What is a decentralised Exchange?
Decentralized exchange also called (DEX) is a cryptocurrency exchange where crypto traders buy directly with the seller in the absence of mediation from the bank, brokers and other central counterparts. A local retail trader is a good example of a decentralized market, here, traders transact face to face with the seller. But in digital decentralization, It flourishes with the rise of cryptocurrency and blockchain technology where trading is facilitated by smart contracts. In centralized exchange, buyers usually submit order to the broker, that will transmit the order to the exchange which will match them to the sellers who are ready to accept the price of the buyer, here the centralized exchange serves as an intermediary between the buyer and the seller, but in decentralized exchange, Buyers buys directly from the exchange that submit their order directly to the seller without involving the necessity of an intercessor such as banks or brokers.
How Does a decentralised exchange work?
A decentralized exchange operates based on the concept of decentralization, which means it does not rely on a principal power or negotiator to make trading activities easier. Instead, it is designed as a system of blockchain technology and smart contracts which permit immediate transactions among users. A decentralized exchange acts like a marketplace where a buyer and a seller meet. It operates independently in the absence of the banks or brokers. It engages smart contracts and blockchain technology to make transactions easier. Users engage with DEX through compatible cryptocurrency wallets, which allows them to secure their digital assets and maintain control over their private keys. DEX makes use of smart contracts, which are self–executing contracts designed with predefined rules programmed in code, to automate and enforce the exchange process.
We have three primary categories of distributed exchange, which include:
Order Book DEX: An order book decentralized exchange (DEX) is a platform that enables the trading of cryptocurrencies using order book mechanism. It functions similarly to conventional centralized exchanges but operates without a principal control or intermediary. In an order book DEX, traders buys directly from the exchange that submit their order directly to the seller without involving the necessity of an intercessor such as banks or brokers.
Traders submit orders specifying the cryptocurrency they want to buy or sell, along with their desired price and quantity. These orders are recorded in the order book, and the DEX’s matching engine evaluates the order book, matching buy orders with sell orders based on their price and quantity. For instance, if a buy order aligns with a sell order at the same price, a trade is executed. The DEX facilitates the trade by transferring the agreed-upon amount of cryptocurrencies between the involved parties. The secure and transparent execution of these transactions is ensured by the DEX’s smart contracts.
If an order cannot be immediately matched, it remains in the order book until a corresponding order is placed in the future. In cases where there is insufficient liquidity to fulfill the entire order at once, orders can be partially filled. To maintain liquidity in the order book, participants can act as liquidity providers by depositing funds into the DEX’s liquidity pool. These providers facilitate the matching of orders and earn transaction fees or rewards for their participation. Prominent examples of limit order-based DEX include Uniswap,Sushiswap , 0x, and Balancer.
Automated Market Maker (AMM): An Automated Market maker (AMM) is a platform that provides liquidity to the decentralized exchange. Here, cryptocurrencies are traded without permission and automatically by using liquidity pools instead of a traditional order book.
AMM leverages liquidity pools and smart contracts to enable seamless trades, here the buyer and seller trades against the smart contract and not investors. AMM DEXs have gained significant popularity within the decentralized finance (DeFi) ecosystem due to their user–friendly interface, liquidity provisioning, and algorithmic pricing mechanisms.
For example, in a swap pool that contains two different types of cryptocurrencies, usually Ethereum (Eth) and another token. When someone wants to add their cryptocurrencies to the pool, they need to deposit both Eth and the token in a specific ratio determined by the pool’s existing ratio.
In return for their deposit, the person receives a special token that represents their ownership in the pool. This token shows how much of the total pool they own. As people trade cryptocurrencies using the pool, the value of the pool can go up or down.
Liquidity providers, the people who deposited their cryptocurrencies into the pool, can take out their share of the pool at any time. They will receive an equal value of Eth and tokens based on their ownership in the pool.
Providing liquidity to the pool can be profitable because every trade has a small tax of 30 basis points (0.3%) that is added back into the pool. Examples of AMM DEXs include Uniswap, SushiSwap, PancakeSwap, and Curve Finance.
DEX Aggregators: DEX Aggregators, also known as liquidity aggregator or decentralized exchange aggregator, are financial protocols created to provide liquidity for smaller tokens and pricing. Their main purpose is to assist users in discovering the best prices and liquidity by adding multiple decentralized exchanges. Their objective is to trim the trading process on DEXs by consolidating liquidity and presenting users with the most beneficial prices accessible across various DEXs. These integrators makes trading simple by enabling users to access many DEXs, differentiate prices, and implement trades at the most advantageous rates. They employ intelligent order pattern algorithms to distribute commands among multiple DEXs, lowering slippage and correcting trade execution. Moreover, they offer a smooth user experience by integrating with popular wallets and incorporating advanced quality such as limit orders and portfolio management tools. In essence, DEX aggregators amplify liquidity, promote price discovery, and improve efficiency within decentralized trading ecosystems. They have become highly sought-after tools for traders operating in the decentralized finance (DeFi) sector. Notable examples of DEX integrators include 1inch, Matcha, and Paraswap.
