A decentralized exchange, or DEX, is a platform for cryptocurrencies that enables peer-to-peer trading between traders to buy, sell, and swap various digital assets. A decentralized cryptocurrency exchange differs from a centralized exchange in that there are no middlemen between the users. Blockchain technology is used by DEX platforms to replace third parties or organizations that frequently provide brokerage services in the traditional financial sector.
A trading platform or, at least, a brokerage that will enable them to convert their fiat dollars to cryptocurrencies must typically be selected anytime an investor joins the cryptocurrency ecosystem. This platform will typically be a centralized exchange playing the same role as banks and traditional stock exchanges.
The blockchain protocol philosophy, on the other hand, forbids the usage of “gatekeepers” or middlemen whose existence inside the traditional financial media appears to create bottlenecks. These include repeatedly exploited counterparty risks, exorbitant transaction fees, and protracted processing and settlement periods.
The advantages of DEXs are covered later in this tutorial, but it is important to note now that DEXs were developed to overcome the majority of these ‘gatekeeper’ flaws.
Centralization Vs. Decentralization:
The primary distinction between centralized and decentralized exchanges is that centralized platforms are managed by a fixed team, giving the exchange greater control and voice over its users. On the other side, decentralized platforms use a peer-to-peer system using blockchain technology, giving users additional power and giving them full control over their accounts.
Decentralized Exchanges: Types:
Let’s think about the numerous varieties that exist and how you may distinguish between them as a newcomer in this field before we examine how DEXs function. These are the three primary DEX types or groups.
DEX Order Book Platforms:
Similar to their centralized counterparts, order book-based decentralized exchanges operate by keeping track of all open orders in some way, either online or off. They represented the blockchain’s initial iteration of the DEX idea.
They come in two varieties, namely,
DEXs for both on-chain and off-chain order books are available.
Every instance of a transaction is recorded on the blockchain by on-chain order book DEXs. In essence, it is possible to examine all open orders online, and any order cancellations are likewise recorded on the blockchain. Because of this, using this kind of DEX was frequently time-consuming, difficult, and expensive.
Additionally, front-running tactics are common in the on-chain order book DEXs. In contrast to traditional markets, where brokers can profit.
The Interstellar DEX from Stellar and the XBTS DEX from Bitshares are two excellent instances of on-chain order book DEXs.
Order book off-chain DEXs only transfer matching orders to the blockchain for settlement, and they maintain a record of all pending orders offline. Since the DEX is susceptible to an attack on the order book, all unmatched orders are retained offline, which results in the introduction of centralization.
However, since less data needs to be written to the network, keeping open orders offline is advantageous since it lowers transaction costs and boosts blockchain throughput.
DEXs with an off-chain order book include those from Binance, IDEX, and Ether Delta.
Aggregators of DEX:
Decentralized exchange aggregators gather liquidity from many DEXs, as the name suggests. The basic idea behind their business model is to link traders on their platforms with liquidity pools on many other platforms, giving them access to a wider range of trading pairs and greater liquidity.
Low liquidity DEXs gain from aggregators’ services, and consumers take advantage of quick transaction times at lower prices. As a result, the DEX aggregators see an increase in users.
They also reduce security and safety hazards by limiting the number of platforms traders must use to complete their trading objectives. Furthermore, centralized exchanges (CEX) are more user-friendly than DEXs, and DEX aggregators frequently operate in this way. Users of DEX aggregators will therefore benefit from seamless user experiences that they would not otherwise get on a normal DEX.
Rhino. fi (formerly DeversiFi), 1inch exchange, Slingshot, and Matcha by 0x are a few examples of DEX aggregators.
Automated Market Makers (AMM) AMM exchanges are more recent iterations of DEX systems created to solve the drawbacks of using order books. Smart contracts and financial incentives are used by AMMs to create liquidity on their platforms.
AMM exchanges’ central tenet is that liquidity is maintained within a holding contract where investors are enticed to make contributions to holding pools known as liquidity pools. By using these pools, assets are always available for trading when other users require them.
Consider the situation of a trader who has to exchange between Ethereum (ETH) and USD Tether (USDT). They will receive USDT in exchange for the ETH they deposit into a liquidity pool run by a DEX. The liquidity and ease of asset swapping increase with the size of the pool. Larger pools also lessen slippage, which is the price difference between placing an order and having it executed.
How is a liquidity Pool Operated?
Utilizing liquidity pools is a rather straightforward concept. Imagine it as a pool of water, with the water serving as a metaphor for all of the pool’s other elements. There can never be just one asset in a liquidity pool; in fact, most have two tokens, though some have tried as many as eight.
Investors are known as liquidity providers (LPs) because they are motivated to add assets to the pool to supply liquidity. They receive a portion of the fees traders pay to access or “draw” from the pool as payment for their participation. Liquidity mining is the term for this activity.
When a trader converts their tokens, they withdraw one asset (or one of the other assets held in the pool) while concurrently depositing one of the assets present in that specific pool. Smart contracts are used to lock and secure the funds, and everything operates independently.
How to Use Decentralized Exchanges?
It is important to understand how centralized DEXs operate in order to comprehend DEXs and how they function. Because DEXs are a development of centralized exchanges (CEXs), this is the case. They were introduced to address some of the issues that CEX platforms were having as well as to take advantage of blockchain technology.
The Operation of a Centralized Exchange (CEX)
With CEXs, a business acts as a go-between for investors and traders, providing a platform or “market” for the purchase, sale, or even holding of assets. Due to financial incentives, CEX platforms are typically attractive to consumers, providing more streamlined and smooth interactions.
The regulatory body that will oversee the CEX platforms’ operations in a particular jurisdiction will require that they first register with it. Following that, they will set up the platform and restrict access to it to those who have been granted permission to use it.
