How do decentralized exchanges (DEX) work?

A decentralized exchange (DEX for short) allows customers to trade cryptocurrencies. Unlike conventional crypto exchanges, however, these are not centrally managed, but are based on blockchain technology. The control of, for example, the order book, but also the merging of purchase and sale orders is decentralized.

What is a DEX?

A decentralized exchange (DEX) is a cryptocurrency trading venue where stakeholders trade directly with each other. Unlike centralized exchanges (CEX), users can trade anonymously on decentralized exchanges and are not dependent on an intermediary third party.

So a decentralized exchange (or DEX) is a peer-to-peer marketplace where transactions take place directly between crypto traders. DEXs fulfill one of the main possibilities that cryptocurrencies or blockchain technology enables: the promotion of financial transactions that are not carried out by banks, brokers or other intermediaries. The most popular DEXs – such as Uniswap and Sushiswap – use the Ethereum blockchain and are part of the growing range of decentralized finance tools that make a wide range of financial services directly available through a compatible crypto wallet.

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How does a DEX work?

Unlike centralized exchanges like Coinbase, DEXs do not allow exchanges between fiat and crypto. Instead, they exclusively trade cryptocurrency tokens against other cryptocurrency tokens. A centralized exchange (CEX) allows you to trade fiat against cryptocurrencies (and vice versa) or crypto-crypto pairs. Trading on a CEX, however, requires a detour via a bank. Often you can also perform more advanced transactions, such as margin trades or limit orders. However, all these transactions are settled by the exchange itself via an “order book”. This sets the price of a specific cryptocurrency based on current buy and sell orders. The same method that exchanges such as Nasdaq use.

Decentralized exchanges, on the other hand, are a set of smart contracts. They algorithmically price different cryptocurrencies against each other and use “pools of liquidity”. There, investors deposit crypto assets in exchange for interest-like rewards. They enable trading and ensure liquidity.

While transactions on a centralized exchange are recorded in the exchange’s internal database, DEX transactions are processed directly on the blockchain.

DEXs are typically based on open source code. This means that anyone interested in the theory can see exactly how they work. It also means that developers can adapt existing code to create new competing projects. Therefore, Uniswap’s code has been adapted from a number of DEXs with “swap” in their names, such as SushiSwap and PancakeSwap.

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What are the advantages and disadvantages of a DEX?

advantage

Anonymity: No personal information is required to use the most popular DEX. Users can shop without having to go through a KYC (Know Your Customer) process.

Large selection: If you’re interested in finding a token that’s still in its infancy, DeFi has you covered. DEXs offer a virtually unlimited selection of tokens, from the familiar to the completely unknown.

Benefit in developing countries: Peer-to-peer lending, fast transactions, and anonymity enabled by DEXs make the decentralized exchanges popular, especially in developing countries. Especially when there is no solid banking infrastructure. Because anyone with a smartphone and an internet connection can trade on a DEX.

No central party: Customers can trade with each other peer-to-peer. Banks, brokers or other intermediaries become redundant. As a result, fees are usually lower than on centralized exchanges. The coins are in your wallet and not on the exchange.

Disadvantages

Customer service: Unlike CEXs, there is usually no support or contact person with DEXs. So if you make a mistake or encounter problems, there are only limited sources of help (eg a community forum).

Warm wallet storage: Since the tokens are in your own wallet, you are responsible for keeping your coins.

Low liquidity: Despite their rapidly increasing user numbers, DEXs are not yet that widespread. As a result, there may be temporary liquidity constraints. Especially on smaller exchanges. However, problems of this type are a rarity and are considered almost solved due to increasing use.

No FIAT crypto exchange: Only cryptocurrencies can be exchanged for other cryptocurrencies on DEXs. An exchange for fiat money is not possible. So you first need to connect a wallet with cryptoassets to the respective decentralized exchange.

You want to know where is the best place to buy Bitcoin and other cryptos?

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