Decentralized Exchange (DEX)
A decentralized exchange (DEX) is a peer-to-peer marketplace where cryptocurrency traders conduct transactions directly with one another. The most well-known DEXs, such as Uniswap and Sushiswap, make a wide range of financial services like financial analysis, reporting, and budgeting accessible straight from a compatible crypto wallet using the Ethereum blockchain. One of the main applications for cryptocurrencies, which allows for financial transactions without banks, brokers, and payment processors, forms a growing group of decentralized finance (DeFi) products. DeFi and Decentralized Exchanges, which run without a central authority, are only as secure as their smart contracts. Even with the most thoroughly vetted contracts, some intelligent contracts have the potential to be abused, which might result in users losing their money or tokens. More than two million DeFi dealers were active as of April 2021, a ten-fold increase from May 2020. In the coming paragraphs, we’ll discuss the following:
- Operation of DEX
- Possible Advantages
- Potential Downsides
- User’s Interaction
- Applications of DEX
- DEX security
- Further benefits and limitationsÂ
The discussion below will help us understand the basic concept of a decentralized exchange and an insight into its functions, pros, and cons with real-life examples.
What is the Operation of DEXs?
Contrary to centralized exchanges like Coinbase, DEXs only exchange cryptocurrency tokens for other tokens. They do not permit transactions between fiat and cryptocurrency. You can exchange fiat currency for cryptocurrencies (and vice versa) or crypto-crypto pairs, such as some of your bitcoin for ETH, through a centralized exchange or CEX. Additionally, you can frequently make more complex decisions like placing limit orders or engaging in margin transactions. However, the exchange manages all these transactions through an “order book” that determines the price for a particular cryptocurrency based on active buy and sell orders, similar to how stock exchanges like Nasdaq do it.
On the other hand, decentralized exchanges are just a collection of smart contracts. They employ “liquidity pools” to facilitate trades. Moreover, they algorithmically set the prices of different cryptocurrencies against one another. Investors lock to cash in these pools for rewards that resemble interest.
DEX transactions are settled immediately on the blockchain, unlike centralized exchange transactions, which store in the exchange’s own database.
People design DEXs using open-source software, allowing anyone curious to see exactly how they operate. That also means that programmers can modify already-existing code to produce brand-new rival projects, as demonstrated by the numerous DEXs with “swap” in their names, such as Pancakeswap and Sushiswap. They have been using Uniswap’s code.
What are the Possible Advantages?
Large selection
If you’re looking for a hot token in its early stages, DeFi is the place to go. On DEXs, there is a nearly endless variety of tickets, from the well-known to the unusual and utterly random. Moreover, because anyone may create a liquidity pool for an Ethereum-based token and mint one, a more excellent range of enterprises will be available, both vetted and unvetted. So buy with caution, without a doubt!
Reduction Of Hacking Risks
In a DEX, traders’ wallets hold all the money; they are allegedly less susceptible to hacking. Additionally, DEXs reduce “counterparty risk,” or the likelihood that one of the parties engaged, including
What are some Potential Downsides?
Decentralized exchanges are difficult to navigate and require some specialist expertise; plan on doing a lot of studies and don’t count on the DEX to provide much assistance. Typically, you’ll need to search elsewhere for a walkthrough or explainer. Due to the possibility of making a mistake, such as sending funds to the incorrect wallet, they give caution. Another frequent problem includes coupling two cryptocurrencies in a liquidity pool, one more volatile than the other, which might lead to “impermanent loss.” The key lesson here? Make your inquiries. A smart contract’s flaw Any DeFi system is only as secure as the smart contracts that make it possible, and even after exhaustive testing, code can still have exploitable weaknesses.
Intelligent contract weakness Any DeFi protocol is only as safe as the smart contracts that drive it, and code might still have exploitable defects that lead to the loss of your tokens (despite thorough testing). Additionally, not all uncommon occurrences, human errors, and hacks can be foreseen by developers, even though an intelligent contract may function as intended under normal conditions.
How Do Users Interact With a DEX?
