What Are Decentralized Exchanges?

What is a decentralized exchange? Learn how it works and why they are so important in the growth of cryptocurrency.

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As cryptocurrency enters the mainstream, you’ve likely heard the term decentralized exchange. But what are decentralized crypto exchanges and how do they work? Decentralized exchanges, also referred to as DEXs, are peer-to-peer (P2P) digital currency exchanges that allow users to trade with each other directly and securely without the use of an intermediary. 

The financial sector operates using several different types of active exchanges, and in recent months, DEXs have shown tremendous growth compared to other exchanges. This growth is exhibited not just in the number of exchanges but also in the volume of trading done on the exchange. A recent report from Chainalysis found that the monthly trade volume on DEXs increased from $10 billion in July 2020 to $368 billion in May 2021. The report points out that the popularity of DEXs “coincides with the explosive growth of the DeFi category in general.”  Currently DEXs see anywhere between $5-$15B in daily volume. 

Whether you’re just looking to brush up on your DEX knowledge or are new to the term, we’ll walk you through everything you need to know about decentralized exchanges.  

Decentralized Exchanges vs. Centralized Exchanges

The main difference between decentralized exchanges and centralized exchanges is that a decentralized exchange has no intermediary between traders, whereas a centralized exchange is the intermediary.

In a decentralized exchange, smart contracts facilitate trade orders. These are programs stored on the blockchain that run automatically when certain conditions are met. Smart contracts allow trades to occur without an intermediary because the process is automated based on pre-existing rules that actors on both sides of the trade accept. Traders control their funds within their wallets and must take full responsibility for where they send funds and keeping private keys safe. 

When using a centralized exchange, the platform itself facilitates the trading of cryptocurrency. Centralized exchange markets operate an order book where buyers and sellers offer prices they are willing to pay or receive and trades are executed when the price of a buyer and seller match. These exchanges are often easy-to-use, regulated, and function as a trusted intermediary. Centralized exchanges encompass every aspect necessary for digital trading. They offer access to digital assets, hold traders’ funds and keep them safe, ensure fair market pricing, and abide by regulatory compliance.

To help you become more familiar with the specifics of a decentralized exchange, we’ll now go over the various types available to traders. 

Types of Decentralized Exchanges

There are multiple types of decentralized exchanges available, and each operates in its own way. Four commonly used DEXs architectures are automated market makers (AMMs), DEX aggregators, on-chain order books, and off-chain order books.

Automated Market Makers (AMMs)

Automated market makers are decentralized crypto exchanges that effectively remove all intermediary involvement in the crypto trading process. Instead of using order matching systems or order books, automated market makers (AMMs) rely on autonomous protocols. 

These autonomous protocols use liquidity pools in the place of a traditional buyer and seller market. So, instead of the trade occurring between a buyer and a seller, on an AMM platform users trade against a liquidity pool.

Automated market maker platforms create liquidity pools by incentivizing liquidity providers to supply the pools with assets, namely tokens. Users of the DEX voluntarily contribute assets to the liquidity pool. And in return for providing tokens to the pool, these users typically earn a fee. 

A mathematical formula determines the price of the tokens in the pool and works to support as much balance as possible. However, if large amounts of a token are added or removed from the liquidity pool, it can result in a discrepancy between the market price and the token’s pool price. 

DEX Aggregators

Another type of decentralized exchange is a DEX aggregator. DEX aggregators are platforms that aggregate liquidity by sourcing it from several DEXs. Data is accumulated from multiple DEXs and complex algorithms are used to calculate and determine the best trade, in seconds. In cases where split trades provide the best price, aggregators can facilitate the trade.

On-Chain Order Books

Decentralized exchanges that use on-chain order books process everything on the blockchain. This includes any order modifications or cancelations. While this results in a highly transparent process, it is also rather time-consuming. Although, newer on-chain order books like Serum, improve the speed of transactions. The technology behind Serum’s central limit order book (CLOB) allows users to trade with each other inexpensively and in a trustless, non-custodial way. 

DEXs with on-chain order books may allow funds to stay in users’ wallets. This has the advantage of allowing traders to leverage their trades with borrowed funds from platform lenders. While this can increase earning potential, it also increases liquidation risk. 

Off-Chain Order Books

Although off-chain order books are still considered decentralized, these DEXs are more centralized than on-chain order books. Instead of storing orders on the blockchain, off-chain order books store orders elsewhere.

This practice may reduce costs and improve speed. Off-chain order books allow traders to leverage their trades by lending to other traders. In return, these funds earn interest, and the exchange secures them. It is important to keep in mind that off-chain order books can also pose liquidity risks.  

How to Use DEXs

To use DEXs, a user must simply connect a pre-existing crypto wallet to the decentralized exchange or use a wallet with DEX capabilities. The lack of an intermediary means you are not required to register or go through any KYC (know your customer) processes. All you need is a smartphone or a computer that is connected to the internet. 

