Decentralized Exchanges — or DEXs — are crypto exchanges that fully respect the core principles of the crypto space.
Their functionality relies on smart contracts and blockchain-based models that allow users to benefit from anonymity, financial inclusion and a wide range of crypto projects.
But users who want to discover these tools of the distributed financial system should be aware of possible risks: in this article, we’ll cover the main features of decentralized exchanges, how they work and the main differences with centralized platforms.
Characteristics of DEXs
Decentralized crypto exchanges are platforms that provide a way for traders to exchange cryptocurrencies peer-to-peer: according to the principles of decentralized finance, a decentralized crypto exchange does not require an intermediary to exchange cryptocurrencies.
The use of smart contracts makes it possible to do direct transactions. These are based on blockchains and they include preset requirements that need to be met in order for the transaction to be executed correctly. For more information on smart contracts, please refer to our previous article here.
To use DEXs, traders just need to connect their DeFi wallets — these tools will allow you to benefit from the many services offered by the DeFi space, along with the capability to manage your crypto trades in total privacy.
Privacy is actually one of the main differences between DEXs and another popular type of crypto exchange — centralized exchanges (CEXs).
What’s the Difference Between Decentralized Exchanges and Centralized Exchanges?
With decentralized exchanges, one of the core values of cryptos, privacy, is respected: users can enjoy a financial system that doesn’t require their personal details, and direct transactions allow lower costs — since there are no intermediaries.
However, many users prefer CEXs, which are similar to traditional financial institutions.
To better understand both protocols, here are the main differences between DEXs and CEXs:
- Cryptos and fiat:
CEXs allow users to use both cryptos and fiat, while DEXs only allow to trade cryptocurrencies. This can be a downside of DEXs for all those traders and investors who want to use traditional currencies, or who don’t have enough knowledge to work with crypto pairs.
- Central database:
CEXs take charge of users’ trades and deposits, while any DeFi trade is directly recorded on the blockchain — as we mentioned, DeFi exchanges allow peer-to-peer transactions, so there is no centralized database to manage transactions.
CEXs use order books to make it possible for buyers and sellers to find their counterpart when it comes to trading. Centralized exchanges are able to maintain high levels of liquidity, since they can centralize any operation needed to maintain such liquidity. In addition, they have the help of institutional traders. This allows them to keep lower levels of slippage when compared to decentralized exchanges. Slippage represents one of the main risks involved in the use of DEXs: it occurs when the price of an asset when the trade is complete is different from the price it had when the trade was about to start, as a direct consequence of high volatility.
When you use CEXs, you are entrusting your private keys to the exchange. Private keys are like the passwords of your financial accounts: you need them to prove that you own your assets, to sign transactions, to allow transfers and manage your funds. This doesn’t happen with DEXs — as we will see in detail later.
- Account Verification:
Working like traditional financial institutions, CEXs need your personal details and you need to verify your account according to the KYC (Know Your Customer) procedures put in place by the CeFi platforms. DEXs’ structure reduces the counter-party risk — that is, the risk that one of the parties involved in the trade or in any other agreement won’t meet their obligations. For this reason, they don’t require you to sign up or verify your account, because they don’t have to manage any possible dispute, as well as they don’t manage your funds on your behalf.
CEXs regulatory measures attract more institutional investors, and this is one of the reasons why CEXs generally have more liquidity.
So, both DEXs and CEXs have pros and cons. DEXs are inclusive, but can experience liquidity issues. CEXs are centralized, but they allow people to convert fiat to cryptos — that’s why they’re used by most people who want to start their journey in the crypto space.
How Do I Use a DEX?
As we mentioned, DeFi crypto exchanges work on a peer-to-peer basis: no central authority manages transactions, allowing buyers and sellers to manage their trades and accounts autonomously and anonymously.
To use decentralized exchanges, you just need to connect your DeFi wallet: for the reasons we just mentioned, DeFi exchanges managed to reduce the counterparty risk, so you won’t need to sign up and share your personal details to be identified by the platform.
