One of crypto’s most interesting innovations is the decentralized exchange (DEX). As the name implies, DEXs allow users to trade with each other without having to first deposit their funds with a centralized entity.
And with the recent combustion of centralized crypto institutions, DEXs are back in the spotlight.
In this article, we will explore the DEXs’ properties, their advantages and limitations, providing you with a comprehensive understanding of these decentralized exchange platforms.
Properties Of An Exchange
The four core functions of any exchange are (1) capital deposits, (2) order books, (3) order matching and (4) asset exchange.
In order to create a fully decentralized exchange or DEX each of these functions must be decentralized.
Typically on cryptocurrency exchanges, the asset exchange part is decentralized by default as the assets are cryptocurrencies. The other three functions, especially deposits, are usually centralized due to Know Your Customer (KYC) and Anti Money Laundering (AML) regulations.
Benefits Of DEXs
Centralized exchanges are required to seek users’ identities for any capital deposits; this is stored on a centralized server that holds your personal information. An exchange with any form of centralized databases or servers is allowing you to access the cryptocurrency market while decentralized exchanges give you access and cannot shut anyone out.
The most obvious benefit of a DEX is the same as with any decentralized application which is censorship resistance. Any application built on a decentralized blockchain can’t be shut down unless the entire chain is shut down. This is important as many countries have banned or heavily restricted cryptocurrency use.
In order for citizens of these countries to be able to access the ecosystem, they need applications that their government can’t shut down. If your access point to the crypto world is a centralized exchange, then your ability to access cryptocurrency is no more free or independent than your ability to access regular currency.
Cons
Decentralized exchanges also require the user to be 100% responsible and in control of their funds. For some people, this might be a negative — not everyone wants to be in charge of the safety of their assets, but by shouldering the responsibility on your own, your funds are as secure as you want them to be.
Several million dollars of cryptocurrencies have been stolen from users when the centralized exchange that they used was hacked. By taking your funds into your own hands and using a DEX, your funds are your responsibility and a corporation’s security vulnerabilities won’t affect you.
Of course, the DEX’s code can still have vulnerabilities or be compromised. So you should still use them with caution — try and educate yourself as best as you can about the platform that you are using and take extra steps to secure your own assets as best as you can.
Read: The Decentralized Financial Revolution: How DeFi Is Shaping The Future Of Money (2023)
How Do DEXs Really Work?
To trade on a DEX, you need a non-custodial wallet like MetaMask or Trust Wallet.
Let us pretend that we have some ETH and we want to trade it for USDC. We go to a decentralized exchange and first authorize the platform to access our funds. Once authorized, your coins do not leave your Web3 wallet until the moment you hit that “Swap” button and then confirm the trade.
But what is actually happening behind the scenes? The DEX does not magically find another user who just happens to want your ETH and is willing to give you USDC for it (which is what happens on centralized exchanges).
On a DEX, your trades are made possible by what is called a “liquidity pool,” which is basically a massive wallet holding the two tokens you want to trade ETH and USDC. When you hit that “Swap” button, your ETH gets deposited into the pool and USDC gets withdrawn from it. You are charged a trading fee as well as a gas fee because this is an on-chain transaction.
But where does this liquidity pool even come from? Answer: from other users — the magic behind DEXs is that it is entirely powered by other users, who “pool” their ETH and USDC so that other users can trade them. So those trading fees are being paid to them.
How To Use A DEX Tutorial
As an example, let us walk through the process of using a popular DEX aggregator, 1inch, to perform a token swap:
1. Visit the official 1inch website and connect your Web3 wallet to the platform.
2. Select the network you wish to trade on.
3. Choose the crypto asset you want to swap from and to, along with the desired amount.
4. Execute the transaction by clicking the “Swap” button. Make sure to review your transaction details, fees and slippage tolerance before confirming the swap.
Final Thoughts
DEXs still have a lot of catching up to do with centralized exchanges that can generally provide more robust features and a better user experience.
DEXs are no doubt an important part of the future of cryptocurrencies and are already a major help for people in restricted countries that want to access the blockchain ecosystem. With more growth and development in time they will be more advanced and become a better option against traditional exchanges.