DEX is the short form for decentralized exchange. Decentralized crypto exchanges are P2P blockchain-based marketplaces where users trade crypto assets. In contrast to centralized exchanges where transactions take place through a centralized orderbook, transactions in DEX occur directly between traders without interference from intermediaries.
The decentralized exchanges guarantee traders transparency in all financial transactions and are regarded as the cornerstone of DeFi. Some notable decentralized exchanges include 1 Inch, Uniswap, dYdX, and PancakeSwap.
How DEX works
DEXs are built on blockchains and use smart contracts for their operations. The central idea behind the workings of DEX is the removal of intermediaries to offer smooth trading, meaning DEX doesn’t provide custody of users’ assets. On a DEX, users can hold their crypto assets in their wallets 24/7. All the transactions on a decentralized exchange platform are made possible using automated algorithms. Users in any DEX platform must pay trading and network fees. The network fee is the gas cost of any transaction performed on chained. In contrast, the trading fee refers to the amount collected as specified in the design of the underlying protocol.
For experienced crypto users interested in using a decentralized exchange, it is an effortless process. A DEX doesn’t require users to provide email addresses or even perform a sign-up procedure. A trader only needs a crypto wallet.
However, before using any DEX platform, traders should choose a network that supports their wallet while considering its fees. Afterward, funding the wallet with the appropriate native token of the network is all they need to enjoy all the trappings accompanying the DEX platform.
There are three primary designs of DEX, each with unique features. All of them are briefly explained below.
Automated Market Makers (AMMs)
The AMM system came into being due to the consistent pressure in the blockchain sector brought about by liquidity problems. Unlike in other exchanges where smart contracts are used for buy and sell order matching, AMMs use liquidity pools, which refer to a pre-funded pool of crypto assets.
The liquidity pool is funded by users who later earn interest from the transaction fees charged on individual trades. AMMs pride themselves as platforms that allow traders to execute orders and earn profits in a permissionless manner. The only demerit associated with the AMM design is slippage, which can occur due to a lack of liquidity, thus making buyers pay more for their orders.
Order Book DEXs
Order books assemble real-time records of every open buy and sell order. Order book DEXs come in two major categories, off-chain, and on-chain order books. With this model, users are entitled to numerous trading options as the exchange also allows them to lend and borrow money from one another.
A DEX aggregator allows traders to dip into the liquidity of a range of decentralized trading pools to get best execution with minimal slippage. Especially, for large transactions, DEX aggregation protocols can be very useful.