of them brings to the table and how each of them works. 

Security

One of the main reasons why centralized exchanges are not recommended by the biggest cryptocurrency traders out there is the fact that they have the potential to be hacked. There have been numerous security breaches in the past, the most infamous one being Mt. Gox, alongside Bitfinex and even Coincheck. They have, as a result, caused massive distrust in the cryptocurrency industry and have caused financial damage to many of their users. 

Hackers stole quite a lot, and as such, many tend to distrust centralized exchanges, unless they truly outshine with their usage of high-level security and have backup plans in place.

However, the custodial way through which centralized exchanges operate is often considered one of the main culprits in putting a target on their backs from hackers. They maintain their liquidity by keeping the funds of their users on the platform itself, it’s just how all of it works. 

On the opposite end of the spectrum, you have decentralized exchanges, which are a lot less susceptible to these types of risks due to the fact that their users have the ability to freely trade on the platform through the usage of both a hot wallet as well as a cold wallet without the need to enter private keys or recovery seeds. 

The user itself is the only one in charge of maintaining the security of their account. Furthermore, stealing from individual users is a lot more costly and difficult, and generally, even if a hacker succeeds, the value they’d get would not outweigh the effort that they would need to put in to do so. By comparison, the value stored in centralized exchanges is a lot higher, so they make a lot more sense to target from the perspective of a hacker.

Privacy

Many people tend to use cryptocurrencies due to the fact that they offer a high level of anonymity and user privacy. However, many if not all centralized exchanges will require users to comply with what is known as the Know Your Customer (KYC) requirement. 

KYC is the process of a financial institution’s obligation to verify the identity of its users. This is a part of measures that are placed to prevent money laundering as well as terrorism financing. It is a standard practice in the investment industry and is commonly found in centralized exchanges due to the fact that they can know specific information about the clients and the users.  This will typically involve information such as a utility bill, identification cards such as a driver’s license or a passport, and an image of the person holding the documents in question.

This in turn will force the holders of cryptocurrencies to give up personal data to the exchange itself. All of a sudden, instead of making an anonymous and encrypted transaction, they have your ID, image, and address. 

Decentralized exchanges on the other hand do not implement this. They are not maintained by any central authority and as such, there is no requirement for any KYC protocols. This provides users privacy when they end up making trades through the usage of a decentralized exchange. Note that this might change in the future, as regulators are constantly looking for ways to enforce KYC onto crypto wallets.

Sovereignty

Sovereignty is essentially the legal right of a user to govern their own funds without any outside interference. In other words, the user has full control over their funds. Through the usage of decentralized exchanges, users have full custody of their funds and are able to use them in any way they see fit. This means that users will not have to be concerned with scenarios such as the exchange freezing their assets, or blocking withdrawals. Keep in mind that not every single decentralized exchange out there will operate in the exact same way, and when you compare them, some of them are semi-decentralized while others are fully decentralized, so make sure you do your due diligence before using one.

However, not everything is perfect, and decentralized exchanges do unfortunately come with their own fair share of disadvantages as well. It is up to you to ultimately decide if the advantages outweigh the disadvantages of using one.

Transaction Speed

Here’s the thing, processing orders on decentralized exchanges is slow due to the fact that the trading calls need to be first broadcasted to the network and then confirmed by the miners themselves before they are fully processed. This is one of the main reasons why the trades conducted on decentralized exchanges have a higher level of price slippage, or in other words, the transactions do not execute due to the changes in the values of the cryptocurrencies which are swapped at the time.

There’s also another concern referred to as front-running where users can initiate trades that have higher gas fees in order for them to be executed a bit earlier than those that are still in the pending phase. 

Liquidity

Liquidity defines how easy it is to convert cryptocurrency into FIAT currency quickly. It also defines if this can be done without actually lowering the asset’s value. It can also be used to enable trades between FIAT and cryptocurrencies to be completed instantly without any price slippage. The level of liquidity will depend on how many users the exchange has. 

All centralized exchanges will achieve a high level of liquidity by having a lot of capital pumped into them. On the opposite end of this spectrum, decentralized exchanges often encounter issues in terms of liquidity due to the fact that their liquidity is reliant on the number of users that actively trade on the platform. They, at times, do not have access to the funds which they can move in order to facilitate the trades. However, the decentralized finance (DeFi) space has created a lot of solutions through liquidity pools which decentralized exchanges can use as a form of liquidity. 

The liquidity pool essentially creates a market for a pair of assets on a decentralized exchange, and when the pool itself is created, a liquidity provider will be able to set the initial price and equal supply of both assets. This concept of an equal supply remains the same for all of the other providers that will provide liquidity to the pool itself.

These liquidity providers need to be incentivized, and they are in proportion to the amount of liquidity that they provide to the pool. When the trade is facilitated, the transaction fee is actually proportionally distributed throughout all of the liquidity providers. Keep in mind that different smart contracts enable use-cases for liquidity pools. 

The Bottom Line

Currently, centralized exchanges make up the majority of market activity, due to the fact that they offer regulatory oversight as well as insurance at times. However, due to the recent growth of DeFi, we have seen an increased room for the development of decentralized cryptocurrency exchange protocol as well as aggregation tools. 

Decentralized Exchange Locked Total Value in DeFi USD
Decentralized Exchange Locked Total Value in DeFi (USD)

You have platforms such as Uniswap, Curve, and others that display the potential for platforms that rely on liquidity providers instead of on order books. Each iteration of a decentralized exchange has attempted to streamline the user experience, but most importantly, all of them have attempted to remove trust in a third party. Decentralized exchanges do not hold the funds of their customers, so even breaches will not put the funds of the users at risk, or expose any sensitive information about the users, which is an extreme benefit. 



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