Every individual in the world must have heard about cryptocurrencies in recent times. People are interested in cryptocurrencies for various reasons other than the availability of a new instrument for digital financial transactions. However, you would definitely need a cryptocurrency exchange for trading with cryptocurrencies. Decentralized exchanges are one of the prominent types of cryptocurrency exchanges with full decentralization.
It enables transactions on a peer-to-peer basis without the involvement of intermediaries alongside a slew of other benefits. As a result, it is inevitable for any individual following the crypto space to wonder about the basics of DEX or decentralized exchange and its functionalities. The following discussion attempts to serve as a detailed guide on DEXs, how they work, and the different types of DEXs. In addition, you can also find an overview of the advantages and risks associated with DEXs.
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What is a Decentralized Exchange?
The first thing that you would search for in a guide to DEXs would obviously refer to decentralized exchange meaning. DEXs are basically peer-to-peer marketplaces, just like stock markets where cryptocurrency traders could carry out transactions directly. The striking highlight of decentralized exchanges is that they do not transfer the responsibility for the management of your funds to custodians or intermediaries. DEXs can ensure transactions by leveraging smart contracts, which basically include self-executing agreements specified in code.
Decentralized exchange or DEX had been created to exclude the need for any authority for supervision and authorization of transactions on the exchange. DEXs support peer-to-peer or P2P cryptocurrency trading by linking crypto buyers and sellers together. DEXs are also generally non-custodial in nature, thereby allowing users to have control and ownership of their private keys. Such type of advantages has been driving the popularity of DEXs in recent times. However, it is also important to identify the roots of decentralized exchange development to understand their implications comprehensively.
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History of Decentralized Exchanges
There is no doubt that decentralized exchanges have emerged as formidable competition to centralized crypto exchanges. However, the interesting fact about the growth of DEXs in the short period of the time in which they have ascended. One of the earliest stages of decentralized exchange development would take you to the hashed time-locked contracts or HTLCs. HTLC offered a basic cryptographic escrow system that can facilitate trustless, on-chain transactions between users. The most promising examples of prototype DEXs based on HTLCs include LocalBitcoins and Bisq, which were launched in 2012 and 2014, respectively.
Subsequently, the next evolution of DEX exchange was evident with the arrival of first DEXs on Ethereum. The power of Ethereum smart contracts fueled the new generation of exchanges and introduced prolific improvements over HTLC-based exchanges. In the present times, DEXs have become a pivotal element in the crypto world by enabling trading with considerable improvements in crypto volume. Interestingly, decentralized exchanges facilitated almost $600 billion worth of trade volume in the one year between June 2020 and June 2021.
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Working of Decentralized Crypto Exchanges
The next crucial aspect in any discussion on the DEX crypto exchange would obviously point towards its working. It is important to identify how a decentralized exchange works in order to find more about its functionality. The working of a DEX decentralized exchange would depend considerably on the design.
Therefore, you can find a lot about the working of DEXs by reflecting on the distinct types of designs for decentralized crypto exchanges. In the most basic sense, the working of DEXs involves users keeping custody of their funds and using them for trading. Users have to incur transaction fees alongside the trading fee on the DEXs, and traders would basically interact with the smart contracts on blockchain for using DEXs.
You can find three common types of decentralized exchanges such as order book DEXs, DEX aggregators, and automated market makers or AMMs. Each type of decentralized exchange allows direct trade between users through smart contracts. Let us learn more about the different types of DEX exchange to understand their working comprehensively.
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Automated Market Makers or AMMs
The different types of decentralized exchange or DEX would obviously include the name of Automated Market Makers or AMMs. The automated Market Maker system uses smart contracts efficiently to address the liquidity problem. AMMs leverage blockchain-based services for obtaining information from exchanges and other platforms for setting the price of traded assets.
Blockchain-based services, in this case, are referred to as blockchain oracles. Rather than matching the buy orders and sell orders, the smart contracts in AMM-based decentralized exchanges could leverage liquidity pools. The liquidity pools are basically pre-funded pools of assets, which serve an important role in the working of AMM-based DEXs.
Users provide funding for the liquidity pools and get rewarded with transaction fees allocated for trades on the concerned pair. Such types of users, also known as liquidity providers, must deposit the equivalent value of each asset in a trading pair for earning interest on their crypto assets with liquidity mining.
Liquidity pools in AMM-based decentralized exchange development can allow traders to execute orders. At the same time, traders could also earn interest in a trustless and permissionless manner. AMM-based DEXs are generally ranked on the basis of the total amount of funds locked in their smart contracts.
The AMM-based DEXs also have a formidable setback in the form of slippage, which emerges due to a lack of liquidity. Slippage is clearly evident when the lack of liquidity leads to the buyer paying more than the market price on their orders. In such cases, larger orders are more likely to encounter higher slippage. Furthermore, liquidity providers could also face the risks of impermanent loss due to the volatility of one asset in trading pairs.
The notable examples of AMM DEXs include Bancor, Balancer, Sushi, Curve, and Uniswap.
