Ever heard about Uniswap or Pancakeswap? A decentralised cryptocurrency exchange, or DEX, is a place where users can trade cryptocurrencies without a broker, unlike centralised exchanges. Let’s take a look at what DEXs are, how they work and what are their benefits.
DEX key features:
- A DEX is a decentralized exchange that utilizes smart contracts to automate and secure transactions
- They offer a wide range of tokens, including those not available on centralized exchanges
- Most DEXs don’t require Know Your Customer (KYC) verification
- Transactions are transparent but not directly linked to personal identities
Decentralised exchanges (DEX) are blockchain applications that coordinate large-scale cryptocurrency trading among many users. They do this entirely through automated algorithms, instead of the traditional approach where exchanges act as financial intermediaries between buyers and sellers. In doing so, users do not have to relinquish custody of their coins, but this also comes with a drawback for some: you are responsible for the security of your cryptocurrencies.
How does a centralized exchange work?
A centralised exchange, such as Binance, Kraken or Coinbase, is a website or app where people can buy, sell or trade cryptocurrencies that are backed on that exchange. Let’s say we want to buy Ethereum (ETH):
You can head to the exchange, provide some banking and identification credentials, and add some funds. Occasionally, this process can stretch over multiple days, which is a downside of centralized platforms when compared to DEXs. The exchange will then offer you a price, determined by the order book that lists people buying and selling at various rates, allowing you to complete the transaction. Subsequently, these Ether tokens will appear in your account, and you have the option to trade them for other digital assets on the platform. However, you’re not the actual owner of these ETH tokens; you’re essentially placing your trust in the exchange to serve as your custodian. Any trading activities you engage in, like swapping BTC for ETH, are executed not on the blockchain but within the database of the exchange.
Centralised exchanges collect users’ cryptocurrencies in crypto wallets (often “hot” wallets connected to the internet), which are controlled by the exchange. The cryptocurrency exchange controls your private keys. While there are ways around this, as exchanges allow you to transfer tokens to a private wallet, this is an extra step later if you want to trade in that cryptocurrency. You know how the »old« crypto saying goes – »Not your keys, not your coins«.
Centralized exchanges are also prone to a host of issues, including security vulnerabilities, high fees, and the risk of censorship. Enter DEX, or Decentralized Exchanges. These platforms aim to solve these problems by removing the middleman from the equation.
Things are not that black and white though. Conversely, centralized exchanges are typically more user-friendly for beginners and can frequently provide quicker trading since they aren’t reliant on blockchain infrastructure. Take Binance, for instance, which has become a go-to platform for those intrigued by cryptocurrencies but daunted by the complex procedures involved. For such individuals, having a centralized crypto exchange serve as the guardian of their assets is entirely acceptable.
So how does a decentralized exchange (DEX) work?
In a nutshell, a Decentralized Exchange (DEX) is a peer-to-peer trading platform that operates without a central authority. The cornerstone of any DEX is the smart contract. These are self-executing contracts with the terms directly written into lines of code. When you initiate a trade, a smart contract is created, specifying the conditions of the transaction. Once these conditions are met, the trade is executed, and the assets are transferred.
DEX don’t own your coins. That means they address this in three ways: an on-chain order book, an off-chain order book or an automated market maker approach (AMM).
- On-chain order book: In the on-chain order book, every transaction gets logged onto the blockchain. This includes not just the completed purchases but also the initial buy requests and any order cancellations. While this represents the pinnacle of decentralization, it can come at the cost of higher fees and slower transaction speeds due to the necessity of recording all activities on the blockchain.
- For off-chain order books, all this happens elsewhere, but in a blockchain only the final transaction is settled. As the orders are not stored on the chain, this method may run into some of the security issues of centralised exchanges, but is not as slow or expensive as on-chain order books.
