What is a Decentralized Exchange?
Both seasoned and inexperienced crypto traders alike know that DEXs are at the heart of decentralized finance, but what are they, exactly?
In this plain English guide to decentralized exchanges, we explain what DEXs are, how they work, and the benefits and drawbacks of using these crypto exchanges. Additionally, we’ll also compare decentralized and centralized exchanges.
Keep reading to build your knowledge on one of the core concepts in crypto trading!
What Is A Decentralized Exchange?
A DEX is a peer-to-peer cryptocurrency exchange that doesn’t require an intermediary or middleman to complete transactions. Instead, your crypto assets are managed by self-executing smart contracts, which are essentially pieces of code programmed to link buyers and sellers.
As a result of this decentralized setup, users have independent control over everything. This includes:
- Choosing which crypto wallet extensions to install
- Purchasing all sorts of digital assets and coins that haven’t been vetted by a token exchange authority
How Does A Decentralized Exchange Work?
DEXs represent the future of finance, and that’s why it’s crucial to understand how they work. This is especially true because most decentralized trading platforms host a large selection of digital currency, which requires a working knowledge of the system to navigate it properly.
So, how do they work? Unfortunately, no one answer covers all DEXs. Instead, different decentralized markets use various algorithms to facilitate trading activity on the blockchain network.
Let’s look at the two most common systems used within decentralized crypto exchanges.
Automated Market Maker (AMM)
When initiating an exchange on a more traditional trading platform, users need to put in an “order” to buy or sell at their desired market price – meaning the transaction can take a while. The Automated Market Maker, or AMM Exchange, aims to solve the problem of insufficient liquidity using blockchain technology. But how does it manage this?
The answer is simple: pre-funded tools called liquidity pools. Each pool has something called a “trading pair”, which are two different currencies that it can automatically exchange.
Unlike centralized cryptocurrency exchanges, investors can buy and sell currency with the liquidity pool without waiting for another user to put up a matching order. It also uses aggregation tools to fetch a currency’s price to ensure everything checks out. As a result, the vast majority of traders can get what they want, when they want it.
Order Book DEX
An order book DEX reflects a more traditional form of trading activity usually found on the stock exchange. Users can list their buy or sell orders at specific prices, and the order book DEX will take note and match them with a counterpart that fits their needs. The main drawback is that an exchange platform that uses the order book method may take more time than the alternative.
Benefits Of A Decentralized Exchange
Private And Secure
Unlike traditional financial exchanges, DEXs don’t require any identifying documents. That means you can trade while being completely anonymous. Despite this focus on user privacy, blockchain technology manages to be secure – that’s because of smart contracts.
Smart contracts can protect you from potential fraud because they’re hard-coded to follow specific rules. For example, if two users initiate a trade, but one side tries to scam the other, the smart contract may block the exchange.
As we mentioned earlier, DEXs are faster than their centralized counterparts and charge less in trading fees. That’s because the platform itself doesn’t aim to make a profit off transactions, meaning that everything usually benefits the users.
Because DEXs are hosted on the blockchain, their code is completely open-source. That means anyone can look at the rules and protocols an exchange runs on. However, while this can help identify bugs early on, it can take a while to implement actual fixes.
Drawbacks Of A Decentralized Exchange
Potential Scam Coins
DEXs are entirely open and lack a centralized authority, and that means no committee or board deliberates on currencies that show up on the exchange. As a result, uninformed buyers may buy a coin specifically designed to trick people into thinking they’re legitimate.
Vulnerabilities In Smart Contract Systems
As we mentioned earlier, a DEX’s code is completely open-source. While this is primarily a good thing, it is a double-edged sword. Unsavory parties looking to find vulnerabilities in a smart contract’s code will find it very easy to experiment and tinker with the system.
Final Thoughts On Decentralized Exchanges
Decentralized exchanges represent everything good about cryptocurrency: they shift the power to the individual user rather than the systems and services in place. However, that doesn’t mean they’re perfect creations. Because DEXs are still in their infancy, there’s lots of room for improvement and growth.
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