As a crypto trader or investor, exchange plays a vital role in trading your assets. As a result, exchanges assumed responsibility for connecting buyers and sellers. Moreover, crypto trades would be impossible and inefficient without a medium to facilitate the trade.
Exchanges act as a marketplace for trade, thereby assisting in the widespread adoption of cryptocurrency and blockchain technology. However, third-party participation undermines the technology's core tenet –decentralization. To combat third-party and centralized exchange participation, decentralized cryptocurrency exchange emerges.
What is a Decentralized Exchange (DEX)?
A decentralized exchange (DEX) is a peer-to-peer (P2P) exchange where buyers and sellers exchange crypto assets directly. Put simply, DEX allows users to buy and sell crypto assets with one another without the need for a central authority. Furthermore, unlike centralized exchanges (CEX), DEX platforms are non-custodial, allowing users to have control of their private keys when using the platform to carry out transactions.
DEX uses on-chain data and relies on self-executing smart contracts to keep track of every transaction and access the blockchain without a centralized authority. This means trading takes place on a DEX using smart contracts and on-chain data, and each transaction is recorded on the blockchain. Although DEX projects require developers to support automation, they do not need a centralized exchange to act as a middleman.
How Does DEX Work?
DEX operates autonomously using smart contracts. As a result, there is no need for a third party because the smart contract is self-executing and allows direct trade between buyers and sellers. However, to reduce the possibility of cryptocurrency price imperfections, decentralized exchanges use Automated Market Maker protocols to configure the price of each cryptocurrency. Hence, the operation of a DEX decentralized exchange is hugely reliant on its design.
Automated Market Maker
AMM are protocols that automate and govern the process of liquidity provision. This is a DEX protocol in which a mathematical formula determines prices. Instead of using an order book like traditional exchanges, asset prices on DEX are determined by a pricing algorithm. Smart contracts in AMM-based DEX leverage on liquidity pools. A liquidity pool is a smart contract held within a community-driven pool of various paired tokens. Liquidity pools are pre-funded asset pools that play an essential role in the operation of AMM-based DEXs. AMMs do not require counter-parties to execute trades because such transactions take place through a pool of various paired tokens.
DEX Aggregator
A decentralized exchange aggregator is a type of trading protocol that sources and routes liquidity across multiple DEXs based on predefined requirements rather than serving traders solely from its liquidity pools. This means DEX aggregators are not required to service traders strictly from their own liquidity pools.
DEX aggregators also strive to protect users from pricing impacts and reduce the likelihood of failed transactions. Some DEX aggregators also use liquidity from centralized platforms to provide a better user experience while maintaining their decentralized nature.
Consequently, as decentralized exchanges are built on blockchain networks that enable smart contracts and where users retain custody of their assets, each trade incurs a cost. As a result, users of the DEX are typically charged two types of fees: network and trading. Network fee goes to the underlying protocol for the on-chain transaction, while trading fees are collected by its liquidity providers, token holders, or a combination of both.
Advantages of DEX
Anonymity and Privacy
No central server stores the data of the users exchanging assets, lowering the risk of data theft or unauthorized access by a third party. As a result, users are not required to go through registration procedures and Know Your Customer(KYC) processes. Hence, users who trade assets on a DEX remain anonymous because all transactions are encrypted, and users' identities are limited to their wallet numbers.
Enhanced Security and Protection
One of the significant advantages of DEX is that it does not control its users' funds. In addition, because there is no third-party involvement with DEX, users have better asset security because the private key is in their possession.
Also, DEXs operate on the same network of interconnected computers as a blockchain network. As a result, they are well-protected against hacking or computer attacks that could endanger the security of user funds.
Zero Counterparty Risk
The main advantage of decentralized cryptocurrency exchanges is that they do not hold customer funds. Counterparty risk occurs when the other party in a transaction fails to fulfill its part of the bargain and breaches its contractual obligations. This risk is eliminated because decentralized exchanges operate without intermediaries.
Token Availability
Tokens not listed on centralized exchanges can still be freely traded on DEXs as long as supply and demand exist. This means DEX can list any token created on the blockchain upon which they are built, implying that new projects will likely list on these exchanges before centralized exchanges.
Risks Associated with DEX
Not Beginner Friendly
The DEX platform can be confusing and difficult to use at first if you are new to the platform. As a result, expert user guidance or instruction is almost always required to understand them and begin operating on them.
Liquidity Risk
The most important aspect of an exchange platform is liquidity, which results in low spreads. Unfortunately, a DEX typically has little liquidity because it lacks manipulation capacity, resulting in significant slippage and a suboptimal user experience. Also, you may be unable to locate the trading pairs you require, and sometimes assets may not trade at a fair price.
Smart Contract Risk
Smart contracts on blockchains are open to the public, and anyone can examine their code. Exploitable bugs in smart contracts may evade thorough audits and code reviews. As a result, auditors may find it difficult to predict possible new exploits that could cost liquidity providers their tokens.
Slow Transaction Speed
Transactions are processed slowly because trading calls must be communicated to the blockchain network for miners to confirm before they can be processed. As a result, traders are more likely to experience price slippage, which occurs when a transaction fails to exchange due to a change in asset value.
Final Takeaway
The most notable feature of DEXs is that they do not entrust responsibility for managing your funds to custodians or intermediaries. This means DEXs are self-contained decentralized applications (dApps) that allow cryptocurrency buyers and sellers to trade without giving up control of their funds. For example, an atomic swap can be considered a DEX because it uses a similar peer-to-peer swapping concept.
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