A decentralized exchange (or DEX) is a peer-to-peer marketplace where crypto traders conduct transactions directly with one another. DEXs fulfill one of crypto’s primary functions: they facilitate financial transactions that are not mediated by banks, brokers, payment processors, or any other type of intermediary.
Popular DEXs, such as Uniswap and Sushiswap, use the Ethereum blockchain. They are part of a growing suite of decentralized finance (DeFi) tools, which enable access to a plethora of financial services directly from a compatible crypto wallet.
DEXs are booming, with $217 billion in transactions passing through them in the first quarter of 2021. There were more than two million DeFi traders in April 2021. This a tenfold increase from May 2020.
How do DEXs function?
DEXs, unlike centralized exchanges like Coinbase or Kraken, do not allow for fiat-to-crypto exchanges. Instead, they only trade cryptocurrency tokens for other cryptocurrency tokens.
Investors can trade fiat for crypto (and vice versa) or crypto-crypto pairs. For example, trading BTC for ETH, using a centralized exchange. You can also make more advanced moves, such as margin trades or setting limit orders.
All of these transactions are handled by the exchange itself, which establishes the price for a specific cryptocurrency based on current buy and sell orders.
Decentralized exchanges are nothing more than a collection of smart contracts. They use algorithms to determine the prices of various cryptocurrencies against one another. They use liquidity pools to facilitate trades.
While central exchange transactions are recorded on the exchange’s internal ledger, DEX transactions are settled directly on the blockchain.
DEXs are built with open-source code, enabling anyone with an interest to see exactly how they work. This also means that developers can reuse existing code to create new competing projects. This is how Uniswap’s code has been reused by a slew of DEXs with the word “swap” in their names, such as Sushiswap and Pancakeswap.
What are some advantages of using a DEX?
A wide range of options
If you want to find a hot token in its early stages, DeFi is the place to be. DEXs provide a virtually limitless variety of tokens, ranging from the well-known to the strange and completely random. Because anyone can develop an Ethereum-based token and an associated liquidity pool, there will be a wider range of projects, both vetted and unvetted.
Hacking risks can be reduced
Since funds in a DEX trade are stored on the traders’ own wallets, they are less vulnerable to a hack. (Relatedly, DEXs reduce what is known as “counterparty risk,” which is the likelihood that one of the involved parties, including the central authority in a non-DeFi transaction, will default.)
Anonymity
Most popular DEXS do not require any personal information to be used.
Utility in the developing world
Because DEXs enable peer-to-peer lending, quick transactions, and anonymity, they are becoming increasingly popular in developing economies where solid banking infrastructure may not be available. DEXs are available to anyone with a smartphone and internet.
What are some of the disadvantages?
More difficult user interfaces
Navigating decentralized exchanges requires some specialized knowledge. Be prepared to do a lot of research, and don’t expect the DEX to provide much assistance. For the most part, you’ll have to look elsewhere for a walkthrough explanation.
Caution is required because it is possible to make irreversible mistakes. You don’t want to send coins to the wrong wallet. Another common issue is “permanent loss”. This occurs when a more volatile cryptocurrency is combined with a less volatile one in a liquidity pool.
The vulnerability of smart contracts
Any DeFi protocol is only as secure as the smart contracts that power it. Code can have exploitable bugs that result in the loss of your tokens. And, while a smart contract may work as intended under normal conditions, developers cannot anticipate all rare events, human factors, and hacks.
Risky coins
Due to the unvetted, avalanche of tokens available on most DEXs, there is a greater number of risks to be aware of. A red-hot token could be “rug pulled” when its creator mints a large number of new tokens. This overwhelms the liquidity pool and tanks the coin’s value.
Before purchasing a new cryptocurrency or experimenting with a new protocol, it is critical to learn as much as possible. Read white papers, visit Twitter feeds or Discord channels, and look for audits of any project you are interested in.
Check out sites like Consensys or Chain Security.
What is the best way to interact with a DEX?
- You can use a crypto wallet like Metamask (for your web browser) to connect to a DEX like Uniswap (for mobile)
- While you can interact with DEXs directly from the waller browser, a simpler method is to open the website in your computer’s web browser and click “Connect to a Wallet.”
- You should see a QR code (mobile) that you can scan with your phone’s camera. Your wallet will be linked to the DEX once it has been scanned
- To begin trading on most DEXs, you’ll also need a supply of Ethereum, which you can obtain from an exchange like Coinbase, Kraken or Gemini. You’ll need some ETH to pay the fees (known as gas) that are required for any transaction on the Ethereum blockchain. These are distinct from the fees levied by the DEX.
Dex fees and how they work
Fees differ. For example, Uniswap charges a 0.3 percent fee, which is divided among liquidity providers. A protocol fee may be added in the future. However, it is important to note that the fees levied by the DEX can be dwarfed by the gas fees levied by the Ethereum network. The ongoing ETH2 upgrade are intended to reduce fees and speed up transactions.
Final thoughts
More blockchains equals more value for DEXs.
It is widely understood that DeFi projects will eventually connect multiple blockchains, allowing information to flow seamlessly from one chain to the next. Indeed, the cryptocurrency market and multichain adoption are less of a zero-sum game than is commonly assumed. And, as the multichain future becomes clearer, it will become clearer that the additional functionality, usability, and scalability it provides is aiding in the onboarding of new users to the DEX community.
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Jay Speakman is a technology writer based in San Francisco, California. He writes on the topics of blockchain, cryptocurrency, DeFi and other disruptive technologies. Clients include Avalanche, Be[in]Crypto, Trust Machines and several blogs devoted to blockchain gaming. He will not rest until fiat currency is defeated.
