If you are wondering what are decentralized exchanges, you are in the right place. A decentralized exchange (also known as a DEX) is a peer-to-peer exchange where transactions take place directly between cryptocurrency traders.
DEXs put into practice one of the key capabilities of cryptocurrencies: making financial transactions without the need for banks, brokers, payment processors or any other kind of intermediary.
The most popular DEXs – such as Uniswap and Sushiswap – use the Ethereum blockchain and are part of the growing suite of Decentralized Finance (DeFi) applications, which offer a huge range of financial services and are accessible directly from a compatible cryptocurrency wallet.
DEXs are booming as more and more people choose to trade using decentralized exchanges. Just check the chart below to see how the market skyrocketed in less than two years.
What Are Decentralized Exchanges
How Decentralized Exchanges Work
Unlike centralized exchanges like Kucoin or Binance, DEX does not allow exchanges between fiat and crypto – instead, they only allow the exchange of cryptocurrency tokens for other cryptocurrency tokens.
Through a centralized exchange (or CEX), you can exchange fiat for cryptocurrencies (and vice versa) or cryptocurrencies for cryptocurrencies – for example some of your BTC for ETH.
You can also make more complex moves, such as trading margin or placing limit orders. However, all of these trades are handled by the exchange itself through an “order book” that sets the price of a particular cryptocurrency based on current buy and sell orders – the same method used by exchanges like Nasdaq.
Read Also: Best Trading Platform for Cryptocurrency: The Top 8 Crypto Exchanges
DEXs, on the other hand, are simply a set of smart contracts. They determine the prices of various cryptocurrencies relative to each other algorithmically and use “liquidity pools” – in which investors lock up funds in order to earn rewards in the form of interest – to process trades.
While transactions on a central exchange are recorded in that exchange’s internal database, transactions on a DEX are settled directly on the blockchain.
DEXs are usually based on open-source code, meaning that anyone interested can see exactly how they work.
It also means that developers can adapt existing code to create new competing projects – for example, this is how Uniswap’s code has been copied and adapted by a whole host of DEXs with “swap” in their names, such as Sushiswap and Pancakeswap.
What are the potential benefits?
What are the potential disadvantages?
How to Interact With a DEX
You can connect to a DEX like Uniswap using a cryptocurrency wallet like Metamask, Terra Staton, xDefi (for your web browser) or Coinomi (for mobile).
You’ll also need an Ethereum amount to start trading on most DEXs, since this is used to pay transaction fees (aka gas) on the Ethereum blockchain. These fees are separate from the fees its puts on the DEX.
If you are going to use any other blockchain to interact with the decentralized exchange you will need to have a small amount of that coin in your wallet to cover transaction fees.
For example, if you are connecting to pancakeswap, which operates on the Binance Smart Chain, then you will need to have some BNB – Binance’s native token – on your wallet to be able to cover the network’s gas fees.
How do the charges work?
The fees vary. Uniswap has a 0.3% fee that is split between liquidity providers and a protocol fee could be added in the future.
However, it’s important to note that the fees DEXs put up can be very small compared to the fees for using the Ethereum network.
The expected upgrade to Ethereum 2.0 (as well as a number of “layer-2” solutions such as Optimism and Polygon) are also designed in part to reduce fees and speed up transactions.
Why are exchanges decentralized?
Exchanges are decentralized because they avoid a single point of failure.
Exchanges decentralize by distributing data and functions across the network. If one site goes down, there are others to backup the flow of information. The records of all past transactions on an exchange will be stored in different locations, so they cannot all be hacked at once or erased.
A decentralized exchange also gives users more control over their personal data. Large, centralized exchanges have been known to sell user data to third parties or use it for their own marketing purposes. Decentralized exchanges put the power back in the hands of the users, allowing them to choose who has access to their data.
Decentralized exchanges also make it difficult for government agencies to monitor or interfere with trading activity.
In summary, decentralized exchanges offer many advantages over their centralized counterparts. They are more secure, more private, and more resilient to outages or attacks. Decentralized exchanges put the power back in the hands of the users, giving them more control over their data and their trading activity.
Which is an example of a decentralized exchange?
There are many types of decentralized exchanges, but the most common type is the decentralized exchange built on top of the Ethereum blockchain.
These exchanges use smart contracts to facilitate trades between different cryptocurrencies. Some popular decentralized exchanges built on the Ethereum blockchain include Uniswap, Sushiswap, Kyberswap, Bancor, and AirSwap.
In addition to Ethereum-based decentralized exchanges, there are also a few Bitcoin-based decentralized exchanges, such as Bisq.
Other blockchains, such as EOS, NEO and Thorchain also have decentralized exchanges built on them such as Newdex and Switcheo and Thorswap.
How do decentralized exchanges make money?
Decentralized exchanges (DEXs) are a new type of exchange that, rather than being run by a single company, is instead powered by a network of users. This makes them much more secure, as there is no one central point of failure. However, this also means that they don’t make any money – at least, not in the traditional sense.
So how do decentralized exchanges make money? The answer is, they don’t – at least, not directly.
Instead, most DEXs are powered by cryptocurrency called an ERC20 token – built ontop of the Ethereum network.
These tokens are used to pay for transaction fees on the network, and can also be traded on the DEX itself. The value of the tokens is directly linked to the success of the DEX, so as the exchange grows in popularity, the value of the tokens should increase.
This gives users a incentive to hold onto the tokens, rather than selling them for a quick profit, which helps to keep the exchange running smoothly.
Of course, there are always exceptions to the rule. Some DEXs do charge small listing fees for new tokens, and there are also a handful of ‘ hybrids’ which combine elements of both centralized and decentralized exchanges.
Are decentralized exchanges legal?
Depends on who you ask. Decentralized exchanges are not the same as a regular cryptocurrency exchange, which require an individual to hold all of their own assets and those of others in custody.
Decentralized exchanges do not use third-party custodians in any way at all! However, for some governments, decentralized exchanges may be considered illegal because they may facilitate illegal activities.
Other governments may have different interpretations. If you are unsure whether or not decentralized exchanges are legal in your jurisdiction, we recommend that you seek professional legal counsel.
People have not been prosecuted for using a decentralized exchanges, neither a decentralized exchange was shut down by authorities – as of today.
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