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What is DEX? How does it work?

May 21, 2021

Reading Time: 6 minutes

You’ve probably had your fair share of hassles with cryptocurrency exchanges and their lengthy KYC verification processes. Sign up with your email, choose a strong password, set up two-factor authentication, verify your account, hope your account gets verified, and start trading.

Imagine you didn’t have to hassle with signing up and going through lengthy verification processes to start trading. Well, that’s what DEXs are for. DEXs, short for Decentralized exchanges, solve a lot of problems centralized exchanges fail to solve.

While they may be a little more complex to use, however, with the increasing adoption of cryptocurrencies and blockchain solutions in general, it’s time you learn and make the shift. As a result of Defi’s recent performance, more customers have joined the cryptosphere; as a result, exchange platforms have advanced as full-service solutions for everyone’s crypto trading needs.

Centralised markets, on the other hand, face significant risks to customers, with billions of dollars in Bitcoin, Ethereum, and other cryptocurrencies losing per year as a consequence of fraudulent hacks and scams. The increasing number of malicious users and sophisticated hacks taking place on these platforms have attracted a lot of attention from regulators who are aggressively regulating these platforms and impacting user privacy in the process. Decentralised exchanges (DEXs) have gained prominence over time to aid customers in dealing with these challenges

In this article, we’ll be discussing DEXs and see if they are any better than centralized exchanges.

What are decentralized exchanges?

Decentralized exchanges or DEXs allow cryptocurrency traders to purchase, sell, swap, or trade their funds while retaining control of their identities.

A peer-based model provides the complete independence from the process of asset transfer and trade issuance is completely divergent from the centralised exchanges, where commodities are handed over to the middlemen who then have only IOUs for their customers.

Third-party authorities such as the Exchanges had to be removed to maintain DEXs because of the need to manage and vet transactions made within a single exchange. Additionally, with the help of smart contracts, DEXs can operate automated order books and trades, making them purely peer to peer.

How does a Decentralized Exchange work?

Decentralized exchanges operate similar to their centralized counterparts; however, they’re significantly different when it comes to other infrastructural operations. Note that there are quite a few types of decentralized exchanges available to the users that can be divided into the following categories.

On-Chain Order Books

On-chain order books DEXs are Decentralized exchanges that execute everything ‘on-chain.’ This means every order is written onto the blockchain. On-chain order books DEXs are undoubtedly one of the more transparent approaches where users don’t have to lose control of their assets to intermediaries to relay the orders.

However, on-chain DEXs are also one of the more impractical approaches since you have to ask every node on the network to record the orders. Moreover, you’ll also be forced to rely on miners to aggregate your orders into the blockchain, which could cost you time and money.

Some of the most popular On-chain order book decentralized exchanges are Bitshares and StellarTerm.

Off-Chain Order Books

While off-chain order books decentralized exchanges are still decentralized in some way or form; however, they’re more centralized than on-chain order books. Unlike on-chain order book DEXs,  every order is hosted on a centralized entity.

A positive example of Off-chain order book decentralized exchange is the 0x protocol.

Automated Market Markers (AMM)

After gaining popularity in 2020 and playing a significant role in the success of the DeFi sector, the Automated Market Makers are used by popular DEX platforms like Uniswap, Kyber Network, and SushiSwap. Interestingly, AMMs don’t need any order books like their counterparts. Instead, AMMs utilize smart contracts to establish liquidity pools that automate trade execution based on specified parameters.

Advantages of DEXs

Decentralized exchanges are often praised for their enhanced privacy, tight security, and greater user control they offer to asset holders.

Security

Today, the biggest risk inherent to centralized exchanges is hacking. Malicious breaches of notable exchanges like Coincheck, Mt. Gox, and Bitfinex have affected the crypto sphere and significantly devastated the public’s trust in the space. The Coincheck hack is easily one of the largest hacks surmounting to over $500 million worth of cryptocurrencies, followed by Mt.Gox’s $472 million.

Unlike Centralized exchanges, DEXs are not vulnerable to this type of risk since users can freely trade on their platforms via cold or hot wallets without having to lose control of their private keys or recovery seeds. Simply put, users are responsible for maintaining the security of their accounts.

Privacy

Almost every centralized exchanges require sign-ups to comply with Know Your Customer verification processes. This forces asset holders to give up sensitive information to the exchange operator.

Interestingly, most DEXs do not implement this. Since they aren’t governed by any central authority, there’s no need to use KYC protocols.

Control

Users can exercise complete control over their funds in DEXs. Users will have complete custody of their funds and will be able to use them as they please. However, note that this doesn’t mean every DEX allows users to exercise complete freedom.

Disadvantages of DEXs

As impressive as they can be, Decentralized exchanges have their fair share of drawbacks, and it is important to note these points before coming to a conclusion.

Transaction Speed

The processing speed of DEXs can be excruciatingly slow. This is because trading calls must be broadcasted to the network and verified by miners before being aggregated to the network. Moreover, this is why trades on DEXs are subject to suffering from price slippage, where transactions fail to execute due to variations in prices of the cryptocurrencies being swapped.

Liquidity

Centralized exchanges tend to be highly liquid because of their enormous capital. However, DEXs tend to have problems when it comes to liquidity. This is because their liquidity is heavily dependent on the number of users actively trading on the platform.

Bottomline

Decentralized exchanges are set to disrupt the crypto sphere by offering an innovative solution to maximize returns from your trading activities while maintaining security. Moreover, security, accessibility, and security are the core reasons why Decentralized exchanges were introduced in the first place.

However, it is important to understand that DEXs do not solve every problem centralized exchanges deal with. As impressive as they are, DEX has its fair share of issues that traders like you have to keep in mind whenever planning ahead. However, with that said, seeing how DeFi continues to innovate the crypto sphere, it is more likely than ever that we see Decentralized exchanges overcome their issues and potentially replace centralized exchanges.

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