A Complete Guide On Decentralized Exchange

A decentralized exchange (or DEX) is a marketplace where crypto traders conduct transactions directly with one another. DEXs fulfil one of crypto's fundamental capabilities: facilitating financial transactions that do not involve banks, brokers, or other intermediaries. Several prominent DEXs, such as Uniswap and Sushiwap, operate on the Ethereum blockchain.

The operation of a decentralized exchange

In some ways, DEXs are comparable to their centralized counterparts, but in others, they differ significantly. Let's begin by noting that users can access various decentralized exchange types. The common denominator is that orders are executed on-chain (using smart contracts) and users never surrender control of their funds. Some research has been conducted on cross-chain DEXs. Still, most DEXs focus on assets on a single blockchain (such as Ethereum or Binance Chain).

  • On-chain order registers
    In some decentralized exchanges, everything is done on-chain (hybridized approaches will be discussed shortly). Every order (including modifications and cancellations) is recorded on the blockchain. This is arguably the most transparent method, as you are not relying on a third party to relay the instructions to you, and there is no way to conceal them.
    Unfortunately, it is also the least useful. Since you are requesting that every node in the network record the order forever, you incur a cost. You must wait until a miner adds your message to the blockchain, which makes the process cumbersome.

    Some identify front running as a flaw in this model. In markets, front running occurs when an insider aware of an impending transaction uses that knowledge to place a trade before the transaction is executed. Therefore, the frontrunner benefits from information that is not publicly known. In general, this conduct is illegal.
    If everything is recorded on a global ledger, there is no way to front-run in the conventional sense. However, a different type of attack is possible: a miner observes the order before it is confirmed and ensures that their order is added to the blockchain before the targets.
    Stellar and Bitshares DEXs are examples of on-chain order book implementations.
  • Non-standard order books
    Off-chain order registers in some ways, DEXs are still decentralized, but they are more centralized than the previous entry. Instead of posting every order to the blockchain, they are stored elsewhere.
    Where? That depends. A centralized entity could be in charge of the entire order book. If the entity is malicious, it could manipulate the markets to some extent (i.e., by front-running or misrepresenting orders). Nonetheless, you would benefit from non-secure storage.
    This is exemplified by the 0x protocol for ERC-20 and other tokens deployed on the Ethereum blockchain. Instead of functioning as a single DEX, it provides a framework for "relayers" to manage off-chain order books. Using 0x smart contracts and additional tools, hosts can access a combined liquidity pool and relay user orders. Once the parties are matched, the trade is only executed on-chain. In terms of usability, these approaches are superior to those that rely on on-chain order books. They are subject to different speed constraints because they utilize the blockchain less frequently. Nonetheless, the trade must be settled on it, making the off-chain order book model slower than centralized exchanges.
    Binance DEX, IDEX, and EtherDelta are examples of off-chain order book implementations.
  • Automated Market Makers (AMM)
    Tired of reading the phrase "order book"? Excellent, as the Automated Market Maker (AMM) model eliminates the concept. It requires neither makers nor takers, merely users, game theory, and a touch of formulaic black magic.
    The particulars of AMMs depend on their implementation; typically, they consist of a collection of smart contracts and ingenious incentives to encourage user participation. Check out What Is Uniswap and How Does It Work? For a description of these implementations. For an illustration of how the Uniswap DEX operates.
    Today's AMM-based DEXs are typically user-friendly, integrating with wallets such as MetaMask and Trust Wallet. However, as with other types of DEXs, trades must be settled via an on-chain transaction.
    Uniswap and Kyber Network (which utilizes the Bancor protocol) are both working on facilitating the exchange of ERC-20 tokens.

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What are the possible advantages of utilizing a DEX?

  • Wide variety: Defi is the place to find a hot token in its infancy if you're interested. The tokens are available on DEXs range from the well-known to the obscure and random. Because anyone can mint an Ethereum-based token and create a liquidity pool for it, there is a greater variety of both vetted and unvetted projects. (Buyer, be highly cautious!).
  • Hacking risks can be reduced: Because all funds in a DEX trade are stored in the traders' wallets, they are theoretically less vulnerable to hacking. (In addition, DEXs reduce what is known as "counterparty risk," which is the probability that one of the involved parties will default, including the central authority in a non-DeFi transaction.)
  • Anonymity: When using the vast majority of DEXs, you don't need to provide personal information.
  • Utility in the developing world: DEXs have gained popularity in developing economies due to their ability to facilitate peer-to-peer lending, instant transactions, and complete anonymity. A DEX is accessible to anyone with a smartphone and an internet connection.