Using DeFi wallets also means that you’re the only responsible for your private keys — you won’t entrust them to the platform. This allows you to fully control your crypto assets, but this has a downside: if you lose your private keys, no one will be able to help you regain access to your funds — so, always store them in a safe way.
Challenges of DEXs
Of course, the functioning of decentralized exchanges might make it challenging to find sufficient liquidity on the exchange — consider that liquidity refers to how easy it can be to buy or sell an asset. Low liquidity is the cause of one of the main problems experienced by DeFi exchanges — high slippage.
Fortunately, the DeFi space is sufficiently developed and has already found solutions not only to allow larger liquidity, but also to make DeFi exchanges work smoothly.
To cover this topic in detail, let’s look at another component of DeFi crypto exchanges — AMMs.
Automated Market Makers (AMMs)
If DeFi exchanges just worked by connecting buyers and sellers, the price of assets on decentralized crypto trading platforms would largely differ from the price found on other exchanges. Of course, this would never attract users, and all the benefits offered by decentralized exchanges would be useless. DEXs developed a system to keep prices fair and good levels of liquidity.
This system is made up of Automated Market Makers (AMMs): they rely on blockchain oracles to collect information about prices on different exchanges, and control liquidity pools — which gather liquidity provided by users and represent the markets that people can use to trade.
More liquidity corresponds to more stability, so DEXs also developed systems to reward liquidity providers. But usually, these rewards consist of fixed LP fees. This may not reflect market volatility, since LPs that provide liquidity for volatile markets can experience higher losses and face issues like impermanent loss — the loss incurred by LPs when the tokens they provide to the pool lose value.
To find new solutions to DEXs main downsides, some decentralized exchanges use different systems to reward LPs.
KyberSwap, for instance, uses the Dynamic Market Maker (DMM) protocol to better reflect market volatility and maximizes rewards for its liquidity providers. In this model, LP fees are not fixed, but adjusted according to volatility: if a market is volatile, higher LP fees are charged; if the market is more stable, fees will be reduced.
Uniswap uses a different system: it rewards liquidity providers according to different tiers — the LP can choose the tier — to better reflect risks involved in the pool. The 0.05% tier works better with stable tokens, while the 0.3% and 1% tiers are best suited for riskier pools.
Another example is Bancor, which allows liquidity providers to focus on single assets, with 100% exposure, to earn returns without the need to provide liquidity for crypto pairs — as it usually happens with liquidity pools.
The Benefits of Using Decentralized Exchanges
With a decentralized exchange, crypto trading can be managed autonomously, without the need for any central authority.
This makes it possible for users to own their assets and private keys, along with a number of other benefits:
- Wide variety of crypto projects: on DEXs you can find both popular crypto projects and projects that are in their infancy.
- A DEX is generally safer than a CEX: a DeFi exchange uses smart contracts to work properly and allow peer-to-peer transactions. So, if conditions set in the contract are not met, the contract — like contracts built to allow crypto transfers — won’t execute. Moreover, each user has a different crypto wallet to manage funds, there is not only one authority that manages all transactions. This makes it more difficult for hackers to attack users.
- You can use DEXs without sharing your personal details: this is a huge advantage for all those who live in developing countries and for unbanked people, but also for those who want to have full control over their financial lives in developed economies. This also means that DEXs don’t have geographical boundaries.
Decentralized exchanges allow peer-to-peer transactions that are directly recorded on blockchains thanks to their infrastructure based on smart contracts.
Some of their benefits are financial inclusion, capital efficiency and cost reduction — since a DeFi wallet is all you need to participate in the market and you don’t have to pay higher fees for the services offered by centralized platforms. But at the same time, they have some disadvantages — mainly related to lower levels of liquidity if compared to centralized exchanges, such as slippage.
Crypto traders should be well aware of both pros and cons of decentralized exchanges, and the functioning of decentralized finance as a whole: follow our Kyber Academy to get all the info you need.