What is a decentralized exchange? A beginner’s guide to DEX protocols
A decentralized exchange or DEX is a promising cryptocurrency exchange with complete decentralization.
A DEX supports peer-to-peer cryptocurrency trading without involving any intermediary. Therefore, it is suitable for every person related to the crypto world who wants to know the fundamentals of DEXs and their functions. This article discusses a detailed guide on DEXs, their types, benefits, and challenges. Read on to learn more!
A Brief Introduction to DEX
DEXs work like stock markets where cryptocurrency traders directly execute transactions. The robust feature of DEX is that they don’t transfer the responsibility of funds handling to intermediaries or custodians.
DEX can make transactions by ascending smart contracts, which generally incorporate self-implementing stated in code. DEXs can exclude the requirement for any authority for monitoring and authorization of transactions on the exchange. Since DEXs are non-custodial, they enable users to get ownership and control over their private keys. These benefits have made DEXs more popular these days. Nevertheless, it is also crucial to recognize the roots of DEX creation to understand their significance.
History of DEXs
Although DEXs are new, they have started challenging centralized cryptocurrency exchanges in terms of volume and users. The first and foremost modern DEX came in 2017. One of the earliest phases of DEX creation would be the HTLCs (Hashed Time-Locked Contracts). HTLCs can offer a fundamental cryptographic escrow system for aiding distrustful, on-chain trades between users who don’t depend on each other.
LocalBitcoins and Bisq were introduced in 2012 and 2014, respectively. These proto-DEXs depended on HTLCs and showcased that fundamental decentralized trading was easy.
With the rise of the first DEXs on Ethereum, the next evolution of DEX was evident. Ethereum smart contracts accelerated the new gen of exchanges and brought massive enhancements over the HTLC-based exchanges. DEXs have become a crucial component in the cryptocurrency world by allowing trading with many boosts in crypto volume. Furthermore, DEXs aided nearly $600 billion in trade volume between June 2020 and June 2021.
Types of DEXs
Using smart contracts, developers can build three main formats of DEXs: AMMs (Automated Market Makers), Order Book DEXs, and DEX Aggregators. Every DEX facilitates direct trade among users via smart contracts. Let’s discuss various types of DEXs to understand their function fully!
1. Order Book DEXs
This type of DEX is one of the main approaches in the DEXs’ creation. The model maintains records of every open order for buying and selling assets. The purchase orders showcase a trader’s interest in buying and bidding for an asset at a fixed rate. Besides, sell orders showcase that the trader wants to sell or request a special rate for the mentioned asset. The difference between the rates is the reason for deciding the order book’s intensity and the asset’s market rate.
Two different Order Book DEXs are there: on-chain and off-chain order books. On-chain order book DEXs refer to the DEXs that store their open order data on the chain. These DEXs could assist traders in improving their positions with finances from lenders on their platform.
However, off-chain order book DEXs store the Blockchain networks’ order books. They allow transaction settlement on the Blockchain. Hence, they provide the worth of centralized crypto exchanges. Another crucial feature of an order book DEX platform is the challenge of liquidity problems. Generally, order book DEXs correlate centralized exchanges and enforce extra changes for on-chain transactions. Nevertheless, with smart contract-associated issues, off-chain order book DEXs can eliminate the expenses.
2. AMMs (Automated Market Makers)
AMMs are another type of DEXs. It uses smart contracts effectively to identify the liquidity risks. AMMs enhance Blockchain-related services to acquire data from exchanges and other platforms to fix the rate of traded assets.
Blockchain-based services are known as Blockchain oracles. Smart contracts could boost liquidity pools instead of matching the purchase and sell orders. These pools are generally pre-funded pools of treasures, which play a pivotal role in the function of AMMs.
Users give finances for these pools and enjoy rewards with transaction charges assigned for trades on the specific pair. These users or liquidity providers should deposit a similar value of every benefit in a trading pair for growing interests in their crypto treasures through liquidity mining.
