A Decentralized Exchange: What Is It?

Definition

A peer-to-peer marketplace where transactions take place directly amongst cryptocurrency traders is known as a decentralized exchange, or DEX. DEXs enable financial transactions that aren’t mediated by banks, brokers, or any other middleman, which is one of the main potential applications of cryptocurrency. Uniswap and Sushiwap are only two of the well-known DEXs that operate on the Ethereum network.

How do DEXs operate?

DEXs only swap cryptocurrency tokens for other cryptocurrency tokens, as opposed to facilitating transfers between fiat and cryptocurrency like centralized exchanges like Coinbase do. You can trade fiat for cryptocurrency (and vice versa) or crypto-crypto pairings (e.g., exchange some of your bitcoin for ETH) via a centralized exchange, or CEX. More complex actions, like as margin trades and limit orders, are frequently available to you as well. However, the exchange handles all of these transactions using a “order book” that is similar to what stock exchanges like Nasdaq do to determine the price of a certain cryptocurrency based on buy and sell orders that are already in place.

Conversely, decentralized exchanges are nothing more than a collection of smart contracts. The values of different cryptocurrencies are set against one another algorithmically, and trades are facilitated via “liquidity pools,” where investors deposit money in return for interest-bearing incentives.

DEX transactions are resolved immediately on the blockchain, in contrast to transactions on centralized exchanges, which are documented in the exchange’s internal database.

Since DEXs are often developed using open-source code, anybody with a curiosity can view their internal workings. This implies that programmers can modify already-written code to produce brand-new, rival projects. In fact, Uniswap’s code has been modified by a plethora of DEXs with the word “swap” in their names, such Sushiswap and Pancakeswap.

What possible advantages come with utilizing a DEX?

Huge selection: DeFi is the place to go if you’re looking to discover a popular token at the start of its life. DEXs provide an almost infinite variety of tokens, ranging from the well-known to the unusual and completely arbitrary. Because anybody may mint an Ethereum-based token and establish a liquidity pool for it, a wider range of projects, both verified and unvetted, are available. (Definitely buyer beware!)

Hacking risks can be decreased: In theory, traders are less vulnerable to a hack because all of the money involved in a DEX exchange is kept on their own wallets. (In connection with this, DEXs also lessen “counterparty risk,” which is the possibility that one of the parties—possibly the central authority in a non-DeFi transaction—will default.)

Anonymity: To utilize the majority of widely used DEXs, no personal information is needed.

Utility in poor nations: DEXs are becoming more and more common in developing nations, where there may not be a strong banking system, because to the peer-to-peer lending, quick transactions, and anonymity they provide. A DEX allows trading by everyone with a smartphone and an internet connection.

What are a few possible drawbacks?

more challenging user interfaces It takes some expertise to navigate decentralized exchanges, and the interfaces aren’t always user-friendly. Expect to do a lot of research and don’t expect the DEX itself to provide much assistance. Generally speaking, you’ll need to search offsite for an explanation or walkthrough. Because mistakes might be made that cannot be corrected, such as transferring funds to the incorrect wallet, caution is necessary. When two cryptocurrencies in a liquidity pool are paired, one of them may become more volatile than the other, a phenomenon known as “impermanent loss” may occur. (What should be the key lesson learned from this? Conduct independent research.)

Vulnerability in smart contracts Any DeFi system is only as safe as the smart contracts that drive it; even after extensive testing, code may have vulnerabilities that may be exploited and cost you tokens. Furthermore, even while a smart contract could function as planned in ideal situations, developers cannot account for all uncommon occurrences, human error, and hackers.

Coins with more risk Because most DEXs provide a wide range of unvetted tokens, there are also more frauds and schemes to be cautious of. When a token’s creator mints a large number of new tokens, overflowing the liquidity pool and severely damaging the coin’s value, a hot streaking token may be “rug pulled.” It’s important to learn as much as you can about new protocols and cryptocurrencies before experimenting with them or purchasing them. Read white papers, check out developer Twitter feeds and Discord channels, and look for audits of any project you’re interested in (some larger auditors include Certik, Consensys, Chain Security, and Trail of Bits).

How would you communicate with a DEX?

Using a cryptocurrency wallet like Coinbase Wallet, you may use your web browser or a smartphone to connect to a DEX like Uniswap. For those who are just starting out, we suggest utilizing the Coinbase dapp wallet, which can be found within the Coinbase app.

To begin trading on the majority of DEXs, you’ll also need an Ethereum supply, which you may obtain via an exchange like Coinbase. To pay the costs (often referred to as gas) associated with each transaction on the Ethereum blockchain, you need to have some ETH. These are not included in the fees that the DEX imposes.