First, determine which exchange platform you want to use. Each platform typically has its own set transaction fee, so it is wise to consider this when selecting your exchange. Next, you’ll want to ensure your wallet is compatible with the exchange. Finally, you’ll need to fund your wallet with the platform’s native token.  

The initial funds you need in your wallet will be used to cover “gas fees” that are in addition to any transaction fees the DEX charges. These gas fees pay miners for every blockchain transaction.  

You have the option of using a wallet extension that enables you to access your funds from your browser. These extensions are user-friendly and can be installed the same way other extensions are. If you have an existing wallet, you can import it, and if you don’t, you can simply create a new wallet. 

There are both advantages and disadvantages of using a DEX. Keep reading to find out what they are. 

Advantages of Using a DEX

There are multiple advantages of using a DEX: 

  • Privacy: DEXs afford users increased privacy as compared to centralized exchanges. A decentralized exchange is an environment that does not require any of the usual identification processes. Instead, there is an anonymous exchange of cryptocurrency.
  • Lower cost: The transaction fees incurred on DEXs are usually lower than those charged on centralized exchanges. This makes decentralized crypto exchanges more appealing to traders. 
  • Reduced risk of hacking: A welcome byproduct of the peer-to-peer nature of decentralized exchanges is a reduced risk of hacking. No assets are transferred to an exchange, which reduces the risk of theft or fund loss.
  • Full control of funds: Additionally, users always retain full control of their funds.
  • Ability to trade all tokens: While centralized exchanges may support a handful of the most popular cryptocurrencies, decentralized exchanges allow users to trade all tokens, including the latest obscure cryptocurrencies.

Disadvantages of Using a DEX

While the advantages of DEXs are many, there are some disadvantages to consider when deciding to use a DEX. The main concerns are:

  • Lower liquidity: Currently, DEXs offer lower liquidity than centralized exchanges. As more users adopt them, however, the liquidity should improve.
  • Impermanent loss: Decentralized exchanges expose you to impermanent loss. This occurs when the ratio of tokens in the liquidity pool shifts and causes asset price changes. Upon withdrawing tokens, your deposited assets are worth a lower dollar amount than when you deposited them. 
  • Not able to recover funds: While the lack of a KYC process can be an attribute, when it comes to recovering lost, misplaced, or stolen funds, this is a hindrance.
  • Less user-friendly: Decentralized exchange interfaces are not as easy to navigate as other exchanges. Some require specialized knowledge and rarely do DEXs offer guidance. You’ll need to do your own research to understand how to use these exchanges and avoid making any costly mistakes.
  • Vulnerability of smart contracts: Decentralized exchanges function using smart contracts. This code may function properly nearly all the time, but it is not infallible. Code has the potential to be exploited by bugs that were not anticipated by developers. 
  • Coin scams: While having access to a wide variety of tokens is desirable, unvetted coins pose a scam risk. Coin prices can be manipulated and it’s important to thoroughly vet any tokens you are not familiar with to avoid loss of funds. 

The Future of Decentralized Exchanges

As decentralized finance continues to move at light speed, the future of decentralized exchanges is tremendously bright. A decentralized exchange has the potential to deliver all the conveniences of centralized exchanges at an increased speed and in a trustless, censorship-resistant environment. While there are still advances to be made, DEXs will serve as an integral part of the evolution of DeFi. 

As a recent Forbes article states, “The open source, peer-to-peer nature of the blockchain opens financing possibilities never imagined.” One motivating component driving decentralized finance forward is the reality that protocols on the blockchain can integrate easily with other protocols. This is something that cannot be done using centralized finance. 

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While scaling transactions on a blockchain presented the largest bottleneck previously, progress over time has been exponential. The ambition clearly exists to be able to service millions of users with decentralized crypto exchanges and DeFi in general. 

People Also Ask About

How to Invest in DeFi?

There are multiple ways to invest in DeFi: 

  1. Purchase a coin or token that uses DeFi technology. 
  1. Stake a DeFi lending platform by depositing cryptocurrency into the platform and earning interest on the holdings. 
  1. Deposit funds to the DeFi platform that pays the highest interest rate and continuously move the funds to the platform with the best incentives. This type of investing is called yield farming. 
  1. Lend your crypto to other users on the platform and earn interest. 
  1. Invest in the DeFi network, application, or protocol itself.  

What Is DeFi and Why Do We Need It?

DeFi stands for decentralized finance, and it is the blockchain-based system that enables applications ranging from cryptocurrencies to financial services. With DeFi, two parties can interact peer-to-peer without an intermediary.

We need DeFi because, over time, we’ve experienced the flaws in centralized finance and decentralized finance offers a forward-thinking solution. DeFi benefits include:

  • Allowing more people to access financial services  
  • Lower transaction rates 
  • Improved costs interest rates 
  • Increased security 
  • Greater transparency 

While DeFi may not yet be ready for mainstream usage, it is evolving rapidly and becoming more user-friendly.   


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