A decentralized exchange (DEX) is a digital currency exchange that allows users to buy crypto through direct, peer-to-peer cryptocurrency transactions, all over a online platform without an intermediary. It differs from a traditional centralized exchange, where a typical transaction involves a third-party entity (e.g. bank, trading platform, government institution, etc.) that takes custody of user funds, and oversees the security and transfer of assets between two parties.
Decentralization is a fundamental philosophy of blockchain technology and the crypto space. It redistributes authority from a central power, and places it in the hands of users. And the concept of decentralization is reengineering how many conventional financial services operate.
Decentralized exchanges have also grown in popularity over the past couple of years, with spot trading volume slowly shifting away from centralized exchanges, up until early 2022, when “crypto winter” set in.
|Spot Trading Volume Percentage, DEX vs. CEX|
How a Decentralized Exchange (DEX) Works
Decentralized exchanges provide a decentralized platform that allows users to exchange assets without having to trust their funds with another entity.
With a decentralized exchange, a blockchain, or distributed ledger, takes the place of the third party. By moving critical operations onto a blockchain, the underlying technology may help to eliminate single points of failure, allowing users to have greater control of their assets, and support safer and more transparent trading.
DEXs use smart contracts to execute market transactions by allocating transactions’ operations to autonomous code, but there are multiple variations of order fulfillment with differing degrees of decentralization.
Like digital currencies, decentralized exchanges were created in response to flawed and archaic financial systems that passed along risks of a centralized system to its users. Those risks often include insufficient security, technical issues, and a lack of transparency.
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Different Types of Decentralized Exchanges
Full decentralization is more of a philosophy than a rule of thumb, as it’s not very practical based on first-layer blockchain scalability limits. As a result, most decentralized exchanges are actually semi-decentralized, using their own servers and off-chain order books to store data and external programs or entities for the exchange of user assets.
Due to this reliance on centralized components, semi-decentralized exchanges’ operations may be subject to government oversight. However, and perhaps most importantly, users still maintain control of the private keys to their funds.
Although DEXs continue to evolve and operate cross-chain with other DApps, DEXs typically operate a single blockchain. One thing all decentralized exchanges have in common is that they execute orders on chains with smart contracts, and at no point do they take custody of users’ funds.
|The Different Types of DEXs|
|On-Chain Order Books||Processes transactions on a blockchain network, without the inclusion of a third-party|
|Off-Chain Order Books||Utilizes an off-chain, centralized entity to process transactions and govern the order book|
|Automated Market Makers||Uses algorithms to automatically price asset pairs in real-time|
|DEX Aggregators||Compile data from numerous DEXs to increase options and liquidity for traders|
On-Chain Order Books
For some decentralized exchanges, transactions are processed on-chain, including modifying and canceling orders. Philosophically, this is the most decentralized and transparent process, because it circumvents the need to trust a third party to handle any orders at any time. However, this approach is not very practical in execution.
By placing all stages of an order onto the blockchain, DEXs go through a time-consuming process of asking every node on the network to permanently store the order via miners, as well as pay a fee.
Some criticize the decentralized crypto exchange model because its slow transaction times allow for front-running, which is when an investor watches the price of an asset closely, waiting at the last minute to buy or sell right before they anticipate the price rising or falling. (Note that this type of “front-running” is different from stock front-running, where an investor purchases a security based on insider information, such as a future event that will impact stock price.)
Others counter that since all orders are published on a public ledger, there is no exclusive opportunity for any select individual to front-run from a traditional perspective. However, it has been questioned whether a miner can front-run by noticing an order before it’s confirmed and force their own order to get added to the blockchain first.
Off-Chain Order Books
DEXs with off-chain order books are still decentralized to some degree, but are somewhat more centralized than their on-chain counterparts. As opposed to orders being stored on the blockchain, off-chain orders are posted elsewhere, such as a centralized entity that governs the order book. Such an entity could exploit access to the order books to front-run or misrepresent orders, however, users’ funds would still be protected from the DEXs non-custodial model.
Some ERC-20 tokens on the Ethereum blockchain provide a DEX that operates similarly. Though some degree of decentralization is sacrificed, a DEX can provide a framework for parties to manage off-chain order books through smart contracts. Hosts can then access a larger liquidity pool and relay orders between traders. Once the parties are matched, the trade can be executed on-chain.