They are able to provide services like asset custody and a platform for opening and closing trading transactions. They can do this using both fiat money and digital assets. One of the main advantages of CEXs over DEX platforms is their support for traditional assets, which they can do because they are regulated.
Nevertheless, despite their benefits, they also have several glaring drawbacks, such as:
• Security risks: Because CEXs are so centrally located, they attract hackers who might be searching for ways to steal money, compromise systems, or steal client information, among other things;
• Data, privacy, and security threats may be posed to customers by the CEX platform if it abuses its rights to store their data;
• Risks associated with custody – keeping client funds may be advantageous or detrimental. Using a CEX platform that handles self-custody for digital assets is a terrific alternative for investors who require assistance.
• Service availability – due to compliance with regulatory requirements, several CEX platforms are geographically restricted and have little to no access to potential customers. This poses a significant security risk that has been exploited on numerous occasions in the past.
• Blockchain technology was developed to promote economic independence, which called for the development of DEXs.
The Operation of a Decentralized Exchange:
The fundamental idea behind DEXs is that they serve as peer-to-peer marketplace hosts and reduce the need for centralized platforms. Through the use of DEXs, users can communicate directly with one another due to the following characteristics:
• Anyone, wherever, can access these DEX platforms and trade with other users at any time; no geographical restrictions;
• Self custody – DEXs do not demand that traders deposit money someplace to use services. Tokens can be directly exchanged between wallets by users;
• Anonymity – AMMs and order book-based DEXs do not require their users to identify information, except some DEX aggregators, some of which operate in a hybrid manner;
• All types of digital assets, from cryptocurrencies to non-fungible tokens (NFTs), can be supported indefinitely by DEX platforms because they are not required to comply with regulatory bodies.
In addition to the aforementioned benefits, DEXs also have built-in benefits like lower costs, straightforward interfaces, and speedy transaction processing times. The majority of these advantages can be attained by eliminating the middlemen used in the CEX model.
Methods for Utilizing Decentralized Exchanges:
When compared to a few years ago, DEXs are getting more and more popular, which is partly attributable to the rising popularity of Bitcoin (BTC) and the recent collapse of the FTX exchange. The latter underscored the significance of self-custody of digital assets and further demonstrated the drawbacks of centralized exchanges.
Since different platforms offer different functionality, there are a few things you must take into account before you can begin using a DEX.
1. Blockchain Networks:
There are several blockchain networks, some of which allow smart contracts and, as a result, can host DEXs. Ethereum is the biggest among them, but depending on your needs, there are several respectable options to take into account. Determine the asset you wish to buy and the one you already have in your wallet to trade before deciding between networks;
2. Liquidity of an Asset:
The liquidity of an asset is a metric used to describe how simple it is to purchase or sell a given item on the open market. The asset is more liquid the simpler it is. Utilizing the total value locked (TVL) statistic, which is displayed on the majority of DEX scanners, is the greatest approach to gauge liquidity. Make sure to verify.
3. Reputation:
It’s crucial to take into account a specific DEX platform’s popularity as well as whether or not it has a good or bad reputation. There are several methods to get scammed in the Bitcoin industry, but the most popular one is to use unreliable platforms whose roots conceal dubious operators. Investigate each site you are thinking about, and make sure the exchange is reliable;
4. User Experience:
User experience Several factors, such as the interface, ease of interoperability with users’ wallets, network speed, etc., have an impact on a user’s experience. You might not be able to judge a platform’s usability until you use it, therefore to prevent making poor decisions, thoroughly investigate every interaction and read about other people’s perspectives;
5. Asset support:
There are more than 100,000 tokens available on the cryptocurrency market, each of which is housed on a different independent blockchain network. So many DEXs are currently supporting these networks, and the majority of them do not allow tokens on unsupported protocols. You will need a DEX that either supports these various protocols or one that supports a wrapped version of the token of interest if you need to swap tokens across many blockchains. For instance, on the BNB Chain ecosystem, ETH is also available as Wrapped ETH (WETH).
Conclusion:
The use of decentralized exchanges by Bitcoin users is a terrific way to preserve their financial independence. They make it possible for everyone to access services without restriction, which is the core principle of Bitcoin, the most well-known cryptocurrency.
When selecting a platform, various considerations should be taken into account, as was covered in this tutorial. Every time you find a new DEX you want to try out, you must go over that list and tick it off. By doing this, you lower your risks and guarantee that each platform that enters your crypto toolbox does so on merit.
FAQS
A DEX is what?
Decentralized exchange, or DEX, is a cryptocurrency platform that enables peer-to-peer trading for traders to buy, sell, and swap between different digital assets. This is in contrast to how centralized exchanges (CEX) operate, which connect various exchange users through intermediaries.
How is a DEX put to use?
There are three basic categories of DEXs, and each operates slightly differently. DEXs of the order book type maintain track of pending orders in an order book. To provide a fluid trading experience at cheap costs and little slippage, DEX aggregators connect to several DEXs’ liquidity pools. Automated Market Makers (AMMs) offer other traders liquidity in exchange for a cut of the trading fees, which incentivizes users to deposit tokens.
How is a DEX platform profitable?
The majority of DEXs make money by collecting transaction processing fees. For instance, a trader who wants to switch between two assets will pay a fee that is, let’s say, 0.5% of the trade’s value.
Where do I begin to trade on a DEX?
To begin trading on a DEX, you require three items. Selecting a platform that meets your needs comes first. Connect it to your Bitcoin wallet so you can exchange some tokens there. Finally, exchange using the DEX. This guide includes a more thorough response; for more information, scroll to the section on using a DEX.
