TL;DR
- Decentralized exchanges have emerged as a popular alternative to centralized exchanges like Coinbase and Binance.
- Decentralized exchanges give users authority and accountability by allowing them to conduct transactions directly from their wallets using smart contracts.
- Order book, DEX aggregators, and automated market makers are the three different types of DEX.
Introduction
Crypto exchanges are believed to be one of the major driving forces behind the huge adoption and success of cryptocurrencies nowadays. While centralized crypto exchanges continue to dominate the majority of the crypto exchanges’ market share, decentralized exchanges have risen as an alternative for crypto enthusiasts.
In this article, we will discuss everything about DEX and see if it could be the next step of cryptocurrency development.
What is DEX?
A decentralized exchange (DEX) is a peer-to-peer (P2P) market that connects cryptocurrency buyers and sellers without the use of a middleman to facilitate the transfer and custody of the funds.
A DEX is designed with “disintermediation” in mind, which refers to doing away with middlemen and enabling common people to interact with one another directly. This typically means that protocol administrative rights are governed by a decentralized autonomous organization (DAO), made up of a group of stakeholders, which votes on key protocol decisions.
Some notable examples of DEX aggregators
Uniswap
Uniswap is now the top decentralized exchange by trading volume It was the first DEX on the Ethereum blockchain, enabling users to exchange any ERC-20 token.
Uniswap is open source, which means that anyone can freely use it as a model for developing their own DEX. Even more impressive is that it does not charge users any fees to register tokens on the market.
SushiSwap
SushiSwap is a DEX on multiple networks. The platform’s design is based on the Uniswap constant-product automated market maker (AMM).
SushiSwap charges a fee for each swap, which is then given to the liquidity providers as compensation for their labor.
PancakeSwap
A decentralized exchange called PancakeSwap is based on the BNB Chain. It makes it simple for users to swap BEP-20 standard tokens.
After Uniswap and SushiSwap, PancakeSwap is currently the third-largest AMM platform. PancakeSwap dominates the market among the AMM solutions created on BNB Chain. It has gained massive popularity within a short period of time since its introduction in September, 2020.
The evolution of DEX
The first DEX can be dated back to 2014, when Counterparty protocol was established to compete with Mastercoin protocol – a protocol where many tokens on top of Bitcoin can be launched. However, the platform did not gain much attraction because the ecosystem was too small and immature at the time to be ready for DEXs.
Then as time went by, many DEX platforms such as Uniswap , Bancor,… went live. And in 2018, the total trading volume of DEX exploded to $2.7 billion in 2018. The transaction volume of DEX in the next year decreased slightly to only $2.5 billion.
How does DEX work?
Like any other decentralized applications, DEXs are operated on automated smart contracts. They are lines of code that can generate different outputs based on the inputs they receive.
These smart contracts set the prices of various cryptocurrencies using “liquidity pools” – a mechanism in which users can lock their assets to provide the much-needed asset liquidity for traders to swap between currencies and receive interest- like reward for their work.
The way decentralized exchanges work is quite similar to that of CEXs. DEXs also have the features such as buying, selling and exchanging crypto assets by the users. However, DEXs do not rely on a third party to hold the client’s funds.
Top 3 popular types of DEX
There are many types of DEXs today, but the three main types of decentralized exchanges include: Automated market makers (AMM), Order books DEXs and DEX aggregators.
Automated market makers (AMM)
An automated market maker uses smart contracts to address the liquidity issue. These AMMs rely on blockchain-based services known as blockchain oracles to determine the price of traded assets by gathering data from exchanges and other platforms.
Instead of matching buy and sell orders, the smart contracts of these DEXs use pre-funded pools of assets known as liquidity pools.
Order books DEXs
Order books keep track of all open buy and sell orders for certain asset pairs. The depth of the order book and the market price on the exchange are determined by the difference between the buy and sell price.
Order book DEXs have two types: on-chain and off-chain order books. With on-chain, everything is recorded on the blockchain, whereas with off-chain, orders are stored somewhere else and users’ funds are kept in their wallets rather than being posted to the blockchain.
DEX aggregators
DEX aggregators were created to address the problem of inadequate liquidity on decentralized exchanges. They are financial protocols that provide users with access to numerous trading pools through a single dashboard. By the middle of 2020, DEX aggregators had accounted for over 20% of decentralized trade volumes because of the opportunities they provide.
The advantages of DEX
Diversity
With over 7,400 cryptocurrencies available, DEXs offer a practically infinite variety of tokens. Users will find a wider variety of projects, both verified and unvetted, as nearly anyone can mint their Ethereum-based token and establish a liquidity pool for it.
Anonymity
Since many DEXs are not controlled by any central entities, the users are not required to complete the Know Your Customer (KYC) process found on CEX platforms. This can be a huge convenience for those who do not want to share their personal information.
Security
One of the biggest benefits of DEXs is security. Because DEX is non-custodial, users do not have to use their private keys or recovery seeds. The entire control of the wallet remains in the hands of the users.
The risks of DEX
DEXs can be viewed as a revolutionary step in the crypto industry, but there are still some major drawbacks that need to be addressed. It is extremely important to consider these risks before deciding on whether users should choose DEXs or not.
Dangerous tokens
Since virtually anyone may create their own token, there are more scams and schemes to be on the lookout for. A token’s value may be abruptly “rug pulled” if its creators issue an excessive number of new tokens, which would overwhelm the liquidity pool.
Liquidity issues
Lack of liquidity is one of the urgent concerns for many decentralized exchanges. Because decentralized exchanges rely on the number of active users trading on the platform, they attract significantly lower liquidity compared to their CEXs counterpart.
Inability to restore access
Lack of KYC regulation can lead to a serious problem when users face an unpleasant situation like the inability to cancel a transaction in the case of losing a private key, or not having their assets returned to them on request.
Conclusion
Although decentralized exchanges are still in their infancy, it is undeniable that with the constant innovation and development of the crypto sector, DEXs will keep evolving to keep up with the fast pace of the financial world to provide crypto’s enthusiasts the best experience possible.