Order Book DEXs
The order book model in decentralized exchanges is one of the earliest approaches in the development of DEXs. Order books maintain records of all the open orders for purchasing and selling assets for specific pairs of assets. The buy orders imply a trader’s interest in purchasing or bidding for an asset at a particular price. On the other hand, sell orders show that the trader is prepared for selling or asking for a specific price for the concerned asset. The discrepancy between the prices is responsible for determining the depth of the order book alongside the asset’s market price.
You could discover two distinct types of order book DEX crypto exchange, such as on-chain and off-chain order books. The DEXs which store their open order information on the chain are referred to as on-chain order book DEXs. On-chain order book DEXs could help traders in leveraging their positions by using funds from lenders on their platform.
On the other hand, off-chain order book DEX or decentralized exchange platforms store the order books of the blockchain networks. The off-chain order book DEXs only enable transaction settlement on the blockchain, thereby offering the value of centralized crypto exchanges.
Another important aspect of an order book decentralized exchange or DEX platform is the risk of liquidity issues. Order book DEXs basically compete with centralized exchanges and generally impose additional fees for on-chain transactions. On the other hand, off-chain order book DEXs can reduce the costs, albeit with smart contract-related risks.
The notable examples of order book DEXs active today include Loopring, Gnosis Protocol, and IDEX.
Decentralized exchange aggregators are also emerging as one of the top additions in a decentralized exchange list for obvious reasons. They are basically trading protocols that work by sourcing and routing liquidity throughout multiple DEXs according to specified requirements.
As a result, DEX aggregators don’t have any need for servicing traders exclusively from their own liquidity pools. So, you can clearly notice how DEX aggregators could play a crucial role in delivering efficient approaches for crypto trading.
Some of the notable examples of DEX aggregators in the present times include Slingshot, 1inch, and Ox or Matcha.
New Innovation in Decentralized Exchanges
It is also important to take note of the new horizons for decentralized exchange development with a specific focus on new innovation. The new Integral DEX provides a clear example of blending the AMM and order book models for DEX development. The new hybrid DEXs could free capital from depth, thereby enabling the exchange for mirroring order books of competitors on its personal, smaller liquidity reserves.
As a result, it can realize the value of concentrated and highly efficient liquidity. You could also note many new variations of AMM DEXs, such as the Proactive Market Making or PMM style. The example of DODO DEX showcases the practical application of the Proactive Market-Making style in a new decentralized exchange list. The Proactive Market Making or PMM style enables the DEX for proactive modification of parameters such as price curves in real-time to enable improved trading efficiency.
Benefits of Using DEXs
Decentralized crypto exchanges have evolved as one of the promising avenues for crypto trading in recent times. Some of the common advantages you can find with almost every entry in a decentralized exchange list include the following.
Availability of Tokens
Decentralized exchanges provide easier availability of tokens, especially the ones minted on the blockchain they have been developed on. As a result, new projects would also list their tokens on the exchanges prior to listing on the centralized exchanges.
The next important advantage associated with decentralized exchanges would refer directly to the anonymity of users. Users don’t need to pass the standard identification procedures such as Know Your Customer or KYC processes with decentralized crypto exchanges.
Lower Counterparty Risk
Counterparty risk is clearly evident when one of the parties involved in a transaction does not fulfill their end of the deal. The basic decentralized exchange meaning shows how DEXs facilitate transactions through smart contracts. So, you don’t have to depend on any intermediary for transactions, thereby gaining freedom from counterparty risks.
The unique highlight of a DEX or decentralized exchange is that it does not control the funds of users. On the contrary, traders have custody of their funds and can interact with the DEX according to their preferences.
Risks of Using DEXs
Apart from the distinct advantages of decentralized exchanges, it is also important to identify the following risks associated with them.
Requirement of Specific Knowledge
Users should have knowledge about security-related concepts for safeguarding their funds in a DEX crypto exchange. In addition, you also need to have specific knowledge regarding the selection of wallets and to fund the wallet with suitable tokens.
Unverified Token Listings
It is possible for any individual to list a new token on decentralized crypto exchanges with the objective of liquidity. However, this can lead to rug pull scams for investors. As a result, investors could purchase tokens with the assumption that they are getting another token. So, traders need to invest due diligence in verifying tokens before investing in them.
Smart Contract Risks
The final addition among risks associated with a DEX exchange would refer to smart contract risks. Exploitable bugs in smart contracts could escape comprehensive audits and detailed code reviews, thereby leading to further damage.
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The first-ever decentralized exchanges started to come in 2014 and have gained attention with the growing popularity of DeFi. With the power of the Automated Market Maker system, DEXs have evolved beyond their conventional setbacks in the order book model. However, decentralized crypto exchanges have proved as vital platforms for users to borrow funds for leveraging their positions or offer liquidity for obtaining trading fees.
DEXs have also enabled users to earn passive income on their crypto holdings by depositing them in liquidity pools. On the contrary, the use of smart contracts in DEXs continues to present possibilities of risks. Learn more about decentralized crypto exchanges and find the best alternatives.
*Disclaimer: The article should not be taken as, and is not intended to provide any investment advice. Claims made in this article do not constitute investment advice and should not be taken as such. 101 Blockchains shall not be responsible for any loss sustained by any person who relies on this article. Do your own research!