DEXs: What is a decentralized exchange and how does it work?


Decentralized exchanges, or DEXs, are peer-to-peer marketplaces where cryptocurrency traders can conduct transactions without entrusting their funds to an intermediary or custodian. Decentralized exchanges, or DEXs, are peer-to-peer marketplaces where cryptocurrency traders can conduct transactions without entrusting their funds to an intermediary or custodian.

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What are decentralized exchanges, and how do DEXs work?


Decentralized exchanges, or DEXs, are peer-to-peer marketplaces where cryptocurrency traders can conduct transactions without entrusting their funds to an intermediary or custodian. These transactions are facilitated by the use of smart contracts, which are self-executing agreements written in code.


DEXs were designed to eliminate the need for any authority to oversee and authorize trades conducted within a specific exchange. Peer-to-peer (P2P) cryptocurrency trading is possible on decentralized exchanges. A peer-to-peer marketplace connects buyers and sellers of cryptocurrencies. They are typically non-custodial, which means that users retain ownership of their wallet's private keys. A private key is an advanced encryption method that allows users to access their cryptocurrencies. After logging into the DEX with their private key, users can immediately access their crypto balances. They will not be required to submit any personal information, such as names and addresses, which is ideal for those who value their privacy.


Automated market makers, for example, helped to attract users to the decentralized finance (DeFi) space and contributed significantly to its growth. DEX aggregators and wallet extensions fueled the growth of decentralized platforms by optimizing token prices, swap fees, and slippage, all while providing users with a better rate.


What are decentralized exchanges?


Smart contracts are used by decentralized exchanges to allow traders to execute orders without the need for an intermediary. Centralized exchanges, on the other hand, are managed by a centralized organization, such as a bank, which is otherwise involved in financial services and seeks to profit.


Because they are regulated entities that custody users' funds and provide easy-to-use platforms for newcomers, centralized exchanges account for the vast majority of trading volume in the cryptocurrency market. Some centralized exchanges even provide deposit insurance.


A centralized exchange's services are comparable to those provided by a bank. The bank safeguards its clients' funds and provides security and surveillance services that individuals cannot provide on their own, making it easier to transfer funds.


Decentralized exchanges, on the other hand, allow users to trade directly from their wallets by interacting with the smart contracts that power the trading platform. Traders must protect their funds and accept responsibility for their loss if they make mistakes such as losing their private keys or sending funds to the wrong addresse


The deposited funds or assets of customers are issued a "I owe you" (IOU) via decentralized exchange portals, which can be freely traded on the network. An IOU is essentially a blockchain-based token with the same underlying asset value.


Popular decentralized exchanges are built on leading blockchains that support smart contracts. They are built directly on the blockchain and are built on top of layer-one protocols. The Ethereum blockchain underpins the most popular DEXs.


How do DEXs work?


Because decentralized exchanges are built on blockchain networks that support smart contracts and where users retain custody of their funds, each trade incurs a transaction fee in addition to the trading fee. To use DEXs, traders interact with smart contracts on the blockchain.


Decentralized exchanges are classified into three types: automated market makers, order books DEXs, and DEX aggregators. Through their smart contracts, all of them enable users to trade directly with one another. The first decentralized exchanges, like centralized exchanges, used the same type of order books.

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Automated market makers (AMMs)


To address the liquidity issue, an automated market maker (AMM) system based on smart contracts was developed. These exchanges were inspired in part by Ethereum co-founder Vitalik Buterin's paper on decentralized exchanges, which described how to execute trades on the blockchain using contracts holding tokens.


These AMMs rely on blockchain-based services called blockchain oracles, which provide information from exchanges and other platforms to set the price of traded assets. Instead of matching buy and sell orders, these decentralized exchanges' smart contracts use pre-funded pools of assets known as liquidity pools.


Other users fund the pools, and they are then entitled to the transaction fees charged by the protocol for executing trades on that pair. To earn interest on their cryptocurrency holdings, these liquidity providers must deposit an equivalent value of each asset in the trading pair, a process known as liquidity mining. If they try to deposit more of one asset than the other, the pool's smart contract invalidates the transaction.


Using liquidity pools allows traders to execute orders or earn interest without requiring permission or trust. These exchanges are frequently ranked based on the amount of funds locked in their smart contracts, known as total value locked (TVL), because the AMM model has a disadvantage when there is a shortage of funds.


