What is a Decentralised Exchange (DEX)?

Decentralised exchanges have seen increasing adoption in the past several years and have become a foundational pillar of the crypto ecosystem. These exchanges are booming. In Q1 2021, transactions worth $217 billion flowed via DEXs. As of April last year, there were over two million DeFi traders – that’s a 10-fold increase from May 2020. 

With all these in context, all crypto enthusiasts must have an idea about these exchanges. 

If you want to know all about decentralised exchanges, you can refer to this guide below.

Decentralised exchange: Know the basics
 

A DEX or decentralised exchange is a peer-to-peer marketplace in which crypto traders make direct transactions without handing over management of their funds to a custodian or an intermediary. A DEX depends on smart contracts to enable traders to execute orders without an intermediary. 
 

Decentralised exchanges fulfil one of the core possibilities of cryptocurrency – foster financial transactions which brokers, banks, or any other intermediary do not officiate.

Popular DEXs have been developed on top of leading blockchains which support smart contracts. Several popular decentralised exchanges like SushiSwap and Uniswap run on the Ethereum blockchain.
 

Working of a decentralised exchange
 

Unlike centralised exchanges, DEXs do not allow exchanges between cryptocurrency and fiat. Instead, they exclusively trade crypto tokens for other crypto tokens.

DEXs are a set of smart contracts. They establish prices of different cryptos against each algorithmically and make use of “liquidity pools” to facilitate trades. Investors lock funds in these pools in exchange for interest-like rewards.
 

DEX transactions are directly settled on the blockchain, unlike a centralised exchange where transactions get recorded on an internal database of the exchange.
 

Usually, decentralised exchanges are developed on open-source code, implying that interested individuals can exactly see the way they work. This also indicates that developers can develop new competing projects by adapting existing code. That’s how the code of Uniswap has been adapted by a host of decentralised exchanges with “swap” in their names like Pancakeswap and SushiSwap.
 

DEXs are developed on top of blockchain networks support smart contracts and where users keep custody of their funds. Owing to that, a transaction fee is levied on every trade besides the trading fee. 
 

Types of decentralised exchanges
 

There are primarily three types of DEXs that include:

• Order books DEXs 
• DEX aggregators
• Automated market makers (AMMs) 

In short, all of these enable users to trade with one another via their smart contracts directly. Given below is a detailed account of these three:

Order book DEXs
 

Order books compile records of every open order to sell and purchase assets for particular asset pairs. 

Buy orders indicate that a trader wants to bid for or buy an asset at a certain price. On the other hand, sell orders signify that a trader is ready to ask a specific price for or sell that particular asset. The spread between the prices helps determine the market price on the exchange and the order book’s depth.  

Order book DEXs are of two types – off-chain order books and on-chain order books.

DEX aggregators
 

DEX aggregators make use of many different mechanisms and protocols to solve issues linked with liquidity. Essentially, these platforms aggregate liquidity from different decentralised exchanges to optimise token prices and swap fees, minimise slippage on large orders and provide traders with the best possible price in the minimum possible time.

Automated market makers (AMMs)

Automated market makers (AMMs) refer to a class of DEXs which depend on mathematical formulas to set a token’s price. Similar to normal exchanges, AMMs have different trading pairs: for instance, Ether (ETH) to Dai.

How to use a DEX?

To use a DEX, a sign-up is not necessary. You don’t even require an email address to interact with these platforms. Instead, you as a trader will require a wallet that is compatible with the smart contracts on the network of the exchange.

Follow these steps to use a decentralised exchange:
 

Step 1: Decide a network that you want to use as a transaction fee is incurred on every trade.
 

Step 2: Select a wallet that is compatible with the chosen network.
 

Step 3: Fund the wallet with tokens that are used to pay for transaction fees on the chosen network. You need to buy these tokens on centralised exchanges. You will be able to identify them easily via the ticker symbol they use. For instance, it is ETH for Ethereum. 

After purchasing the tokens, simply withdraw them to the wallets you control.

You must note that it is imperative to avoid fund movement to the wrong network. With a funded wallet, you can either click on “Connect Wallet” present on the web portal of decentralised exchanges or connect the wallet via a pop-up prompt.

Advantages of using a DEX

Trading on DEXs can be an expensive affair. Nevertheless, there are several advantages of using these platforms. These include:
 

• Reduced security risks

There is a lesser risk of getting hacked for experienced crypto users who place custody of their funds with DEXs. This is because decentralised exchanges do not control the funds. Actually, traders guard their funds and interact with the DEX only when they want to do so.

• Reduced counterparty risk

DEXs do not involve intermediaries in their operations. They are based on smart contracts. Hence counterparty risk is eliminated.

• Anonymity

Your anonymity stays preserved when you exchange one crypto for another on a decentralised exchange.

Decentralised exchanges: Risks

Along with the above-mentioned advantages, there are several risks associated with a decentralised exchange, including:

• Smart contract risks

Smart contract hacks, vulnerabilities, exploits and bugs can take place, which may leave decentralised exchange users susceptible to fund losses. 

• Front running risk

Owing to a blockchain transaction’s public nature, trades taking place on a decentralised exchange may be front run by arbitrageurs or MEV (maximal extractable value) bots attempting to siphon value from users.

• Liquidity risk

Though the popularity of DEXs is growing, some decentralised exchange markets have poor liquidity conditions. This results in a suboptimal user experience and massive amounts of slippage.
 

Conclusion

Decentralised exchanges will likely remain a vital infrastructure for the crypto ecosystem, and there will probably be improvements coming up in smart contract security, transaction scalability, user experience and governance infrastructure. However, it remains to be seen whether the present DEX designs will support institutional adoption and long-term growth and if most of the trading activity will migrate to these exchanges.