These models can be more advantageous for users than relying on slower on-chain order books. With less congestion and quicker confirmation times caused by primitive blockchain iterations, off-chain order books can provide faster speeds.
Automated Market Makers (AMM)
An automated market maker (AMM) reinvents order books with pricing algorithms that automatically price any asset pairing in real-time (e.g. Bitcoin-U.S. dollar).
Unlike traditional market-making, whereby firms provide an accurate price and a tight spread on an order book, AMMs decentralize this process and allow users to create a market on a blockchain. No counterparty is needed to make a trade, as the AMM simply interacts with a blockchain to “create” a market. Instead of transacting directly with another person, exchange, or market-maker, users trade with smart contracts and provide liquidity. Unfortunately, there are no order types on an AMM because prices are algorithmically determined, resulting in a sort of market order.
As with other DEX models, an on-chain transaction must occur to settle any trade. As opposed to some DEXs, AMMs tend to be relatively user-friendly and integrate with popular cryptocurrency wallets.
DEX aggregators are precisely what they sound like: aggregators that compile various trading pools. Their main advantage is that they can increase liquidity for traders, particularly for those who are looking to expand their options or trade smaller tokens.
How these aggregators work is similar to a search engine, in that they compile and accumulate information and data from different exchanges to give users more options.
Tips for Using Decentralized Exchanges
Using a DEX has its advantages and risks. While you’re likely using a DEX for its advantages, it’s important to keep those risks in mind. Perhaps most importantly, remember that decentralized exchanges are, for all intents and purposes, operating off the radar and outside of regulatory authorities.
Also remember that as the popularity of DeFi as a whole grows, so too will the use of DEXs, and their features and functions. These are changing platforms and technologies, so do some research to make sure you know what you’re doing, and that you’re keeping your keys, phrases, and assets safe.
Pros of Decentralized Exchanges
There are many reasons fans and followers of crypto have embraced decentralized exchanges. These are some of the pros of decentralized exchanges:
No KYC/AML or ID Verification
DEXs are trustless, meaning users’ funds, privacy, and limited personal data are well preserved. Decentralized exchange users can easily and securely access a DEX without needing to create an on-exchange account, undergo identity verification, or provide personal information.
No Counterparty Risk
Because users don’t have to transfer their assets to an exchange (or third party), decentralized exchanges can reduce risks of theft and loss of funds due to hacks. DEXs can also prevent price manipulation or fake trading volume, and allow users to maintain a degree of anonymity due to a lack of Know Your Customer (KYC) cryptocurrency rules and regulations.
All Tokens Can be Traded
With a DEX, users can trade new and obscure cryptocurrencies that may be difficult to exchange elsewhere. Typically, centralized exchanges only support a dozen or so projects, and most only support the most popular cryptocurrencies, making smaller and less popular tokens more difficult to trade, especially as those exchanges restrict users from other countries.
Reduced Security Risks
As mentioned, decentralized exchanges may be more secure than their centralized counterparts. That’s because no single entity is in charge of assets, and instead, smart contracts and decentralized applications (dApps) automate transactions. It’s all handled by users, in other words, making it very difficult for a hacker or bad actor to infiltrate a centralized pile of assets and steal them.
That said, a bad or poorly developed smart contract could cause issues, which is something to be aware of.
Utility in the Developing World
Many parts of the world lack basic financial services, nevermind access to the crypto markets. That’s another pro for DEXs, which can be used by individuals anywhere in the world regardless of financial infrastructure.
In fact, DEXs may be the most beneficial to users in the developing world, giving businesses a way to transact assets without the need for a third party, where those parties may not be available or willing to operate.
Cons of a Decentralized Exchange
While decentralized exchanges offer some groundbreaking benefits, they also come with a few drawbacks.
Specific Knowledge Is Required
There’s no getting around it: You’ll need to know what you’re doing, at least to a degree, to use a decentralized exchange. Centralized exchanges exist for a reason: They’re relatively easy to use, and handle most of the complicated stuff for users. But when using a DEX, it’s all on the user. There’s no hand-holding, and as such, you’ll want to be confident that you know the ropes before using a DEX.
Smart Contract Vulnerabilities
Another thing we previously mentioned is the fact that smart contracts may be poorly constructed, leading to problems on a DEX. A smart contract is only as smart as the person or entity that created it, and there’s no guarantee that it will work as hoped all of the time.
Smart contracts themselves are similar to bits of code or commands that automate a process, and if there’s an error in the smart contract, it could produce unanticipated results.