Liquidity pools in AMMs creation can permit traders to implement orders. Simultaneously, traders can grow interests distrustfully and freely. Usually, these DEXs get ranks depending on the whole number of funds locked in their smart contracts.
Because of a growing insufficiency of liquidity, AMM-based DEXs also have a terrible difficulty in the form of slippage. You can see the slippage if the inadequate liquidity causes the buyer to pay more than the market rate on their orders. In these matters, the bigger orders can experience higher slippage. Moreover, liquidity providers could experience the difficulty of temporary loss because of one asset’s unpredictability in trading pairs.
3. DEX Aggregators
DEX aggregators have also become popular. Generally, they are trading protocols that work by originating and routing liquidity across several DEXs as per particular needs. Henceforth, DEX aggregators don’t require serving only traders from their liquidity pools. So, you can see how they could deliver effective methods for crypto trading.
Advantages of Using DEXs
The anonymity of users is an advantage related to DEXs. Users don’t have to pass the basic recognition processes like KYC with DEXs.
2. Possibility of Tokens
DEXs offer the possibility of tokens, particularly those associated with the Blockchain. New projects can list their tokens on the DEXs before listing them on the centralized exchanges.
3. Reduced Counterparty Risks
You can see correlated risks when one party gets involved in a transaction and does not meet their expectations about the deal. The fundamental DEX showcases how DEXs aid transactions via smart contracts. Hence, you don’t require to rely on any medium for trades. You can get freedom from counterparty issues.
4. Enhanced Security
Security is a unique aspect of DEX. It doesn’t control the users’ funds. On the other hand, traders can manage their funds and communicate with the DEX as per their choices.
Challenges of Using DEXs
Apart from some benefits of DEXs, beginners should also learn about the risks related to them
1. Smart Contract Issues
Smart contract issues are common risks related to a DEX. Easy bugs in smart contracts could skip comprehensive code reviews and detailed audits, causing more problems.
2. Unproved Token Listings
People with the aim of liquidity can list new tokens on DEX platforms. Nevertheless, it can cause rug pull scams also. Moreover, investors could buy tokens with the thought that they will get another one. Hence, traders must invest due diligence in token verification before spending on them.
3. Need for Particular Knowledge
Users must have security-based ideas for protecting their funds in a decentralized crypto exchange. Furthermore, you should know about the wallets’ choices and fund the wallet with proper tokens.
Centralized Exchanges vs. Decentralized Crypto Exchanges
There are some fundamental differences between centralized exchanges and decentralized crypto exchanges. DEXs work on open-source code without mediums, and their respective communities of users operate them. However, CEXs work on closed-source, proprietary code and their owners or companies administer them.
It can be said that CEXs are authorized, and DEXs are unauthenticated. Nobody will hinder your access to the latter. Anybody with an active internet connection can use DEXs, while CEXs are open to only the individuals who can perform according to the owner’s regulations.
Furthermore, design is an important differentiating factor between the two primary types of crypto exchanges. The DEX ecosystem has developed AMM trading as an innovation in finance, whereas CEXs depend only on the order book trading model. In addition, DEXs can be programmable money legos, so you can easily link them with other open-source DeFi applications to develop new apps. On the other hand, CEXs are made as siloed for profit to enrich their owners.
A few other fundamental differences between CEX and DEX are:
- Due to their trustless and open aspects, DEXs are remarkable for long-tail asset trading, which promotes trading around numerous low-volume, small cryptocurrencies. CEXs are ideal for short-tail asset trading for administrative purposes, promoting much volume around the best cryptocurrencies.
- DEXs provide non-custodial trading, while CEXs are custodial and administrative to the money you deposit onto their platforms.
- The regulatory demands make CEXs provide direct business-to-client shields, such as client service assurances, deposit assurance, etc. Since DEXs are not organizations, they don’t provide these standard protections.
Hopefully, you find this guide to decentralized exchange helpful. Stay connected with Mozaic Finance to learn more about DEXs and how you can save your time with automated DeFi.