What Are Decentralized Exchanges (DEX) And How They Work

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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 Decentralized Exchanges (DEX) And How They Work
-Sushiswap’s homepage

What are the potential benefits?

  • Great variety: If you’re interested in finding a popular token when it’s first released, a Decentralized exchange is the place for you. DEX offers an almost limitless range of tokens, from the well-known to the most bizarre and completely unknown. This is because anyone can create a token and create a liquidity pool for it, so you’ll find a wider range of projects, some trustworthy and some not. (It takes a lot of care for those buying to do good research that the project is trustworthy and not a scam!)
  • The risk of a hack can be reduced: Because all the money in a transaction on a DEX is stored in the wallets of traders/users, it is theoretically less vulnerable to a hack. Similarly, DEXs also reduce what is known as “counterparty risk”, which says that one of the parties involved in a non-DeFi transaction – including possibly the central authority (e.g. bank) might default on the deal.
  • Anonymity: You are not required to provide your personal information to use the most popular DEXs.
  • No personal information is required: Your personal details are not required. Most of the most popular DEXs are not required.
  • Useful tool for developing countries: The peer-to-peer lending, fast transactions and anonymity that DEX has made possible make it increasingly popular in developing economies – where there may not be any stable/reliable banking infrastructure available. Anyone with a smartphone and an internet connection can make transactions through a DEX.

What are the potential disadvantages?

  • Most difficult to use: Navigating DEXs requires some specialist knowledge and their interfaces are not always easy to use – be prepared to do a lot of research and don’t expect the DEX itself to offer much help. In general, you should look outside DEX for a guide or explanations. You need to be careful, because it’s possible that you’ll make a mistake that you don’t correct, such as sending coins to the wrong wallet. Another common problem is known as “impermanent loss” which can result from pairing a fairly volatile cryptocurrency with a less volatile one in a liquidity pool.
  • Smart contract vulnerability: every DeFi protocol is as secure as the smart contracts that power it – and the code may have vulnerabilities (despite thorough testing) that can lead to the loss of your tokens. And while a smart contract can work as intended under normal circumstances, not all rare events, human factors and breaches can be anticipated by developers.
  • Higher-risk coins: With the unlimited, huge range of tokens available in most DEXs, there are also a greater number of scams and that to watch out for. A token that is on a big rise could suddenly do a so-called “rug pull” where the creator “creates” several new tokens, flooding the liquidity pool and knocking down the token’s price. Before you buy a new-to-you cryptocurrency or experiment with a new protocol, it’s important to learn as much as you can about it – read their white papers, visit their Twitter or Discord/Telegram channels they have and look for a published audit for any particular project you’re interested in (some of the biggest auditors are Certik, Consensys, Chain Security and Trail of Bits).

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.

What Are Decentralized Exchanges (DEX) And How They Work
– Two people exchanging money. A Representation of a peer-to-peer exchange.

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.

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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