What is DEX and How Decentralized Exchanges Work


Learn about this alternative for trading cryptocurrencies in a peer-to-peer fashion.

Decentralized exchanges (DEX) are a practical, fast, and secure alternative for trading cryptocurrencies. Even so, they are still not the most widely used by most investors.

Cryptocurrency brokerages play a vital role in buying and selling crypto assets.

In general, there are two types of exchanges, centralized ones and decentralized ones.

The famous exchanges like Binance and Coinbase are used by most investors. These platforms have brought huge facilities for trading cryptocurrencies and have criteria that seek to ensure the safety of their clients.

However, they are not fully decentralized, nor do they preserve the anonymity preached in the creation of cryptocurrencies.

The so-called decentralized exchanges (DEX) function as a less invasive alternative for those who want discretion and privacy.

There is no identity verification or other Know Your Customer (KYC) criteria. To trade, simply connect your wallet and you’re done.

Although DEX have been on the market for a long time, this concept has recently gained fame with decentralized finance (DeFi).

But what is a DEX? Are they secure? Do they have major advantages over traditional exchanges? 

Read on to find out more about decentralized exchanges and whether you should start using one.

What are decentralized exchanges (DEX)?

A decentralized exchange (DEX) is a cryptoactive trading platform where users exchange cryptocurrencies without intermediaries, in so-called peer-to-peer (peer-to-peer) transactions.

Unlike centralized exchanges, DEX is “self-governed”, i.e. it does not have a third party to manage users’ assets, order book, or custody.

It is the users themselves who provide the liquidity for transactions to take place. 

The negotiations take place by executing smart contracts, directly between the portfolios of two users.

At DEX users do not need a login and password, all they need is a digital wallet to connect to the system.

How decentralized exchanges (DEX) work

DEX operate through Automated Market Maker (AMM), which can be translated as Automated Market Maker.

The AMM protocol is a way found by decentralized exchanges to provide liquidity to the platforms’ trades and conduct trades without pairing the buying investors.

Instead of orders or books, DEXs work through smart contracts created on a particular blockchain. That way, everything happens automatically. 

Investors are the market makers themselves. They are encouraged to provide their cryptocurrencies to form the liquidity pools. 

These function as a large crypto-active fund fed by the investors who receive rewards such as tokens or discount on fees.

The automated market maker also uses mathematical formulas to set asset prices taking into account the amount of cryptocurrencies deposited in the pools.

DEXs support any type of trading as long as there is sufficient liquidity and record all their orders on the blockchain, ensuring trust and independence.

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To use a DEX you do not need to create a registration or provide any personal data. Simply connect a cryptocurrency wallet to the desired platform. 

Transactions take place directly between the users’ wallets, not passing through any third party.

For this reason, decentralized exchanges tend to be seen as more agile, less bureaucratic, and more open to new tokens.

In addition to trading crypto-assets, many platforms also act as DeFi, where you can buy and sell assets, earn income, and borrow money.

What is the “problem” with centralized brokerages?

Centralized exchanges (CEX) concentrate most of the cryptocurrency trading volume today.

They are responsible for combining buy and sell orders, using the book order model to achieve greater liquidity.

These centralized exchanges also offer bank gateway services, i.e. they allow users to buy cryptocurrencies with fiat currency, debit or credit cards. 

They are very convenient because, as the name implies, they centralize everything in one place.

In addition to connecting buyers and sellers, they intermediate this negotiation and take care of the custody of the funds.

The main problem with this model of centralized exchanges is that they are managed by a central authority. That is, there is one company that controls your funds and data, similar to a traditional bank.

As they have centralized servers, located in a geographic area with specific sector regulations, they generally oblige the registration and identification of users through processes such as Know Your Client (KYC) and the implementation of Anti-Money Laundering (AML) policies.

Depending on the regulations they may be subject to certain restrictions on the type of assets that can be traded. 

Because they concentrate the resources of thousands of users, these platforms become prime targets for hackers. 

For many investors, centralized exchanges have an acceptable level of risk, as they only look for reputable brokers with solid security and control records.

For others, the lack of anonymity and total control over their assets is seen as a problem. 

The lack of some smaller tokens is also a disadvantage of traditional cryptocurrency brokers.

For greater agility, control, anonymity, and access to assets, some cryptocurrency investors prefer to use decentralized exchanges.

Advantages of Decentralized Exchanges (DEX)

One of the big advantages of decentralized exchanges is the elimination of third parties. Since they are not companies, the trades do not have any kind of intermediary.

Also because of this, they are less bureaucratic and do not require the investor to enter personal data to access them.

See more advantages of using a DEX:

Greater control of assets

DEX are platforms where you buy and sell assets directly from users’ portfolios. 

In this way, the client always keeps possession of his or her cryptocurrencies and obtains total control, without having to leave his or her private key in the hands of a third party, as happens in centralized exchanges.

No Identity Verification

Because they do not require identity verification, DEXs do not store any data on who is using them, giving the user the power of anonymity.

