Decentralized Crypto Exchanges: What Are DEXs And How Does its Works?

Decentralized crypto exchanges (DEXs) are blockchain-based apps that coordinate the large-scale trading of crypto assets by many users. They do this entirely through automated algorithms, instead of the conventional approach of acting as a financial intermediary between buyers and sellers.

DEXs are examples of smart contracts. They’re pieces of code written on top of blockchain networks, like Ethereum. When given certain inputs, these codes trigger various outputs.

A DEX, or decentralized exchange, takes the middlemen out of financial and asset transactions so that regular people can do business without any added cost. This means users can directly hold assets in their own wallets, without a middleman keeping custody.

Innovations that were designed to solve liquidity-related problems, such as automated market makers, helped attract users to the decentralized finance space. These innovations largely contributed to the growth of the DeFi space.

DEX aggregators and wallet extensions fueled the growth of decentralized platforms by optimizing token prices and rates, swap fees, and slippage. Users benefited from these improvements as they were able to make better transactions faster.

What Are Decentralized Crypto Exchanges?

Decentralized exchanges are different from centralized exchanges in that they use smart contracts to execute orders without the need for a middleman. Centralized exchanges are managed by a centralized organization such as a bank, but because of their reliance on financial services, it’s tough for them to make a profit.

Centralized cryptocurrency exchanges account for a large portion of the market because they are the first option for new users to trade easily. But They are more risky centralized exchanges that even offer insurance on deposited assets.

Whereas decentralized exchanges are safe. If funds are lost or stolen, it’s because of a user’s mistake rather than the operator of the exchange.

So, Decentralized exchanges have been built on top of leading blockchains, which allow for smart contracts. These are decentralized exchanges, which means they are not controlled by any one entity and they exist on the blockchain. The most popular DEXs are built on top of the Ethereum blockchain.

In this blog post, we will be discussing what is Decentralized Crypto Exchanges (DEXs), how does it work, their advantages, and disadvantages, and how to use them.

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How Do Decentralized Crypto Exchanges Work?

The great thing about decentralized exchanges is that whenever you make a trade, you’ll never deal with hidden fees. You interact directly with smart contracts to use the DEX.

There are three main types of decentralized exchanges: automated market makers, order books, and DEX aggregators. All allow users to trade without a centralized mediator through smart contracts. The first type of DEX used the same type of order books as centralized exchanges.

Automated Market Makers (AMMs)

To fix the liquidity problem, an automated market maker was created. The inspiration behind these electronic exchanges came from Ethereum co-founder Vitalik Buterin’s paper on decentralized exchanges. This includes how to execute trades on the blockchain using contracts holding tokens.

Blockchains allow for oracles to pick up information from exchanges, providing you with updated and accurate prices for traded assets. Without a need to match buy orders and sell orders, liquidity pools exist as one-time investments to make transactions more efficient.

To provide liquidity, pools are funded by people who then receive transaction fees for the trade execution. These pool participants need to first deposit an asset of equivalent value in the pair being traded, earning interest on their position, which is a process called liquidity mining. If they try to deposit more of one asset than the other, the liquidity contract will not approve it.

What are liquidity pools? That’s a great question! Liquidity pools allow traders to execute orders or to earn interest in a permissionless and trustless way. They are often ranked by the number of funds locked in smart contracts called total value locked (TVL), which is why TVL is a downside for exchanges in which there is not enough liquidity: slippage.

Slippage is a problem for platforms that don’t have enough liquidity. Large orders are more likely to suffer from slippage, which discourages buyers and wealthy traders from using the platform.

In platforms with little liquidity, the buyer may be forced to pay a premium for their order, and larger orders are more likely to have slippage. Low liquidity can deter wealthy traders, who need deep liquidity before they can buy more of an investment.

One risk liquidity providers face is impermanent loss. This is the direct result of depositing two assets to trade a specific pair. When one of those assets becomes more volatile than the other, trades on the exchange can lower the amount of one asset in the pool.

If prices are volatile, and liquidity providers don’t have enough to make trades, they suffer an impermanent loss. That’s because the price of the asset can still change and balancing trades can happen on the exchange. Additionally, there are fees from trading that can cover for the loss over time.

Order Book

Order books contain records of all open orders to buy or sell an asset at a specific price. Buy orders mean that a trader is willing to pay the specified amount for a particular asset, while sell orders are made by traders who are ready to trade assets at the given price. The gap between the two prices determines how far into the order book you’ll go, and what the current price is on the exchange.

DEXs can store their order books on-chain or off-chain. Trading platforms that use an order book typically have open order information available on-chain while users’ funds are stored safely in the platform’s wallet. Leveraged trading with borrowed funds is possible on some DEXs and increases the earning potential of a trade, but it also increases the risk of liquidation as traders may not be able to repay their loans if they lose.

A decentralized exchange (DEX) is an exchange that does not use a centralized server to hold its order books. This means the users of DEXs have the benefits of trading on a centralized exchange but with reduced costs and increased speed.

Exchanges also provide users with options for leveraging their assets through margin trading. This means borrowed money can be used to make larger trades, which could have a higher return but also a much greater loss. The exchange backs these borrowed funds, ensuring lenders get paid even if traders lose their bets.

Despite the many benefits DEXs have over centralized exchanges, they often suffer from liquidity issues. Centralized exchanges provide better pricing with lower fees, and traders are more likely to use them because of that. However, DEXs that use off-chain order books are able to avoid this issue–they only incur a small fee for orders made through smart contracts.