Slippage occurs when there is a lack of liquidity on the platform, causing the buyer to pay above-market prices for their order, with larger orders experiencing more slippage. A lack of liquidity may deter wealthy traders from using these platforms, as large orders are prone to slippage in the absence of deep liquidity.


Liquidity providers face a variety of risks, including impermanent loss, which is caused by depositing two assets for a single trading pair. When one of these assets is more volatile than the other, exchange trades can reduce the amount of that asset in the liquidity pool.


If the price of the highly volatile asset rises while the amount held by liquidity providers falls, liquidity providers suffer an impermanent loss. The loss is temporary because the asset's price can still rise and trades on the exchange can balance the pair's ratio. The proportion of each asset held in the liquidity pool is described by the pair's ratio. Furthermore, trading fees can compensate for the loss over time.


Order book DEXs


Order books keep track of all open buy and sell orders for specific asset pairs. Buy orders indicate a trader's willingness to buy or bid for an asset at a specific price, whereas sell orders indicate a trader's willingness to sell or ask a specific price for the asset under consideration. The spread between these prices determines the depth of the order book and the exchange's market price.


Book of Orders DEXs are classified into two types: on-chain order books and off-chain order books. DEXs that use order books frequently keep open order information on-chain while users' funds stay in their wallets. These exchanges may permit traders to leverage their positions by borrowing funds from lenders on their platform. Leveraged trading increases a trade's earning potential while also increasing the risk of liquidation because it increases the size of the position with borrowed funds that must be repaid even if the traders lose their bet.


However, DEX platforms that keep their order books off the blockchain only settle trades on the blockchain in order to provide traders with the benefits of centralized exchanges. Off-chain order books assist exchanges in lowering costs and increasing speed in order to ensure that trades are executed at the prices desired by users.


These exchanges also allow users to lend their funds to other traders in order to provide leveraged trading options. Loaned funds accumulate interest and are secured by the exchange's liquidation mechanism, which ensures lenders are paid even if traders lose their bets.


It is important to note that order book DEXs frequently experience liquidity issues. Traders usually stick to centralized platforms because they are essentially competing with centralized exchanges and incur extra fees due to what is paid to transact on-chain. While DEXs with off-chain order books reduce these costs, smart contract risks arise due to the requirement to deposit funds in them.


DEX aggregators


To solve liquidity issues, DEX aggregators employ a variety of protocols and mechanisms. These platforms essentially aggregate liquidity from multiple DEXs in order to minimize slippage on large orders, optimize swap fees and token prices, and provide traders with the best price in the shortest amount of time.


DEX aggregators also strive to protect users from the pricing effect and reduce the likelihood of failed transactions. Some DEX aggregators also use liquidity from centralized platforms to provide a better experience for users, all while remaining non-custodial through integration with specific centralized exchanges.


How to use decentralized exchanges


You do not need to sign up to use a decentralized exchange, and you do not even need an email address to interact with these platforms. Rather, traders will require a wallet that is compatible with the exchange's network's smart contracts. DEXs provide financial services to anyone with a smartphone and an internet connection.


The first step in using DEXs is deciding which network to use, as each trade will incur a transaction fee. The next step is to select a wallet that is compatible with the chosen network and fund it with its native token. A native token is a token that is used to pay transaction fees in a particular network.


Wallet extensions that allow users to access their funds directly in their browsers make interacting with decentralized applications (DApps) like DEXs simple. These are installed in the same way as any other extension and require users to either import an existing wallet via a seed phrase or private key or create a new one. Password protection adds another layer of security.


These wallets may also include mobile applications, allowing traders to use DeFi protocols while on the go, as they include built-in browsers that are ready to interact with smart contract networks. Wallets can be synchronized between devices by importing from one to the other.


Following the selection of a wallet, it must be funded with the tokens used to pay for transaction fees on the chosen network. These tokens must be purchased through centralized exchanges and are easily identified by the ticker symbol they use, such as ETH for Ethereum. After purchasing the tokens, users must simply withdraw them to wallets under their control.


It is critical to avoid routing funds to the incorrect network. As a result, users must transfer their funds to the correct one. Users with a funded wallet can connect their wallet via a pop-up prompt or by clicking the "Connect Wallet" button in one of the upper corners of DEXs' websites.


Advantages of using a DEX


Trading on decentralized exchanges can be costly, particularly if network transaction fees are high at the time the trades are executed. However, there are numerous benefits to using DEX platforms.