No Recovery Ability
Unlike centralized exchanges run by private companies with employees, DEXs fundamentally have no recovery ability for lost, stolen, or misplaced funds. Due to a lack of a KYC process or ability to cancel a transaction in the event of a compromised account or loss of private key, users are unable to recover data or be returned their assets.
As discussed, there is no support team or help hotline to notify of missing funds or a lost private key, as users themselves are in control of the process. Because all transactions are processed and stored in smart contracts on the blockchain without any owners or overseers, refunds are incompatible with the network’s model and users are generally unable to regain access to their assets.
Unvetted Token Listings
The crypto space is rife with scams and junk tokens, and given that there’s no central authority in a DEX, it’s relatively easy for some of those junk tokens or coins to find themselves in the listings. Put another way: There is little or no vetting process for what’s listed on a DEX (though it may differ from exchange to exchange). Making sure you’re not falling for a scam coin, then, is on the user.
Many traders prefer centralized services with a greater liquidity pool, choice of instruments, currency pairs, and order types. Decentralized exchanges usually have lower liquidity than centralized platforms because they are newer and smaller, with a smaller potential client base (since DEXs are more difficult to use than CEXs). Yet, paradoxically, they must also attract new users to generate more liquidity.
Transactions take time to be checked and validated on a blockchain network, and the processing speed depends on the network’s miners or validators, not the exchange itself.
Limited Trading Functionality
Decentralized exchanges tend to focus on executing simple buy and sell orders. As such, users may find advanced trading functions such as stop losses, margin trading, and lending are unavailable on most DEXs.
DEXs have suffered from the same network congestion issues relating to scalability issues as their underlying blockchain networks like Ethereum. Ethereum’s first network iteration, like other blockchains, was built to function securely at a smaller scale before scaling solutions were later implemented. Though a transformative network upgrade designed with massive scalability solutions has been in development since 2018, DEXs remain subject to first-layer network transaction ceilings.
Challenges to DEX Adoption
With sophisticated technology, potentially fewer blockchain security risks, and the ability to self-custody funds, further adoption of decentralized exchanges seems likely. But DEXs, for the most part, remain out of the mainstream. Despite the launch and rise in popularity of numerous DEXs within the past few years, some factors may slow down adoption.
Many investors may lack awareness surrounding:
• The security risks of centralized exchanges
• Self-custody as a security option
• How to securely self-custody funds (managing private keys)
• The existence of decentralized exchanges
• The advantages of decentralized exchanges
DEXs also present a few technical barriers to entry:
• Not user-friendly enough
• Network congestion during periods of high volume
• Transactions on current network iterations take time to be validated on blockchains
• High transactions fees during periods of high volume
• Users will only join a DEX with high liquidity
• Cross-chain interoperability must exist for DeFi platforms to interact with each other
• The need for fiat on-ramps and less volatile token prices
Decentralized exchanges are a trustless solution that allows users to buy and sell cryptocurrency without roping in a third party. Though full decentralization is not yet a reality, different types of DEXs provide varying levels of security, privacy, and efficiency from which crypto traders can choose.
As DEXs continue to develop, evolve, and become more practical for users, user adoption may become a focal point as DEXs look to offer greater liquidity. The good news is that DEXs present only one of numerous ways to get involved in the crypto space.
How do DEX fees work?
A DEX facilitates peer-to-peer trading, and levies network fees in order to facilitate those transactions. While fees from DEX to DEX may vary, they differ from centralized exchanges, which may charge trading fees or commissions for executing transactions.
What’s the difference between a decentralized exchange (DEX) and a centralized exchange (CEX)?
A decentralized exchange allows individual users to connect and transact assets without a third party. A centralized exchange, conversely, acts as a third party and takes custody of funds or assets during the transaction. The key difference is that a CEX acts as a central authority.
Are decentralized exchanges legal?
Yes, DEXs are legal, though they do operate in something of a gray area (like most of the crypto space) in that they’re unregulated by a central government authority. Some exchanges may be illegal in certain jurisdictions, too. That may change in the future, though, as regulators outline plans and potential rules for the crypto space.
How can I create a decentralized exchange?
If you want to create your own DEX, you’ll need a lot of background knowledge involving blockchain architecture and more. You would need to know how to code, identify key features that your DEX would have, and much, much more. You’re likely better off using an existing DEX, rather than creating one from scratch.
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