Decentralized Crypto Exchanges Aggregators

DEX aggregators use a number of different protocols and mechanisms to solve problems associated with liquidity. These platforms aggregate liquidity from several DEXs in order to minimize slippage on large orders, optimize swap fees and token prices, and offer traders the best possible price in the shortest time possible.

DEX aggregators use many different techniques to help keep users protected, and decrease the likelihood of unsuccessful transactions. One way that DEX aggregators accomplish this is by breaking up transactions over a series of exchanges. In addition, they will sometimes use liquidity from centralized platforms to provide better user experiences while remaining noncustodial (not controlling any funds).

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Advantages Of Using A Decentralized Crypto Exchanges

DEX trades may be expensive, but they do come with a number of advantages. So, while the network transaction fees might be high, they can actually benefit you in the long run.

To list a token on a centralized exchange, the project must first have it vetted by the exchange and make sure that it fits in with local regulations. A decentralized exchange, on the other hand, can include any token minted on the blockchain it is built upon. This means that most of these exchanges will list a new project before listing it on their centralized counterparts.

When someone exchanges one cryptocurrency for another on a DEX, they don’t have to go through any KYC process. KYC processes generally involve collecting a trader’s personal information, including their full name and ID photo. As a result, DEXs are popular among people who want to keep their identities private.

Cryptocurrency traders who are more experienced and have custody of their funds are at a reduced risk of being hacked, as they can control their funds without the need to interact with the exchange. Trading platforms that get hacked may only be at risk for liquidity providers if they have not yet been hacked or have had their systems compromised by phishing schemes.

Decentralized exchanges reduce counterparty risk because intermediaries are not involved. They operate on the premise of smart contracts which eliminates defaulting on contractual obligations.

To help minimize the risk of using a DEX, users can perform a quick web search to determine whether smart contracts have been audited and what other trader’s experience has been with that DEX.

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Disadvantages Of Using A Decentralized Crypto Exchanges

Despite their benefits, decentralized exchanges also have drawbacks. This includes the difficult nature of using them and technical limitations that make them more susceptible to mistakes. Additionally, there is a lack of vetting token listings that opens up the door for scammers to take advantage of unsuspecting investors.

DEXs allow users to access a decentralized market through cryptocurrency wallets with smart contracts. In order to use DEXs, you have to understand the corresponding concepts of security when it comes to safeguarding your funds.

These wallets need to be funded with the correct tokens of each network. Without a network’s native token, other funds will get stuck, as the trader cannot pay the fee required to move them. Specific knowledge is needed both to choose the wallet and to fund it with the correct tokens.

One of the great benefits of decentralized exchanges is that they don’t suffer from slippage. Near-inverse slippage is often unavoidable when placing orders on centralized platforms, and if you’re an experienced investor, adjustments to their slippage tolerance are nearly impossible. The issue here can be technical, but even users with more limited knowledge may be successful at adjusting it.

If a trader is unfamiliar with the crypto space, they may make mistakes that cost them money. If there’s not a lot of research being done and the trade is rushed, it’s possible to withdraw coins to the wrong network, overpay transaction fees and lose out on potential profits.

Smart contracts on blockchains like Ethereum are public and open-source. Anyone can review their code, which is not the case for centralized exchanges.

Humans make mistakes. So, even if you have audits and code reviews in place, it’s always possible that exploitable bugs could slip through the cracks. Auditors might be unable to foresee new exploits that could cost liquidity providers their tokens.

How To Use Decentralized Crypto Exchanges

Decentralized exchanges do not require any sign-up process. In fact, a trader will only need to download a wallet compatible with the smart contracts on that exchange’s network. Anyone who has a smartphone and an internet connection can take advantage of the financial services offered by DEXs.

To use DEXs, the first step is to decide which network you want to use. You’ll then need to choose a wallet that works with the selected network and fund it with its shared token. A shared token is necessary for paying transaction fees in that network.

Wallets can be installed just like extensions, and they typically require an existing wallet through a seed phrase, private key, or a new one. These tools create an additional layer of security by requiring a password to access the wallet extension. The extension then also facilitates the user’s ability to interact with decentralized applications (DApps) such as DEXs.

A wallet might also have a mobile application, so you can use DeFi protocols when you’re on the go. Every wallet comes with a built-in browser that allows you to interact with smart contract networks. You can sync wallets across all your devices by importing from one to the other.

Wallets need to be funded with the tokens used to pay for transaction fees on the chosen network. These tokens have to be bought on centralized exchanges and are easily identifiable through a ticker symbol, like ETH for Ethereum. After buying the tokens, users simply have to withdraw them to wallets they control.

You should never be transferring funds to a different network because it can lead to complications. That’s why you need to withdraw your funds to the correct network and through the “Connect Wallet” feature, there’s nothing stopping you.

Final Words

If you’re interested in getting started in the world of cryptocurrency trading, a DEX (decentralized exchange) is a great option to consider. DEXes offer increased security and privacy compared to centralized exchanges, and are often more user-friendly, making them ideal for those new to the world of crypto trading. With so many advantages, it’s no wonder that DEXes are becoming increasingly popular among crypto traders.

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About The Author

I have had a keen interest in the world of cryptocurrency and blockchain technology since 2013. My entrepreneurial drive led me to create CryptoGuideToday, a blog dedicated to providing comprehensive coverage of all things related to blockchain and cryptocurrencies. My goal is to educate and inform people about these technologies and provide valuable insights. I am a firm believer that self-education is crucial for achieving success in this field.

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