Decentralized Exchanges (DEX)

A decentralized exchange (DEX) allows trades to happen directly between peers. Unlike centralized exchanges, there is no central entity to oversee trades on a DEX.
DEXs allow traders to be truly anonymous, as they do not mandate a KYC, and the crypto funds you trade are held in the trader’s crypto wallet. These type of exchanges are at the heart of decentralized finance (DeFi) and function as a decentralized application (DApp) built on top of a smart contract blockchain.
Unlike centralized exchanges, DEXs do not support fiat trades, and traders can’t link a bank or a credit/debit card. DEXs rely on liquidity pools provided by other crypto investors in exchange for a reward called yield.

How trading works on a DEX

Traders interact directly with the smart contracts on the blockchain when using a DEX. They perform these trades anonymously from their private crypto wallet, which minimizes the risk of fraud.
There are three main types of DEXs:
  • Automated Market Makers (AMM)
  • Order books DEXs
  • DEX aggregators

Automated market makers (AMMs)

The Automated Market Maker (AMM) model relies on smart contracts to fulfill peer-to-peer trades. Instead of using buy and sell orders, an AMM relies on blockchain oracles to get information about the crypto prices. It then uses liquidity pools to offer digital assets to the traders.
Liquidity pool providers (LPs) are locking a cryptocurrency pair in one of the liquidity pools on the DEX in exchange for a portion of the trading fees. Each DEX and each liquidity pool may have different rewards, similar to bank interests, but higher in value. Users who wish to provide liquidity need to deposit an equivalent value for each digital asset, as liquidity can only be offered in pairs. This process is called liquidity mining.
AMM decentralized exchanges are ranked by the Total Value Locked (TVL) in their smart contracts.
The main disadvantage of using an AMM exchange is the lack of liquidity, which results in high slippage fees for traders. Liquidity providers may also suffer impermanent loss while providing liquidity, but this can be offset by the rewards generated by the trading fees.

How do AMMs work?

Unlike traditional exchanges that use order books, Uniswap uses the AMM model, which utilizes liquidity pools that contain a trading pair to settle trades. During trades, the price of the assets change, so a dynamic calculation of the new rate must take place. These trades happen directly within the pool.
However, liquidity pools serve many traders, and cryptocurrencies are famous for their price volatility. That’s why slippage, a percentage difference between the quoted and executed price, occurs.
A high slippage percentage may be needed for trades with low liquidity, and large trades tend to have a higher slippage. Just like market orders, you can only buy at the price the market is willing to sell.
Traders can select a custom slippage tolerance for each trade. For instance, if you select a 5% slippage tolerance, it means that the received tokens after the trade could be 5% more or less than the initial amount shown.

Order book DEXs

Similar to the traditional centralized crypto exchanges, order book DEXs can have both on-chain order and off-chain order books. Usually, on-chain order books store the trade information on it, and the traders have their funds in their wallets.
These exchanges often allow traders to leverage funds borrowed from lenders from the same platform. This feature enhances the potential profit from trades, but it can also pose higher risks. Unfavorable trades can result in liquidation. Lenders earn interest on the loaned funds.
DEXs that hold the order book off-chain are somewhat similar to centralized exchanges, and this helps reduce fees and increase speed. These DEXs also suffer from liquidity crisis.

DEX aggregators

DEX aggregators use mechanisms specifically designed to solve the liquidity issues associated with it. In essence, these platforms use liquidity from multiple DEXs to optimize swaps and decrease slippage and other fees. Doing so offers the best price on the market in the shortest amount of time.

Decentralized exchange trades

Unlike centralized exchanges, traders only need a compatible crypto wallet to access a DEX.
There are several smart contract blockchains that have DEXs, and each has different transaction fees.
After deciding the network, you will need a compatible wallet for that network and the native token of that network in the wallet to start trading. The native token is used to pay the network fees.
To trade on a DEX, you need to:
  • Decide what network you want to use (Ethereum, Cardano, Solana, BSC, etc.)
  • Have a compatible wallet for that network
  • Visit the DEX and connect your wallet.
  • Start trading