What Are Decentralized Exchanges, And How Do DEXs work?

If you’re at all interested in the cryptocurrency world, then you’ve probably heard of decentralized exchanges (DEXs). After all, crypto is all about decentralization, so it’s no surprise that its users seek our similarly decentralized ways to acquire and exchange it. But what exactly are DEXs, and how do they differ from centralized exchanges?

How Do Decentralized Exchanges Work?

Just like their name suggests, DEXs are crypto exchanges that don’t have a central authority. There is no central server that can be hacked or taken down and no single entity that has control over the exchange. This decentralization offers many advantages, one of the most important ones being security.

The most defining characteristic of decentralized crypto exchanges is having no third parties involved in transactions initiated on such platforms. Instead, trades are made directly between users through an automated process —​​ this method of exchange is called peer-to-peer, or P2P.

Most DEXs are essentially dApps (decentralized applications) or DAOs (decentralized autonomous organizations) that run on Ethereum or any other cryptocurrency network with smart contracts functionality.

So, how do DEXs work? The vast majority of decentralized exchanges operate using self-executing smart contracts and rely on complex code and algorithms to carry out transactions. However, things like the DEX interface, liquidity providers, transaction fees, and more depend on which type of decentralized exchange platform we’re talking about.

Order Book DEXs

Order book decentralized exchanges match buyers and sellers directly, without a central authority. The most popular order book DEX is probably EtherDelta, which was launched in 2016. However, there are many other DEXs representing this category, such as IDEX, Radar Relay, and Paradex.

Order book DEX platforms essentially work like open-air markets: they allow participants to place their best bid or ask prices on assets and then wait for somebody else to come along and fill their orders. Because of this, they are usually quite slow and have lower liquidity. 

The trades most DEXs of this type offer nowadays are fully trustless and non-custodial, which makes them incredibly decentralized, private, and secure. They are also usually the most beginner-friendly DEX platforms due to their similarity to traditional exchanges.

Automated Market Makers (AMMs)

Another type of decentralized exchange is an automated market maker (AMM). These platforms use algorithms to match buyers and sellers and have no need for a central authority. Smart contract technology helps AMMs to split all assets into liquidity pools. Each liquidity pool can be rebalanced whenever users carry out transactions.

Launched in 2018, Uniswap is probably the most popular AMM. Plenty of platforms actually fall into this category: Bancor, Kyber Network, AirSwap, and so on.

These exchanges typically have high trading volumes and low fees. Because of this and the other benefits they provide, AMMs are currently the most popular type of decentralized exchange. Their main downside is that unlike order book DEX platforms, they don’t support complex order types, like stop-loss orders.

DEX Aggregators

Finally, there are also DEX aggregators. These platforms allow users to trade on multiple DEXs simultaneously. 0x Protocol has been around since 2017 and perhaps is the most popular DEX aggregator out there, but there are many other platforms, such as ParaSwap, dex.ag, and OneInch.

These exchanges typically have high trading volumes and low fees. They also tend to be more user-friendly than order book or AMM DEXs. Nonetheless, they typically offer less privacy and security.

What Are the Potential Benefits of Using a DEX?

DEXs are a great choice for anyone concerned about privacy and censorship. Here are some of the biggest benefits they can provide to users.

Decentralization

Decentralization has always been one of the primary principles of crypto and blockchain technology, and DEXs uphold that. When exchanging or buying cryptocurrency on a decentralized exchange, you will never have to worry about any middlemen, which means no extra fees or security concerns.

Increased Security

If a decentralized exchange is hacked, its users won’t have to be afraid that their data will be leaked soon. DEXs do not store user data, so it naturally won’t be compromised should there be any information leaks.

Additionally, most DEXs have a more sophisticated structure than centralized exchanges do. Because of this, they are much harder to compromise.

Resistance to Censorship

As there is no central server, DEXs are also much more resistant to censorship of any kind or form. In contrast, centralized exchanges can be shut down or censored by governments or other regulators — but DEXs cannot.

Variety of Tokens Available

Decentralized exchanges usually offer a lot more tokens than their centralized counterparts.

Privacy: No KYC/AML

DEXs also have a number of advantages when it comes to privacy. When you use a centralized exchange, you have to trust that it will not misuse your personal data. With a DEX, you don’t have to pass KYC/AML, and there is no central entity that has access to your data, so you can be sure that it will not be misused.

Drawbacks of Using DEXs

Although decentralized platforms offer a lot of benefits, they naturally have some drawbacks, too. Let’s explore some of them.

They Are Still Not 100% Safe

As we have mentioned previously, DEXs are typically more resistant to hacker attacks than centralized exchanges. Nevertheless, that does not mean they are fully secure: they can still get hacked. Criminals can use vulnerabilities in smart contracts to steal users’ money.

No Recovery Ability

Some centralized exchanges can occasionally aid users in recovering their money, especially if it was lost to something like sending too little crypto for the transaction. You can read more about the cases where your money can be refunded here.

Low Liquidity

Most DEXs have relatively low trading volume and liquidity, which is crucial for better rates and the normal functioning of crypto markets, especially when volatility is high.

Limited Advanced Features

Many DEXs — probably the overwhelming majority — don’t give users access to advanced tools and features like options or margin trading. If that’s something you are looking for, a centralized exchange may be a better choice for you.

Are Decentralized Exchanges Safe?

DEXs are very secure. In fact, they are generally considered much safer than centralized exchanges. This is because there is no central point of failure: if one server goes down, the others can continue to operate. Additionally, decentralized exchanges are much more private. Again, this is because there is no central authority collecting and storing user data.

Nonetheless, one should remember that no exchange is 100% safe. There have been a number of hacks of both centralized and decentralized exchanges over the years. So, it’s always important to take precautions for your own security, such as using a strong password and two-factor authentication. 

How Do I Buy Crypto on a Decentralized Exchange?

If you’re interested in buying crypto on a decentralized exchange, there are a few things you need to know. First, you’ll need to create an account on the platform of your choice. Then, you’ll need to deposit some cryptocurrency into your account. You will also need to create a crypto wallet that supports the digital assets you are planning to exchange. Once you have done this, you’ll be able to trade cryptocurrency with other users on the platform.

DEX Fees

Decentralized exchanges’ transaction fees vary by platform. Typically, though, they are not that high.

The problem with fees doesn’t arise from the DEX platforms per se: instead, the highest fees most users typically pay are Ethereum’s gas fees. However, they will soon be lowered as ETH goes through the Merge. Additionally, some decentralized exchanges use blockchains other than the Ethereum blockchain, like PancakeSwap, which operates on the Binance Smart Chain.

FAQ

What are some examples of decentralized exchanges?

Some of the most famous DEXs include Uniswap, 0x Protocol, and Venus.

How do decentralized exchanges make money?

Decentralized exchanges make a profit via trading fees and their native tokens if they have any.

What is the biggest decentralized exchange?

At the moment, Uniswap is the biggest DEX.

Are decentralized exchanges legal?

Some DEXs may be banned in some countries and territories, but overall, yes, decentralized exchanges are legal.

Disclaimer: Please note that the contents of this article are not financial or investing advice. The information provided in this article is the author’s opinion only and should not be considered as offering trading or investing recommendations. We do not make any warranties about the completeness, reliability and accuracy of this information. The cryptocurrency market suffers from high volatility and occasional arbitrary movements. Any investor, trader, or regular crypto users should research multiple viewpoints and be familiar with all local regulations before committing to an investment.