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What is a DEX?
A decentralized exchange (DEX) is a type of exchange specializing in peer-to-peer transactions with cryptocurrencies and digital assets.
Unlike centralized exchanges (CEX), DEX does not require a trusted third party or intermediary to facilitate the exchange of crypto assets.
One of the main principles of cryptocurrencies is the disintermediation of finance, as it increases the economic freedom of people anywhere in the world, regardless of who they are. DEXs are a core component of decentralized finance (DeFi).
Probably, without high-quality and liquid DEX, the DeFi cryptocurrency would not have survived the incredible growth that it has experienced.
The popularity of DEX has increased on Ethereum, but since then they have migrated to all blockchains with the functions of general-purpose smart contracts.
DEX are important to the blockchain ecosystem because they are the first decentralized application (dAPP) that you usually interact with when you appear on a new chain. With their help, you can exchange crypto assets for cryptocurrencies and vice versa.
Many DEX not only facilitate the exchange between different cryptocurrencies, but also allow you to earn cryptocurrencies without trading.
How do DEXs work?
In one form or another, DEXs existed in cryptocurrency back in 2012-2014, depending on how to define DEX. Which DEX was the first can be debated, but it is obvious that one DEX changed the landscape forever: Uniswap.
Uniswap became the first working decentralized Automated Market maker (AMM). Before the advent of AMMs, DEXs exchanges had liquidity problems. Thanks to AMM, adding liquidity has become easier and more attractive.
Before the advent of Uniswap with a working AMM, trading on DEX was slow, and crypto assets on the exchange were often traded at a premium to the same crypto assets on CEX.
This is due to the fact that before the advent of AMM, DEX exchanges tried to imitate the work of centralized exchanges. The problem is that the methods used on CEX require a large number of calculations with low latency.
Porting the same methods to DEX meant that they work much slower and still require some centralization. Even worse, the unsuccessful experience of the first DEX scared people away from providing their funds for trading, which did not allow DEX to gain momentum and collect the necessary liquidity.
AMM solved this problem by stimulating the creation of liquidity pools and providing algorithmic trading of these pools. The incentive is commission sharing.
In particular, those who add liquidity to DEX receive a portion of the commission received from trading other participants. As for the trading algorithm, it includes a formula that balances the balances of two assets in a trading pair.
It is important to remember that there is no active trading of two assets in a pair in real time, and the program determines the price depending on the balance of both assets.
What are potential benefits of using a DEX?
Huge variety
If you want to find a “hot” token that is at the initial stage of its development, DeFi is what you need. DEX offers an almost unlimited choice of tokens – from the well-known to the strange and completely random.
This is due to the fact that anyone can issue an Ethereum-based token and create a liquidity pool for it, so you will find more projects, both verified and untested. (The buyer should be careful!).
The risks of hacking can be reduced
Since all funds in DEX transactions are stored in traders’ own wallets, they are theoretically less susceptible to hacking. (In addition, DEX reduces the so-called “counterparty risk”, i.e. the probability that one of the parties involved, including potentially the central authority in a non-DeFi transaction, will default).
Anonymity
No personal information is required to use most popular DEX.
Usage in developing countries
Peer-to-peer lending, the speed of transaction and anonymity provided by DEX make them increasingly popular in emerging economies where reliable banking infrastructure may be lacking. Anyone with a smartphone and an internet connection can trade through DEX.
What are some potential downsides?
Complex user interfaces
Working with decentralized exchanges requires special knowledge, and the interfaces themselves are not always simple – be prepared for the fact that you will have to do a lot of research, and do not expect DEX to offer a lot of hints on its own.
As a rule, you have to look for instructions or an explanation on another site. Caution is necessary because it is possible to make an incorrigible mistake, for example, to send coins to the wrong wallet.
Another common problem is known as “non-permanent loss”, which can occur as a result of combining a more volatile cryptocurrency with a less volatile one in the liquidity pool. (The main conclusion: conduct your own research).
Vulnerability of smart contracts
Any DeFi protocol is only as secure as the smart contracts on which it is based are, and vulnerable errors can be found in the code (despite long testing) that can lead to the loss of your tokens.
And although under normal conditions a smart contract can work as expected, not all rare events, the human factor and hacking developers can provide.
Riskier coins with
The huge number of tokens available on most DEX, there are also a greater number of fraudulent schemes to be wary of. A token that is at the peak of popularity may suddenly be “on the carpet” when its creator mints a bunch of new tokens, overflowing the liquidity pool and bringing down the value of the coin.
Before buying a new cryptocurrency for yourself or experimenting with a new protocol, it is important to learn as much as possible – read technical documents, visit developers’ Twitter feeds or Discord channels, look for audits of the project you are interested in (among the major auditors can be called Certik, Consensys, Chain Security and Trail of Bits).
How do you interact with a DEX?
You can connect to DEX, for example Uniswap, using a cryptocurrency wallet, for example Coinbase Wallet, in a web browser or on a smartphone. If you are just starting out, we recommend using the Coinbase dap wallet, available directly in your Coinbasedapp.
To start trading on most DEX, you will also need a stock of Ethereum, which you can get on an exchange such as Coinbase.
The reason you need some ETH is to pay the fees (known as “gas”) that are required for any transaction made on the Ethereumblockchain. These fees are independent of the fees charged by the DEX exchange itself.
How do DEX fees work?
Fees for services vary. Uniswap charges a commission of 0.3%, which is distributed among liquidity providers, and a protocol fee may be added in the future. However, it is important to note that the fees charged by DEX may be comparable to gas fees for using the Ethereum network.
The ETH2 modernization currently underway (as well as a number of “second-level” solutions, such as Optimism and Polygon) are designed to partially reduce fees and speed up transactions.