Pros of DEXs

  • No KYC
    Numerous exchanges adhere to KYC/AML (Know Your Customer and Anti-Money Laundering) standards. Individuals are frequently required to provide proof of identity and address for regulatory purposes.
    This is a concern for some in terms of privacy and for others in terms of accessibility. What if you do not possess valid documents? What if the information somehow becomes public? Since DEXs do not require permission, no one verifies your identity. The only requirement is a cryptocurrency wallet.
    When a central authority partially manages DEXs, certain legal requirements must be met. In some instances, if the order book is centralized, the host must maintain compliance. .
  • Absence of counterparty risk
    Decentralized cryptocurrency exchanges are appealing because they do not hold customer funds. As a result, catastrophic breaches such as the 2014 Mt. Gox hack will not jeopardize user funds or expose sensitive personal information.
  • Unlisted tokens
    Tokens not listed on centralized exchanges may still be freely traded on DEXs, assuming sufficient supply and demand.

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Cons of DEXs

  • Usability
    DEXs are significantly less user-friendly than traditional exchanges. Centralized platforms facilitate trades in real-time that are unaffected by block times. CEXs offer novices who are unfamiliar with non-custodial cryptocurrency wallets a more forgiving environment. If for some reason, you have forgotten your password, you can have it reset. However, funds lost in cyberspace are irretrievable if the seed phrase is lost.
  • Market activity and liquidity
    The trading volume on CEXs continues to dwarf that on DEXs. Possibly even more importantly, CEXs typically have greater liquidity. Liquidity is the ability to buy or sell assets at reasonable prices. In a highly liquid market, the difference between bids and asks is minimal, indicating intense competition between buyers and sellers. In an illiquid market, it will be more challenging to find someone willing to trade the asset at a reasonable price.
    DEXs are still relatively specialized, so supply and demand for the assets you wish to trade are not always present. You may be unable to locate the desired trading pairs, and even if you do, assets may not trade at a fair price.
  • Fees
    If the network is congested or if you're using an on-chain order book, fees may be higher on DEXs.

What are some possible disadvantages?

  • Trickier user interfaces: Decentralized exchanges (DEXs) can be difficult for those without prior experience or training, as their interfaces are not always user-friendly. Users should be prepared to do their research and not rely on DEX support for answers. Generally, you will need to look elsewhere for a walkthrough or explanation. To illustrate, if you send coins to the wrong wallet by accident, you will lose those coins forever. When pairing a more volatile cryptocurrency with a less volatile one in a liquidity pool, a common issue known as "permanent loss" can occur. (The most important takeaway? Do your investigation.)
  • Smart contract vulnerability: Even after thorough testing, there is always the chance that a DeFi protocol's smart contracts will contain vulnerabilities that could be used to steal tokens. And while a smart contract may function as intended under normal conditions, developers cannot anticipate all rare events, human factors, and hacks.
  • Riskier coins: Most DEXs feature many tokens that have not been thoroughly vetted, increasing the likelihood that you will encounter fraudulent activities. When a token's creator mints a large number of new tokens, overwhelming the liquidity pool and plummeting the coin's value, the "rug could be pulled" on a token on a hot streak. Read white papers, visit developer Twitter feeds or Discord channels, and look for audits of any project you're interested in before purchasing a new cryptocurrency or experimenting with a new protocol (some bigger auditors include Certik, Consensys, Chain Security, and Trail of Bits).

Summary

Over the years, numerous decentralized exchanges have emerged, each iterating on previous attempts to streamline the user experience and construct more robust trading venues. Ultimately, the concept appears to be strongly aligned with the self-sovereignty ethos: as with cryptocurrencies, users do not need to trust a third party. With the emergence of DeFi, Ethereum-based DEXs have experienced a significant increase in usage. If the momentum continues, the entire industry will likely experience an increase in technological innovation.

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