- Automated Market Makers (AMM): Automated market makers (AMMs) are moving away from order books. If you have ETH tokens and want to buy SOL, you need to have someone with SOL who wants eth and is willing to trade at the agreed price. AMMs do away with counterparties and introduce price discovery algorithms, allowing you to trade ETH tokens for SOL tokens regardless of whether there is someone on the other side of the trade. To facilitate this, they typically use so-called liquidity pools, essentially paying users to keep a portion of their funds in a smart contract that can then be used for trading. Individual users therefore play a key role in facilitating trading. Platforms like Uniswap use liquidity pools to facilitate trades. Users provide liquidity by depositing pairs of tokens into a pool, earning fees in return.
What are some of the most popular DEXs?
The largest DEX is Uniswap, founded on the Ethereum blockchain in 2018 by a former mechanical engineer who only learned to code after being fired by Siemens the year before. By the end of 2021, this DEX was processing more than $1 billion worth of transactions every day. It is often considered the pioneer of Automated Market Makers (AMMs). It’s user-friendly, has a wide range of tokens, and offers some of the best liquidity in the DEX space. Uniswap’s V3 offers concentrated liquidity, giving liquidity providers more control over their assets.
Initially starting as a fork of Uniswap, Sushiswaphas evolved into a full-fledged ecosystem with features like yield farming and staking. What sets Sushiswap apart is its focus on community-driven development and features. The platform has its own governance token, SUSHI, that allows holders to vote on proposals and even earn a share of the platform’s fees. On top of that, the Onsen program is a standout, offering high APYs for liquidity providers. Sushiswap also has a feature called Kashi, a lending and margin trading platform that’s isolated into separate risk pools.
PancakeSwap is the leading DEX on the Binance Smart Chain (BSC). It’s a fast and affordable alternative to Ethereum-based DEXs, making it particularly attractive for those looking to escape high gas fees. PancakeSwap has managed to capture a significant user base by offering a range of additional features like lottery tickets, NFTs, and even prediction markets. The DEX uses its native token, CAKE, for governance and staking. The platform also offers ‘Syrup Pools,’ where users can stake CAKE tokens to earn other tokens.
Honorable mentions: dYdX, Apex protocol, Curve, DODO
How can I connect to a DEX?
To access a DEX, you’ll need a few things:
- Crypto wallet: A digital wallet to store your cryptocurrencies. Examples include MetaMask, Trust Wallet, and Ledger.
- Internet connection: Yes, you’ll need this. No brainer, right?
- Some crypto (usually ETH or BNB): Depending on the blockchain the DEX operates on, you’ll need some Ether (for Ethereum-based DEXs like Uniswap) or Binance Coin (for Binance Smart Chain DEXs like PancakeSwap) to pay for transaction fees.
Once you have that, follow the simple steps:
- Install a wallet: First things first, you’ll need a digital wallet that allows you to interact with decentralized applications (dApps). MetaMask is a popular choice and comes as a browser extension. Installation is straightforward, and it’s compatible with both Ethereum and Binance Smart Chain.
- Fund your wallet: Once your wallet is set up, you’ll need to transfer some cryptocurrency into it. This could be ETH, BNB, or any other token that the DEX supports. You can do this from a centralized exchange like Kraken or Binance.
- Connect to a DEX: Navigate to the DEX’s website and look for an option that says “Connect Wallet” or something similar. Click on it, and a pop-up will appear asking you to confirm the connection between your wallet and the DEX.
- Make a trade: Once connected, you can now trade to your heart’s content. The interface will show you trading pairs, liquidity pools, and other options. Select what you want to trade, confirm the transaction in your wallet, and voila! You’ve made a trade on a DEX.
Pro tip – Pay attention to:
- Gas Fees: These are transaction fees, and they can be high, especially on the Ethereum network.
- Slippage: This is the price change between when you make the order and when it gets fulfilled. Always check the slippage tolerance settings.
- Impermanent Loss: When providing liquidity, be aware that the value of your assets can fluctuate.
