Decentralized exchanges or DEXs have revolutionized the world of cryptocurrency. It has completely changed the way to trade digital assets.
But what is decentralized exchange? How do they work? Let’s get to know all this and more about decentralized exchanges below. Let’s dive in.
What are Decentralized Exchanges?
Decentralized exchanges are simple platforms that allow you to exchange your digital currency (cryptocurrency) or assets without any middleman.
There is no central authority between two people who want to exchange their tokens. On the other hand, Traditional exchanges not only have middlemen in between but they also ask for hefty funds to execute trades.
DEXs work using blockchain technology that directly connects one user to the other. These platforms are permissionless hence providing users with more control over the funds.
However, DEXs are limited to trading assets that are issued on the same blockchains as the exchange and can only trade coins issued on the network, necessitating “token bridges” for cross-transactions.
Centralized Exchanges (CEX) platform also conducts its transactions on blockchains but they support wider crypto transactions due to their centralized system.
5 Features of Decentralized Exchanges
Here are the top 5 features of decentralized exchanges:
- Direct connection: You can directly connect on these platforms. You will have full custody of your tokens. Unlike the CEX platform, which holds the private keys and the assets of users.
- No middle-man: There are no middlemen involved in the DEXs, meaning no financial intermediaries like clearing houses or payment networks handle the transactions.
- Direct trading: You can directly trade from your digital wallets. On DEXs, crypto users transact by connecting their specific crypto wallets like Bitcoin wallet for BTC to the platform.
- Transparency: Regardless of being a DEX or CEX platform, all crypto transactions are recorded on the blockchain. They can be easily verified because they are done directly from your wallet and are managed by smart contracts, making them transparent.
- No-fund: DEX trades have charges but these charges are only for using the specific blockchain network to exchange the tokens.
How do Decentralized Exchanges work?
Here is how decentralized exchanges work:
- Automated Market Makers (AMM): These are smart contracts that create different liquidity pools of token pairs. People who want to exchange, directly trade against these liquidity pools. In this, the price is determined by a mathematical formula based on the ratio of the token in the pool.
- Liquidity pools: These are the backbones of DEX platforms because they provide the necessary funds for trading. All the pools are made by the user’s asset contribution and they get a trading fee in return. They get benefits from the transparency, and prices and they also get incentives like staking rewards.
- Order Book: Order books are like digital books where DEXs maintain all the information of a user like what token they buy and what they sell. All the buy and sell orders of users are mentioned in the order books. When a match is found between a buy order and a sell order, trade is done directly. The orders are recorded on the blockchain, ensuring transparency.
- Aggregators: These exchange platforms use liquidity from multiple DEXs to find out the best prices for their users. Aggregators search across various platforms to find the best trading cost. They ensure the users get the most favorable prices making the process very easy.
Trading Process in Decentralized Exchange Platforms
Here are the steps of trading in decentralized exchange platforms:
- Connect your wallet – Firstly, you have to connect your cryptocurrency wallet to DEX.
- Choose tokens – Then, you have to choose some tokens you want to exchange.
- Set trade parameters- In this step, you have to set the amount you want to trade and mention the price limit as well.
- Confirm transaction – You then have to confirm the trade which will be done through smart contracts.
- Wait for confirmation – In the last step, the trade is processed through the blockchain and then confirmed.
Differences between DEX and CEX
We have seen what Decentralized Exchanges are. Now let us get to know the differences between DEX and CEX:
| DEX | CEX |
| Users have main control over their digital wallets and funds. | The exchange platform controls the private keys and funds of users in CEX. |
| DEX is permissionless it Allows users to trade without any KYC. | This platform requires users to complete the KYC procedure. |
| This platform can be less user-friendly at times because it has more complex features and slower transaction times. | CEX is more prone to hacking because they have control over user’s funds in centralized digital wallets. |
| This platform can be less user-friendly at times because it has more complex features and slower transaction times. | This is faster and provides an easy user experience. |
| There is lower liquidity in DEX. | CEX has higher liquidity. |
Pros and Cons Decentralized Exchanges
Now let’s get to know the advantages and disadvantages of DEXs:
Pros of DEXs
- Users maintain their own control over their funds, private keys, and transactions.
- There is a very low to zero risk of hacking or theft in DEXs.
- DEXs allow trading without any personal identification.
- It is also very less prone to censorship and regulatory shutdowns.
- You can access DEX from anywhere in the world without any restrictions.
Cons of DEXs
- DEXs have less liquidity.
- The transaction times are slow because of no-chain processing.
- It can become complex and have a steeper learning curve making it difficult for non-tech people to understand.
- DEX can have higher network fees.
- DEXs perform cross-chain transactions with the help of token bridges, which are separate platforms. This is a time-consuming process and has security implications.
Future of DEXs
The future of DEXs looks promising as time and technology evolve. They will be driven by advancements in blockchain technology and increased demand for decentralized finance (DeFi).
Decentralized Exchanges are expected to improve their service efficiency as they gain more liquidity, and interoperability, enhancing their experience. With concerns about the security of central exchanges, more people will see DEX as a secure exchange platform.
The Bottom Line
Decentralized Exchanges (DEX) provide a very compelling alternative to other traditional crypto trading platforms. Users get to experience a different type of control over their assets, keys, digital wallets, and transactions.
It provides a sense of security to users with minimal chance of hacking and theft. On the other hand, they eliminate the need for financial intermediaries during transactions.
Accessible from anywhere, DEXs are on the path of becoming an even bigger part of the decentralized finance and crypto space offering improved user – experience and scalability.
As the technology matures and its popularity increases, we may also see DEX become an increasingly popular option for cryptocurrency enthusiasts.
