What is a DEX?
Recognize how decentralized exchanges operate and discover how to use your wallet to access them.
Definition
A peer-to-peer marketplace known as a decentralized exchange (or DEX) is where cryptocurrency dealers do trades with one another.
One of the main uses for cryptocurrencies, DEXs is to facilitate financial transactions without the involvement of banks, brokers, or other middlemen.
The Ethereum blockchain powers many well-known DEXs, including Uniswap and Sushiwap.
A decentralized exchange, or DEX for short, is a peer-to-peer marketplace where cryptocurrency traders conduct transactions directly with one another. One of the fundamental uses of cryptocurrencies is the promotion of financial transactions without the involvement of banks, brokers, payment processors, or any other type of middleman. The most well-known DEXs, such as Uniswap and Sushiswap, make a wide range of financial services accessible straight from a compatible crypto wallet by using the Ethereum blockchain. These tools are a part of the expanding family of decentralized finance (DeFi) products. Decentralized exchanges (DEXs) are flourishing; in the first quarter of 2021, $217 billion worth of transactions passed via them. More than two million DeFi dealers were active as of April 2021, a ten-fold increase from May 2020.
How do DEXs work?
Contrary to centralized exchanges like Coinbase, DEXs only swap cryptocurrency tokens for other cryptocurrency tokens, not fiat cash and cryptocurrency. You may swap fiat for cryptocurrency (and vice versa) or crypto-crypto pairings, such as some of your bitcoin for ETH, through a controlled exchange, or CEX. Additionally, you may frequently make more complex decisions, including placing limit orders or trading on margin. However, the exchange itself handles all of these transactions through a “order book” that determines the price for a certain cryptocurrency based on active buy and sell orders, much to how stock exchanges like Nasdaq do.
On the other hand, decentralized exchanges are nothing more than a collection of smart contracts. They employ “liquidity pools” to facilitate trades and set the values of different cryptocurrencies against one another algorithmically. Investors lock cash in these pools in exchange for rewards that resemble interest.
DEX transactions are settled immediately on the blockchain, in contrast to centralized exchange transactions, which are stored in the exchange’s own database.
DEXs are often created using open-source software, allowing anybody with a curiosity to see exactly how they operate. That also implies that programmers may modify already-existing code to produce brand-new rival projects, as demonstrated by the several DEXs with “swap” in their names, such as Pancakeswap and Sushiswap, who have done using Uniswap’s code.
What are potential benefits of using a DEX?
Huge selection: DeFi is the place to go if you’re looking for a hot token in its early stages. A almost infinite variety of tokens, from the well-known to the strange and completely random, are available on DEXs. You’ll discover a wider variety of projects, both verified and unvetted, because anybody can form a liquidity pool for an Ethereum-based token and manufacture one. (Buyer beware, without a doubt!)
Hacking risks can be minimized: Since every DEX trader’s money are kept in their own wallets, they are supposedly less vulnerable to hacks. (Relatedly, DEXs also lessen “counterparty risk,” which is the possibility that one of the parties involved, maybe even the central authority in a non-DeFi transaction, would go out of business.)
Anonymity: The majority of widely used DEXs don’t ask for any personal information.
Peer-to-peer financing, quick transactions, and anonymity provided by DEXs have increased their popularity in emerging nations, where a strong banking infrastructure may not be accessible. A DEX allows trading by anybody with a smartphone and an internet connection.
What are some potential downsides?
challenging user interfaces Decentralized exchanges are difficult to navigate and require some specialist expertise; plan on doing a lot of study and don’t count on the DEX to provide much assistance. Typically, you’ll need to search elsewhere for a walkthrough or explanation. Due to the possibility of making a mistake that cannot be corrected, such as transferring funds to the incorrect wallet, caution is advised. The coupling of two cryptocurrencies in a liquidity pool, one more volatile than the other, might lead to “impermanent loss,” another frequent problem. (The key lesson here? Make your own inquiries.)
Smart contract weakness Any DeFi system is only as safe as the smart contracts that drive it, and code might still contain exploitable defects that lead to the loss of your tokens (despite thorough testing). Additionally, not all uncommon occurrences, human errors, and hacks can be foreseen by developers, even though a smart contract may function as intended under regular conditions.
higher-risk coins There are more frauds and schemes to be on the lookout for because of the unvetted, wide variety of tokens that are available on the majority of DEXs. When a token’s issuer issues a large number of new tokens, the liquidity pool is overwhelmed and the value of the currency plummets, “rug pulling” a hot token. Read white papers, check out developer Twitter feeds or Discord channels, and search for audits of any specific project you’re interested in before investing in a new coin or experimenting with a new protocol (some bigger auditors include Certik, Consensys, Chain Security, and Trail of Bits).
How do you interact with a DEX?
- Using a cryptocurrency wallet like Coinbase Wallet on your web browser or on your smartphone, you may connect to a DEX like Uniswap. We advise utilizing the Coinbase dapp wallet, which is accessible straight from your Coinbase app, if you are just starting started.
- To begin trading on the majority of DEXs, you’ll also need a supply of Ethereum, which you may obtain via an exchange like Coinbase. You need ETH to pay gas costs, which are necessary for every transaction that takes place on the Ethereum network. These are not included in the DEX’s own fees.
How do DEX fees work?
Fees change. A 0.3% cost, divided across liquidity providers, is charged by Uniswap, and a protocol fee may be introduced in the future. However, it’s crucial to remember that the gas costs associated with using the Ethereum network may sometimes exceed the fees the DEX levies. Lower costs and quicker transactions are goals of the upcoming ETH2 upgrade as well as a variety of “layer 2” alternatives like Optimism and Polygon.