A decentralized exchange (DEX) is a platform that enables users to trade crypto without a third party. This guide explains what DEXs are and how they work.
Nearly everyone in the blockchain space agrees that decentralized exchanges (DEX) are the future of crypto trading. That’s because, even now in 2021, trading digital assets on centralized crypto exchanges can be a headache. Before we get into what is a decentralized exchange, let's first look at how centralized exchanges work.
What Is a Decentralized Cryptocurrency Exchange?
Decentralized exchanges are platforms that support cryptocurrency trading. There are approximately one hundred decentralized exchange protocols in development or available for live trading. This is one of the most popular sub-categories within the decentralized finance space.
However, many projects calling themselves a decentralized crypto exchange are not actually decentralized. This really boils down to the debate over what the decentralized definition actually means in practice.
What does decentralized mean? With a true decentralized exchange (DEX), your funds are always in your custody, thus eliminating the security issues that plague centralized exchanges. This means your funds are in your control and remain much more secure. Real decentralized exchanges must also be permissionless because, if a DEX requires users to receive permission, then there must some centralized entity controlling it.
Users never need to deposit or withdraw funds to trade on a true DEX. On top of that, DEXs provide better privacy, transparency, and censorship-resistance, and allow unlimited trading pairs using technologies like atomic swaps.
Liquidity with Automated Market Makers (AMMs)
With their liquidity solutions, smart contracts actually take over the process of the trade. Trades are conducted within AMM crypto liquidity pools rather than between users. Each trading pair has its own pool. The pool continuously reorganizes by a ratio as users buy and sell. Liquidity pools incentivize liquidity providers to supply assets. This is what is known as automated market making.
Uniswap has trading pairs with a liquidity pool ratio of 50/50 between Ethereum (ETH) and any given ERC-20 token. Balancer - another popular ERC-20 DEX - improves upon the AMM model by allowing users to create dynamic liquidity pools of up to eight different assets at any ratio. Prices of assets on Balancer are also determined by liquidity pool ratios.
Liquidity with Peer-to-Peer Order Books
AtomicDEX, Binance DEX, IDEX, and EtherDelta are examples of decentralized exchanges that use order books instead of automated market makers (AMMs). Historically, one of the biggest limitations of decentralized order book exchanges has been liquidity. Because trading uses a peer-to-peer network it's more difficult to quickly match market makers and market takers. Order book-based DEXs can either be off-chain, on-chain or a hybrid combination of the two. AtomicDEX, for example, has off-chain order books that are decentralized (mitigating any risks of malicious actors controlling them), while order matching takes place on-chain.
Matcha by 0x is a top DEX aggregator. As the name suggests, Matcha allows users to find the best prices across several different DEXs, including Uniswap exchange, PancakeSwap exchange. It supports the trading of tokens running on Ethereum, Binance Smart Chain, and Polygon. The 1inch DEX aggregator is another popular option for users who want to find optimal prices of assets across major decentralized exchanges as well as decentralized finance (DeFi) platforms.
Most decentralized exchanges support a variety of third-party crypto wallets. When trading on most DEXs, users connect a wallet to a trading platform and then approve blockchain transactions. Some DEXs such as Komodo's AtomicDEX, have built-in non-custodial wallets. Unlike centralized exchange wallets, decentralized exchange wallets are non-custodial. This means users hold their own private keys, which they use to move funds on public blockchains.
Comparing CEXs and DEXs
As you can tell, CEXs and DEXs offer two very different user experiences for crypto traders. If you're interested in learning more about this topic, read our comparison guide to learn more about centralized vs. decentralized exchanges.
The Future of DEX Technology
Most decentralized exchanges today are limited to a single blockchain protocol such as Ethereum or Binance Smart Chain. DEXs like Uniswap and PancakeSwap are built on top of one of these two smart contract platforms. This means that many cryptocurrencies either need to create a proxy token on those chains or risk limiting themselves to their existing ecosystems, which might have a limited number of DeFi applications. To solve this issue, DEXs are starting to evolve to become multi-chain and cross-chain.
When it comes to bridging blockchains natively, atomic swap technology is the future of DEX technology. Komodo's AtomicDEX, as one example, is compatible with 99% of cryptocurrencies in existence. AtomicDEX uses atomic swaps to enable traders to make swaps cross-chain and peer-to-peer. Dozens of blockchain protocols are already supported, including Bitcoin, Ethereum, Litecoin, and Komodo. This means users can trade BTC for ETH or LTC for KMD, and more cryptocurrencies from a decentralized trading platform while still maintaining control of their Bitcoin private key and private keys for other cryptocurrencies.
Decentralized Exchange FAQs
How many decentralized exchanges are there?
According to CoinGecko, there are over 100 decentralized exchanges as of June 2021. However, the number is probably much higher many smaller or emerging DEXs are often not listed on websites that track trading volume.
Are decentralized exchanges legal?
Yes, decentralized exchanges are legal just like centralized exchanges. The same laws across various jurisdictions apply to DEXs.
Are decentralized exchanges safe?
Yes, DEXs are widely considered to be safe. The user controls their own private keys when making trades, so there is practically zero risk of a large-scale security breach that would lead to loss of funds. DEXs do have a few security challenges to consider, though. Flash loan attacks, rugpulls, and phishing attacks are common.
Can decentralized exchanges be hacked?
Yes, for example, decentralized exchanges may use smart contracts that contain bugs which allow hackers to carry out sophisticated attacks.
What is the most decentralized cryptocurrency?
Bitcoin is generally considered to be the most decentralized cryptocurrency. It is one of the most distributed node networks - a group of computers that verify transactions. Additionally, Bitcoin (BTC) is owned by a larger group of people. However, just as with any blockchain network, there are whales - a small group of users who control a large percentage of the coin supply. There are also a select few mining pools that effectively determine consensus - decide whether transactions are valid or invalid.
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