DEX: Pros and Cons
- Security: One of the most significant advantages of DEXs is that you have full control over your private keys and, by extension, your funds. This is what crypto is all about—financial sovereignty. Besides, many DEXs are built on open-source software, making the code publicly available. This level of transparency is almost unheard of in traditional finance and adds an extra layer of trust.
- Privacy: Most DEXs don’t require Know Your Customer (KYC) verification. This means you can trade without surrendering your personal information, maintaining your privacy and reducing the risk of data breaches.
- Innovation: DEXs are often the pioneers when it comes to innovative features. From yield farming and liquidity mining to complex trading strategies, DEXs are the playground for DeFi enthusiasts.
- Lower fees: Decentralized crypto exchanges function autonomously through self-executing smart contracts. Because they eliminate the need for a middleman, DEXs adopt the same “gas” fee model as the Ethereum blockchain they’re built upon. Typically, DEXs levy modest fees, approximately around 0.3%. While these fees can vary based on network activity, they consistently stay lower than the expenses associated with using centralized counterparts.
- Diversity: Nowadays the market boasts over 30,000 different cryptocurrencies. Centralized exchanges are selective about the tokens they list, focusing on those with sufficient trading volume, scalability, and robust security measures to ensure both profitability and compliance with regulations. On the other hand, many altcoins find their home exclusively on decentralized exchanges (DEXs), where peer-to-peer transactions can occur without the need for high trading volumes. This opens up broader avenues for digital asset engagement and enhances financial inclusivity.
- Scalability: One of the most significant issues with DEXs, especially those built on Ethereum, is scalability. During times of high demand, the network can become congested, leading to slower transactions and sky-high gas fees.
- Not so friendly user interface: DEXs can be a maze for newcomers. The user interface is often less intuitive than centralized exchanges, making it challenging for those who aren’t tech-savvy. This steep learning curve can deter potential users.
- Liquidity: While DEXs have come a long way, they still lag behind centralized exchanges in terms of liquidity. This can result in higher slippage and less favorable trading conditions, especially for less popular tokens.
Decentralized crypto exchanges aim to embody the core principles of blockchain technology, focusing on decentralization and privacy. In these platforms, you maintain ownership of your tokens until you decide to trade them. While some see this as a security advantage, others find the level of personal responsibility intimidating and the associated risks concerning. Advocates of DEXs generally concur: these are the compromises one makes for genuine decentralization. Additionally, DEXs offer a high-risk, high-reward landscape for those hunting for that elusive 1000x crypto asset. Unlike centralized exchanges that list only vetted cryptocurrencies, DEXs are a playground for an array of memecoins and low-cap tokens. While most of these tokens may plummet to worthlessness, a few, like PEPE, have soared to unexpected heights. As always, exercise caution and common sense
What is a Decentralized Exchange (DEX)?
A Decentralized Exchange, or DEX, is a peer-to-peer trading platform that operates without a central authority. It utilizes blockchain technology and smart contracts to facilitate secure and automated transactions between users.
How is a DEX different from a centralized exchange?
In a centralized exchange, the platform acts as an intermediary between buyers and sellers, holding users’ funds in its wallets. In contrast, a DEX allows users to trade directly with each other, without relinquishing control of their assets to a third party.
What are the key features of a DEX?
It utilizes smart contracts for automated and secure transactions, offers a wide range of tokens, including those not listed on centralized exchanges; most DEXs do not require Know Your Customer (KYC) verification and transactions are transparent but not directly linked to personal identities.
How do I connect to a DEX?
To connect to a DEX, you’ll need a crypto wallet like MetaMask or Trust Wallet, an internet connection, and some cryptocurrency (usually ETH or BNB) to pay for transaction fees. Once you have these, you can navigate to the DEX’s website and follow the steps to connect your wallet and start trading.
What are some popular DEXs?
Some of the most popular DEXs include Uniswap, Sushiswap, and Pancakeswap. Each has its unique features, supported blockchains, and community-driven development.
What are “gas fees”?
Gas fees are transaction fees required to process and validate transactions on the blockchain. These fees can be high, especially on congested networks like Ethereum.