Decentralized Exchanges (DEXs) spearhead the Decentralized Finance (DeFi) Trading sector, the largest among DeFi sub-sectors. They offer similar services as their Centralized Exchanges (CEXes) counterparts, but with some unique features that make them unique.
Exchanges are like marketplaces for trading assets. If you have an interest in finance, names like the New York Stock Exchange (NYSE), Nasdaq, and CME probably ring a bell. Cryptocurrency exchanges aren't fundamentally different; they provide a similar service but focus on crypto assets. Popular centralized exchanges include Coinbase, Binance, Kraken, and Bitfinex.
What is a Decentralized Exchange (DEX)?
At its core, a DEX is a marketplace built inside a blockchain. It allows traders to exchange assets without relying on intermediaries such as banks or financial institutions.
In contrast to centralized exchanges, DEXs users receive tokens directly in their wallets by interacting with the protocol’s smart contracts. This circumvents the need for intermediaries, courtesy of the innovative blockchain technology.
How does a Decentralized Exchange (DEX) work?
The majority of DEXs operate via a relatively new mechanism called Automated Market Making (AMM), while some employ the traditional Order Book method, mainly used in centralized exchanges.
- Understanding Order Books
Order books are electronic lists compiling open orders to buy and sell assets for different trading pairs (for instance, BTC/USDT, ETH/USDC).
In an order book, you'll find all the bids placed by buyers and the offers made by sellers. When a buyer and a seller agree on a price, a trade ensues. However, Order Book DEXs face stiff competition from centralized exchanges, which can often lead to a liquidity crunch, hindering their sustainability.
- Automated Market Makers (AMMs)
Most DEXs use the AMM method, which is a system that relies on smart contracts to function. Traders don't interact directly but engage with a smart contract that connects them to a Liquidity Pool.
Liquidity Pools enable Market Makers to earn interest on their holdings by depositing assets and providing liquidity to the protocol. Simultaneously, they serve traders looking for liquidity to trade different asset pairs. Smart contracts automate these activities swiftly, delivering efficient service to traders.
Most Popular DEXs
Uniswap is by far the most popular Decentralized Exchange, with metrics like Trading Volume, Users, and Total Value Locked (TVL) validating its popularity.
Launched on the Ethereum Blockchain in November 2018, Uniswap has garnered significant traction since 2020, largely due to the DeFi upsurge. It functions with Liquidity Pools by the AMM model.
- Cumulative Trading Volume: U$1.34 Trillion
- Total Unique Users: 4.8 Million
- TVL: U$4 Billion
Data from Uniswap.org, DeFiLlama, and Dune Analytics as of March 6th, 2023
The token UNI provides voting power to its holders, who are able to propose changes and participate in the decision-making process of the protocol.
Curve stands out as an AMM protocol, primarily designed to provide extremely efficient stablecoin trading, although offering other options as well.
Since its launch in January 2020 on the Ethereum blockchain, Curve's growth has been impressive, fuelled by the DeFi sector's boom in the second half of 2020 and 2021.
- Cumulative Trading Volume: U$258 Billion
- Total Unique Users: 150 K
- TVL: U$5.57 Billion
Data from DeFiLlama, and Dune Analytics as of March 6th, 2023
The protocol’s utility token is CRV, which provides governance power and incentivizes liquidity providers with bonuses when depositing assets into the pools.
1inch works in a different way from Uniswap and Curve, operating as a DEX aggregator. It scans different DEXs for the best deals and offers the optimal choice to the user, enhancing the user experience (UX) in the DeFi space.
Searching for the best trading prices across numerous available DEXes can often be an exhausting task. However, with 1inch, traders can swiftly access the best offers within seconds.
Interestingly, the protocol was created in 2019 by Anton Bukov and Sergej Kunz in only 18 hours, during a Hackathon event! They say that the protocol was created because they felt the need for a DEX aggregator for their own personal use!
- Cumulative Trading Volume: U$308 Billion
- Total Unique Users: 2.6 Million
- Total Transactions: 38.4 Million
Data from Dune Analytics as of March 6th, 2023
Advantages of Using a DEX
- No Counterpart Risk
Since DEXs operate entirely on smart contracts, the risk of the counterparty failing to honor their obligations is non-existent.
- Token Availability
DEXs offer a broader range of tokens compared to CEXs, mainly because it's more affordable to conduct an IDO (Initial DEX Offering) than an ICO. Also, many centralized exchanges have policies before listing a token to ensure they’re on the same page as regulators
- No KYC Process
When you interact with a DeFi protocol, your identity remains concealed. While your wallet can be tracked, your personal identity isn't directly exposed on the blockchain.
Disadvantages and Risks of Using a DEX
- Smart Contract Risk
As smart contracts are human-programmed, they inherently carry some risks. Cybercriminals constantly probe for vulnerabilities to exploit for personal gains. Always ensure the protocol's smart contracts have been audited by credible firms. While this doesn't completely eliminate risks, it significantly mitigates them.
- Token Availability
While token availability on DEXs is a boon, it can also be a bane. Numerous tokens listed on DEXs are scams, which centralized exchanges would typically reject. To counter this, always verify the contract of the token. If it aligns with the one the DEX offers, it's safe!
Slippage occurs when a DEX lacks sufficient liquidity, resulting in buyers paying higher prices than they would in a liquid market. Higher the order, the greater the slippage. Hence, large investors often opt for the biggest platforms.
The protocol 1inch, presented before, can be a handy tool in this context. DEX aggregators consolidate liquidity from multiple DEXes, offering users the optimal deal with reduced slippage and improved prices, all within a matter of seconds.
Decentralized Exchanges were a great invention to the crypto space.
Decentralized Exchanges have significantly contributed to the crypto ecosystem. The AMM model offers an efficient service for traders, who are gradually turning to DEXs over CEXs. Protocols such as Uniswap and Curve have attracted numerous new users over the past few years, demonstrating the sector's resilience, even in bearish markets!
In light of the recent FTX Centralized Exchange debacle, many traders have opted for DEXs, preferring self-custody of their assets. For a more in-depth understanding, check out our article detailing the rivalry between DEXs and CEXs, and the FTX scenario.
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