Cryptocurrencies brought many notable changes in the world of finance and technology. They not only presented a new alternative for digital money but also the foundation for building the next stages in the evolution of finance. However, cryptocurrencies have become popular only because people could access them. How did people come to trust currencies which they cannot see or hold in hand? How did people access cryptocurrencies? The answer points you towards crypto exchanges. Even if centralized exchanges dominated the crypto world till now, people are eager to discover how decentralized exchange works and offers better value than centralized exchanges.
Lack of clear understanding of decentralized exchanges and their working could be a huge setback for any crypto investor or solution provider. The following discussion offers you a detailed overview of the working of decentralized exchanges alongside the value advantages they offer.
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Definition of Decentralized Exchanges
One of the first things you would need for answering “How does a DEX work?” is the definition of DEXs. What are decentralized exchanges? They are basically peer-to-peer marketplaces, which allow crypto traders to carry out transactions without handing over their assets to a custodian or intermediary. Rather than relying on custodians and intermediaries, smart contracts facilitate transactions on decentralized exchanges. The DEXs use smart contracts for executing market transactions through the distribution of transactions to autonomous code. In addition, users can also leverage different alternatives for order fulfillment on the decentralized exchanges with different levels of decentralization.
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Working of Decentralized Exchanges
The definition of decentralized exchanges shows a lot about how they work. DEXs differ from centralized crypto exchanges by bringing in the functionalities of blockchain with smart contracts. Decentralized exchanges are developed over blockchain networks, which play a formidable role in answering how decentralized exchange works for crypto. Users can keep the custody of their funds in the smart contracts on blockchain networks. You can develop a better impression of responses to “How does a DEX work?” by reflecting on the different types. A detailed understanding of the three different types of DEXs could help you develop a clear impression of how they work.
Automated Market Makers
The first notable category of decentralized exchanges would be the ones using the Automated Market Maker or AMM systems. AMM is an approach that involves the use of smart contracts for resolving the concerns of liquidity on crypto exchanges. The development of AMM crypto exchanges started with the vision for executing trades on blockchain networks by implementing token-holding contracts. Automated Market Makers depend on blockchain-based services, known as blockchain oracles, for obtaining information from other exchanges and platforms to determine the price of assets traded on the platform. If you look closely, AMMs present considerable deviation from how decentralized exchange works with matching purchase and sale orders. On the contrary, the smart contracts in the decentralized exchanges leverage pre-funded pools of assets, referred to as liquidity pools.
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One of the critical components in answers for “How does a DEX work?” would obviously refer to liquidity pools. The liquidity pools in AMM-based decentralized exchanges include two crypto assets in a trading pair. Users have to deposit crypto assets in a similar ratio in the pool and become liquidity providers for the decentralized exchanges. Liquidity providers would receive a specific share of transaction fees for all trades executed on the concerned pair. Liquidity providers have to deposit equal value of each asset in the trading pair for earning interest through liquidity mining. The smart contract rejects any transaction which involves depositing more of one asset in comparison to the other.
Liquidity pools play a significant role in how decentralized exchange works as they enable traders for executing orders and earning interest in a permissionless, trustless and transparent manner. The ranking of such trading pairs on AMM-based DEXs follows the total value locked (TVL) or the number of funds locked in smart contracts.
You can think of liquidity pools as the massive cash reserves which banks use for offering financial services to their customers. The liquidity pools can give crypto traders adequate crypto assets for purchasing, selling, or borrowing. Therefore, they don’t have to wait for another party to match their transaction request for completing the transaction.
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Order Book DEXs
Speaking of waiting for other parties, you can find another method of working of decentralized exchanges in order book DEXs. The order books facilitate the compilation of the documents of all open orders for purchasing and selling assets for particular asset pairs. You can understand how decentralized exchange works with an order book model by identifying the meaning of buy orders and sell orders. Buy orders generally imply that a specific trader wants to purchase or bid for a particular asset at a given price. On the other hand, sell orders imply that a trader is willing to sell a specific asset at a particular price.
In the case of order book DEXs, the difference between buy orders and sell orders helps in evaluating the depth of their order book. The depth of the order book also helps in determining the market price of specific assets on the exchange. Interestingly, you can discover another interesting highlight about order book DEXs while finding out answers for “How does a DEX work?” with the fact that there are two types of order book DEXs.
The two types of order book DEXs are on-chain order books and off-chain order books. Generally, the order book DEXs ensure on-chain storage of information about open orders and put the user’s funds in their wallets only. Such exchanges could help traders in using the funds borrowed from lenders with improved potential for trade. On the contrary, off-chain order books store the order books off the blockchain. These exchanges facilitate trades on blockchain by reducing costs and improving speeds.
The final category of decentralized exchanges also provides vital insights for understanding how decentralized exchanges work in practice. DEX aggregators are completely different from AMM-based DEXs and order book DEXs in the way they work. The DEX aggregators leverage different mechanisms and protocols for resolving issues pertaining to liquidity. Such platforms can openly support the aggregation of liquidity from different DEXs for reducing the issues of slippage on large orders. In addition, DEX aggregators could also ensure optimization of token prices and swap fees alongside offering quick price estimates for traders. Furthermore, aggregators also safeguard users from the detriments of the pricing effect alongside reducing the risks of failed transactions.
How Can I Use a Decentralized Exchange?
The next important concern after how decentralized exchange works would be the best ways to use them. You should know that decentralized exchanges do not have a sign-up process and you don’t need an email address for interacting with DEXs. On the contrary, you would need wallets that support the smart contracts on the network of the exchange. Therefore, any individual with a smartphone and internet connection could make the most of the financial services presented by decentralized exchanges.
Choose a network you want to use and the wallet compatible with the chosen network. You can discover wallet extensions for interacting seamlessly with decentralized exchanges. Users can start using the DEXs by importing an existing wallet by using a seed phrase, using a private key or creating a completely new one. In addition, password protection also safeguards your crypto assets on the exchange.
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How Can I Create a Decentralized Exchange?
The popularity of decentralized exchanges is increasing gradually and presents new prospects for developing DEXs. Interestingly, you don’t have to do much for creating your own decentralized crypto exchange. If you want to know how to create decentralized exchange on your own, then you can follow a few simple steps. You can develop a DEX just like any other decentralized application by using the following steps.
Develop a clear, intuitive, and seamless user interface and user experience elements according to market research and requirements.
Front End Development
Building the front end is a critical stage in how to create decentralized exchange with your requirements. The front end basically involves creating a user-visible side of the exchange. As a matter of fact, the front end defines how your exchange would look and it plays a massive role in ensuring better user engagement.
Back End Development
After you are done with developing the front end, you would need to incorporate logic in your exchange. The back-end development stage deals with coding all the desired functionalities in your exchange.
The security aspect will always be a prominent highlight for decentralized exchanges. You need to add reliable security features like password-protected user access and encrypted database.
Launching the Exchange
You are now ready to launch the DEX after listing the cryptocurrencies you want to see on your exchange. Implement the necessary tests and modifications and you have a reliable decentralized cryptocurrency exchange platform at your disposal.
On a final note, you can clearly notice how decentralized exchange works and how you can create one. Decentralized exchanges are peer-to-peer marketplaces that leverage smart contracts and the power of blockchain for crypto transactions. The working of DEXs depends considerably on the type of decentralized exchange you are evaluating. Automated Market Maker systems, order book DEXs and aggregators are the common examples of DEXs, which showcase how they work differently. With the common objective of improving liquidity for crypto traders and reducing intermediary involvements, DEXs have a long way to go. Learn more about them and discover their true potential right away.
*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!