There are no accounts, Know Your Customer checks, or other restrictions on who can utilize a DEX, in contrast to centralized exchanges. They are trustless and permissionless, making them accessible to everyone with a bitcoin wallet and money.
Users must consequently join using a variety of cold or hot wallets, such as MetaMask, a non-custodial browser wallet, since they cannot keep any bitcoin on a decentralized exchange.
What Applications Does Decentralized Exchange Have?
Transactional Memory
Centralized exchanges frequently retain transaction data for up to six months for security and tax reasons. However, transactions on the Decentralized Exchange are directly viewable on the blockchain, making every transaction transparent. Despite the anonymity of wallet addresses, the blockchain enables everyone with access to see every transaction. DEXs are also entirely open-source, allowing anybody to understand how they function, and many other DEXs, like Pancakeswap, were developed using the Uniswaps code.
Access DeFi
Decentralized Exchanges make it simple for users to enter the realm of DeFi by enabling them to send money anonymously into DeFi protocols like staking without using a centralized exchange.
DEX Security
One of the primary motivations for using a Decentralized Exchange is security, which is of much greater importance in the crypto sphere. Non-custodial wallets, like MetaMask, are a fancy way to express that only the wallet’s owner can access the cryptocurrency. Non-custodial wallets connect to DEXs.
The saying “not your keys, not your coins” refers to the fact that wallets like this give users “keys” that only they can access. Custodial wallets are the ones that keep cryptocurrency on centralized exchanges.
Additionally, since wallets are never actually stored on decentralized exchanges—only connected—only the user ever has access to their bitcoin, with the DEX only serving as an interface for money transfer. As a result, since the customer’s coin was never kept on a DEX in the first place, it cannot be “hacked” from a DEX.Â
Benefits of Decentralized Exchange
Level of Asset Security
Security is a crucial selling point for a decentralized exchange (DEX). It is not guardianship. As a result, users can transact with DEX without providing their private key.
Smart contracts, on the other hand, enable users to set up private external wallets, connect with the DEX, and execute trades automatically.
Lower Price
A decentralized exchange can facilitate trade without intermediaries thanks to self-executing smart contracts, which reduce charging fees. In this instance, DEX employs the gas fee structure frequently mentioned in the Ethereum blockchain.
For exchanges like Swap, DEXs impose modest fees, often about 3%. Even though they vary depending on the network’s conditions, DEX fees are much cheaper than those charged by a centralized exchange.
Privacy
Decentralized exchanges no longer need traders to divulge their private keys and are not responsible for the cash because the crypto wallet is maintained elsewhere.
Users must not go through KYC or AML procedures to utilize DEX. Legally speaking, this might be advantageous in terms of convenience, but it might also present issues in some circumstances.
Decentralized Exchange Drawbacks
Decentralized exchanges have a lot to offer, but there are also some restrictions that users need to be aware of. Some disadvantages of using a decentralized exchange include the following:
Level of Liquidity
Since DEX offers many trading pairs, market segregation is detrimental to liquidity. Nevertheless, asset liquidity on decentralized exchanges has dramatically increased since DeFi’s rise.
Ramps Both On and Off
We are still unable to trade fiat currency directly on DEXs, trade fiat currency, or withdraw money from bank accounts.
In the DeFi ecosystem, stablecoins are a promising replacement for fiat money. However, for novice traders, the absence of a fiat currency on-ramp and exit remains a barrier to entry.
Continually Being Developed
Users should be mindful of these restrictions as decentralized exchanges are still in their infancy, especially for individuals unfamiliar with decentralized blockchain technology. Users must become familiar with the external wallet platform to interact with the DEX. Additionally, users must deposit a particular amount of fiat money or cryptocurrency assets into their wallets to fund them.
The user must finally connect his wallet to the DEX interface to trade. So far, depositing money into CEX is a more straightforward process.
Conclusion
It’s critical to comprehend the advantages and disadvantages of employing DEXs and taking part in DeFi. The most important thing is to ensure you fully understand any protocols you intend to engage with, including the associated risks, how privacy and security measures like encryption keys work, and how to keep your money secure in a non-custodial wallet.