Financial Incentives

 DEX offer incentives to liquidity providers, i.e. those who decide to lend their cryptos to the liquidity pool.

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This is an opportunity to earn passive income from cryptocurrencies.

Lower Fees

With a smaller and more decentralized structure, DEXs consume fewer resources. Therefore, they tend to charge lower fees on their trades. 

The amount varies according to the flow of the network. Thus, the fewer transactions that are taking place in the network, the cheaper the transaction.

Variety of tokens

DEXs trade any asset, as long as there is liquidity. In this way, investors have many more tokens at their disposal, since they are not dependent on the listings of centralized exchanges.

Many small and new tokens are only found on DEX.

Less risk from hackers

The fact that they are on a shared network reduces the risks of attacks and theft of the cryptocurrencies.

Someone malicious would have to take down the entire network to steal the assets, which makes the process much more difficult.

On the other hand, centralized exchanges leave the cryptocurrencies in custody, which makes it more attractive for attacks.

Disadvantages of Decentralized Exchanges (DEX)

The transaction volume of centralized exchanges (CEXs) is still higher than that of DEXs. Because of this, the former still tend to have greater liquidity and the buying or selling of assets at a better price, since there is greater competition between buyers and sellers. 

DEXs are still somewhat niche for more experienced traders and their interfaces and usability can seem a bit confusing. 

See more disadvantages of using a DEX:

Usability

The usability of DEX is still a problem for those who do not understand how they work. They are not as intuitive to the user as traditional exchanges.

For less experienced investors unfamiliar with cryptocurrency wallets, CEXs offer a more user-friendly experience. 

Also, while the password to a centralized exchange account can be recovered, losing the one to your wallet can forever prevent access to funds.

Vulnerability 

As secure as a smart contract may be and function as expected, human factors and hacks can weaken a DEX.

If you make a transaction and get the address of your public key wrong, for example, you will lose the asset you sent.

The blockchain system also does not have the role of verifying that the recipient’s key is correct.

Furthermore, malicious people can use a DEX to trick you and steal your funds.

Since these platforms are anonymous, it is more difficult to trace the perpetrator.

Fees

DEX fees are an advantage and a disadvantage. 

They usually cost less than traditional exchanges, but the amount can vary according to the flow on the network.

The more transactions that are being made, the higher the transaction fee. 

In such cases, the cost of using a DEX can exceed the fees of centralized exchanges.

Asset value 

As DEX still have a low trading volume when compared to traditional exchanges, the low liquidity can cause problems for those who wish to trade higher volumes such as the high risk of value change.

How to trade cryptocurrencies on DEX

To start buying and selling cryptocurrencies through a decentralized exchange you need to access the official website of each of them and connect your cryptocurrency wallet.

To use the services of DEX you necessarily need a hot wallet (online wallet). 

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You also need to check the compatibility of the wallet with the tokens.

An example of a wallet that is compatible with ERC-20 tokens (Ethereum network tokens) is the MetaMask wallet. This wallet can be connected to UniSwap, the most widely used broker for the Ethereum network.

Ironically, the path to enter the DEX ecosystem still requires you to buy cryptocurrencies with cash, since DEXs do not perform the exchange of cash (FIAT) for cryptocurrencies.

You still need to do this on one of the major centralized cryptocurrency exchanges, such as Binance or Coinbase.

Once you own cryptocurrencies, log into the site and connect your wallet, DEX will recognize which cryptocurrencies you have and in what quantity. 

After that, you can start using the services offered.

Services offered by DEX

Some decentralized brokerages use standalone contracts to offer finance services, the so-called De-Fi.

Check out the main ones:

Swap: The “swap” works like an exchange, where the user issues a buy or sell order to trade a certain cryptocurrency. 

Liquidity Pools (LPs): These are tools that allow users to leave their cryptocurrencies locked up in exchange for rewards. 

Lending: Is the service where a user lends his tokens to another and in return receives interest on this operation. 

Examples of decentralized exchanges

Here are some of the most popular decentralized exchanges.

The CoinMarketCap website provides a real-time ranking of trading volume on each DEX that can be viewed at this link.

  • Polygon Balancer;
  • Uniwasp;
  • dYdX;
  • Sushiwasp;
  • PancakeSwap;
  • MDEX;
  • OpenOcean;
  • HoneySwap.

Is DEX worth it?

Decentralized exchanges (DEX) still have some challenges in becoming investors’ options of choice.

Not only do the platforms need to be more accessible to users, but also the culture towards centralized services needs to decrease. 

With the increased interest in and use of crypto-activities, DEX are in a sector that could have a big jump in their development and acceptance.

Currently they are more niche for more experienced users and those who are looking for new tokens if decentralized finance services (DeFi). 

The DEX scheme is so interesting that even some of the centralized brokerages have a peer-to-peer trading area.

This is the case with Binance DEX, a decentralized cryptocurrency exchange launched by Binance.


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