Decentralized exchanges (DEXs) are peer-to-peer marketplaces where crypto traders can conduct transactions without involving any third parties such as banks, brokers, or payment processors.
The most widely used DEXs like Uniswap and Sushiswap use the Ethereum blockchain and belong to the expanding set of DeFi tools that offer a variety of financial services directly from compatible crypto wallets.
In early 2021, $217 billion in transactions went through decentralized exchanges, demonstrating their increasing popularity. By April 2021, the number of DeFi traders had grown to over two million, representing a ten-fold increase from May 2020.
How do Decentralized Exchanges (DEXs) work?
Unlike centralized exchanges(CEXs) such as Coinbase, DEXs only enable the exchange of one cryptocurrency token for another. Through a CEX, it is possible to trade both fiat-crypto and crypto-crypto pairs – e.g. exchanging some bitcoin for ETH. Additionally, more complex activities such as margin trading and setting limit orders are also possible on these exchanges. The prices of cryptocurrencies are determined by an “order book” which records all buy and sell orders – just like stock exchanges like Nasdaq do.
In contrast, decentralized exchanges are composed of automated protocols. They calculate the values of different digital currencies with respect to one another algorithmically and deploy “liquidity pools” — where investors secure their assets in order to gain a return similar to interest — in order to allow trades.
Transactions on a centralized exchange are registered in the exchange’s internal system, but those on a DEX are finalized directly onto the blockchain.
DEXs are typically based on freely available source code, allowing anyone to understand their inner workings. As a result, developers can take existing code and customize it to create new rival projects – this is how Uniswap’s code has been used as the foundation for multiple DEXs with “swap” in their titles such as Sushiswap and Pancakeswap.
What are potential benefits of using a DEX?
There is a big selection: If you are trying to discover a new asset in the early stages, DeFi is the ideal place. Decentralized exchanges offer a seemingly endless variety of tokens, from famous ones to the more unusual and strange. This is because anyone can produce an Ethereum-based token and make liquidity for it, so you will find a great variety of projects that have been inspected and those that have not. (It’s important to be cautious when making purchases!)
Risks associated with hacking can be minimized: due to the fact that all of the funds in a DEX trade are kept in the traders’ own wallets, it is assumed that they would be less vulnerable to being hacked. (This also reduces what is referred to as “counterparty risk,” which means that one of the parties taking part in a non-DeFi transaction, potentially including the central authority, might not fulfill their obligations.)
Anonymity: No identifying details are necessary to utilize the majority of DEXs.
Utility in the developing world: DEXs offer advantages such as peer-to-peer lending, rapid transactions, and anonymity, which make them attractive in countries where banking systems may not be reliable. All that is required to use a DEX is a smartphone and internet access.
What are the possible disadvantages?
Trickier user interfaces: Using decentralized exchanges can be tricky and the user interfaces are often complicated, so doing research is essential. Don’t expect the DEX to provide much help — you will likely have to look elsewhere for instructions or an explanation. It’s important to be cautious because mistakes like sending coins to an incorrect wallet may not be reversible. Another potential problem is called “impermanent loss,” which occurs when a more volatile cryptocurrency is combined with a less volatile one in a liquidity pool.
Smart contract vulnerability: No matter how secure a DeFi protocol is, it can still be vulnerable to bugs in the smart contracts that power it. Even after extensive testing, these flaws can cause users to lose their tokens. Developers may be able to anticipate many potential issues, but there are some rare events, human errors and hacks that cannot be foreseen.
Coins that involve more risk: With the multitude of tokens available on most DEXs without any vetting, there are also more chances for scams and schemes. A token that is doing well could suddenly be “rug pulled,” when its creator prints a large amount of new tokens, which can flood the liquidity pool and cause the coin’s value to decline. Before investing in an unfamiliar cryptocurrency or trying out a new protocol, it is important to research it thoroughly – read white papers, follow developer activity on Twitter feeds or Discord channels, and check if there have been audits done by bigger auditors such as Certik, Consensys, Chain Security and Trail of Bits.
How do you interact with a DEX?
- You can connect to a DEX like Uniswap using a crypto wallet such as Coinbase Wallet in either your web browser or on your smartphone. If you are just getting started we recommend using the Coinbase dapp wallet, available directly within your Coinbase app
- You’ll also need a supply of Ethereum to start trading on most DEXs, which you can get from an exchange like Coinbase. The reason you need some ETH is for paying fees (known as gas) that are required for any transaction that happens on the Ethereum blockchain. These are separate from the fees the DEX itself charges.
How do DEX fees work?
Uniswap levies a 0.3% fee which is shared among liquidity providers, while a protocol fee could be implemented in the future. However, the fees charged by the DEX can be much less than those of Ethereum’s gas fees. ETH2 upgrade and other layer 2 solutions like Optimism and Polygon are being developed to reduce fees and accelerate transactions.