Difference between Decentralized exchange and Centralized exchange
|Decentralized exchange operates based on the concept of decentralization, which means it does not rely on a principal power or negotiator to make trading activities easier
|Centralized exchanges operate on the concept of centralization, which means it relies on central authority to hold users’ funds on their platforms.
|DEX makes use of direct peer-to-peer trading through smart contracts
|Centralized exchanges act as intermediaries for trade execution.
|They are trustless, which means that they ensure that the user privacy are well preserves, which allows investors to maintain high degree of anonymity
|Centralized exchanges often require KYC procedures.
|DEX rely on decentralized liquidity pools, which may have lower initial liquidity.
|Centralized exchanges offer higher liquidity due to their larger user bases
How to interact with decentralized exchange:
- As there are few decentralized exchanges available, like Uniswap, Sushiswap, and Pancakeswap, to interact with DEX, you have to explore and select a DEX that suits your needs, considering factors like liquidity, supported tokens, fees, and reliability.
- Set up a suitable wallet that supports the blockchain network on which the DEX operates. For example, if you’re using Ethereum-based DEX like Uniswap, popular wallets include Metamask, Trust Wallet, or Ledger.
- Ensure that your wallet contains the cryptocurrency tokens you intend to trade on the DEX. If you don’t have the required tokens, you’ll need to acquire them through a centralized exchange or another means.
- Visit the DEX’s website or use a compatible decentralized application (dApp) browser extension like Metamask to access the DEX interface.
- Use the guideline provided by the DEX to link your wallet to the platform, choose the tokens you want to trade, enter the number of tokens you want to trade, evaluate the transaction details.
- Verify the trade. Depending on the DEX, you may have the option to set advanced parameters such as slippage tolerance or transaction speed. After confirming the trade, approve the transaction on your wallet.
- Review the transaction details, gas fees, and confirm the transaction. The DEX will process your transaction on the blockchain, once the transaction is confirmed, you can check your wallet balance or transaction history to ensure the trade was executed as intended.
Risk related with Decentralized exchange
- Smart Contract Risks: Decentralized exchanges rely on smart contracts, which are computer programs that execute transactions. However, these contracts can have vulnerabilities that hackers can exploit, leading to the theft or manipulation of funds if bugs or weaknesses exist in the code.
- Lack of Regulation and Compliance: Unlike centralized exchanges, DEX operates without strict regulations and compliance measures. This exposes users to various risks, such as potential money laundering, fraud, and market manipulation, as there are no established frameworks to monitor and prevent such activities.
- User Errors and Scams: Interacting with DEX involves managing private keys and interacting with smart contracts directly. This increases the likelihood of user errors, such as sending funds to the wrong address or falling victim to phishing attacks. These mistakes can result in irreversible losses for users. Additionally,DEX can be prone to scams, where malicious actors deceive users into making transactions that lead to financial losses.
- Limited Liquidity: Decentralized exchanges typically have smaller liquidity than centralized exchanges, which can result in slippage or challenges in executing larger trades at desired prices due to the limited availability of buy and sell orders in the market.
Advantages of Decentralized Exchanges (DEXs):
- Decentralized exchanges generally offer improved privacy as they don’t necessarily rely on a principal power or negotiator to trade
- Decentralized exchanges are resistant to censorship and regulatory interference because they are not controlled by a single entity. This is particularly valuable in regions where governments impose strict capital controls or limit access to traditional financial systems.
- DEX utilize smart contracts to computerized the trading process. Thiis reduces reliance on central authorities, reducing counterparty threat and minimizing the chances of the exchange failures or fraudulent activities.
- DEX often carry a wide range of token and other cryptocurrencies, especially those with smaller market capitalization. This promotes greater liquidity and trading option for more users, as they are not limited to a curated selection of assets offered by centralized exchanges.
In conclusion, decentralized exchanges (DEXs) have emerged as an alternative option to centralized exchanges, offering distinct advantages for cryptocurrency traders. DEXs operate on the principles of decentralization, making use of blockchain technology and smart contracts to ease direct peer-to-peer trading without negotiators. Users maintain complete control and ownership of their funds, benefiting from increased privacy and resistance to censorship. While DEXs may face challenges such as lower liquidity and risks associated with smart contract vulnerabilities and user errors, they provide opportunities for global accessibility, reduced counterparty risk, and compatibility with various tokens. As the decentralized finance (DeFi) ecosystem continues to evolve, DEXs play a vital role in empowering individuals and promoting inclusivity and transparency in the financial landscape.