Token availability


Before listing tokens on centralized exchanges, they must be individually vetted and ensure they comply with local regulations. Decentralized exchanges can include any token minted on the blockchain upon which they are built, implying that new projects will most likely list on these exchanges before their centralized counterparts.


While this may imply that traders can get in on projects as early as possible, it also implies that all kinds of scams are listed on DEXs. A "rug pull," or typical exit scam, is a common scam. When the price of the tokens used to provide liquidity on these exchanges' pools rises, the team behind the project dumps them, making it impossible for other trades to sell.


Anonymity


On DEXs, users' anonymity is preserved when exchanging one cryptocurrency for another. Users do not need to go through a standard identification process known as Know Your Customer, as opposed to centralized exchanges (KYC). KYC procedures require traders to provide personal information such as their full legal name and a photograph of a government-issued identification document. As a result, DEXs attract many people who do not want to be identified.


Reduced security risks


Because DEXs do not control their funds, experienced cryptocurrency users who custody their funds are less likely to be hacked. Rather, traders protect their funds and only interact with the exchange when they want to. Only liquidity providers may be at risk if the platform is hacked.


Reduced counterparty risk


Counterparty risk occurs when the other party in a transaction fails to fulfill its part of the bargain and breaches its contractual obligations. This risk is eliminated because decentralized exchanges operate without intermediaries and are based on smart contracts.


To ensure that no other risks arise when using a DEX, users can quickly conduct a web search to determine whether the exchange's smart contracts have been audited and make decisions based on the experience of other traders.


Disadvantages of using DEXs


Despite the benefits listed above, there are some disadvantages to using decentralized exchanges, such as the lack of technical knowledge required to interact with these exchanges, the number of smart contract vulnerabilities, and unvetted token listings.


Specific knowledge is required


DEXs can be accessed through cryptocurrency wallets that can communicate with smart contracts. Users must not only understand how to use these wallets, but they must also understand security concepts associated with keeping their funds secure.


These wallets must be loaded with the appropriate tokens for each network. Other funds may become stuck in the absence of a network's native token because the trader cannot pay the fee required to move them. To choose a wallet and fund it with the correct tokens, specific knowledge is required.


Furthermore, even for experienced investors, avoiding slippage can be difficult, if not impossible, when purchasing tokens with low liquidity. Slippage tolerance on DEX platforms is frequently manually adjusted for orders. Furthermore, adjusting slippage can be technical, and some users may not fully comprehend what it entails.


Traders who lack specific knowledge may make mistakes that result in a loss of funds. Withdrawing coins to the incorrect network, paying excessive transaction fees, and losing money due to impermanent loss are just a few examples of what can go wrong.


Smart contract vulnerabilities


Smart contracts on blockchains such as Ethereum are public, and anyone can examine their code. Furthermore, smart contracts of large decentralized exchanges are audited by reputable firms, which aids in code security.


Error is human. As a result, exploitable bugs can still elude audits and other code reviews. Auditors may be unable to anticipate potential new exploits that could cost liquidity providers their tokens.


Unvetted token listings


Anyone with access to a decentralized exchange can list a new token and provide liquidity by pairing it with other coins. This makes investors vulnerable to scams such as rug pulls, which trick them into thinking they are purchasing a different token.


Some DEXs mitigate these risks by requiring users to verify the smart contract of the tokens they wish to purchase. While this solution is effective for experienced users, it returns to specific knowledge issues for others.


Before purchasing, traders should gather as much information about a token as possible by reading its white paper, joining its community on social media, and looking for potential audits on the project. This type of due diligence aids in the avoidance of common scams perpetrated by malicious actors.


Decentralized exchanges keep evolving


The first decentralized exchanges appeared in 2014, but these platforms gained popularity only after decentralized financial services built on blockchain gained traction and AMM technology helped solve the liquidity problems that DEXs previously faced.


Because there is no central entity verifying the type of information traditionally submitted to centralized platforms, it is difficult for these platforms to enforce Know Your Customer and Anti-Money Laundering checks. Nonetheless, regulators may attempt to implement these checks on decentralized platforms.


Regulations governing custodians would not apply to these platforms, as those that accept user deposits still require users to sign blockchain messages in order to move funds off of their platforms.


Users can now borrow funds to leverage their positions, lend funds to earn interest passively, or provide liquidity to collect trading fees on decentralized exchanges.


More use cases may be created in the future because these platforms are built on self-executing smart contracts. Flash loans, which are loans taken and repaid in a single transaction, are an example of how innovation in the decentralized finance space can create previously unimaginable products and services.


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