What Is Decentralized Exchanges (DEX)?

Decentralized exchanges are increasingly becoming popular in cryptocurrency ecosystem, tallying almost USD7 billion in daily trading volume.

What exactly is decentralized exchanges, or in short DEX, and how can it contribute to more development in infrastructure of cryptocurrency?

Since the inception of the new financial ecosystem, Decentralized Finance, the demand for other tokens flourished and new exchanges popped up everywhere, offering different twists for exchange services.

Traditionally, centralized exchanges such as Binance, Luno have been the main get go for the crypto users to exchange tokens but with the smart contracts, developers have built numerous tools to exchange and trade tokens in decentralized manner. Opening up to a new type of exchanges, Decentralized Exchange (DEX).

What Is DEX?

Decentralized exchange (DEX) provides the same service as centralized exchange, except in technical infrastructure, the services are done through execution on blockchain using smart contracts. The users have full custody over their funds unlike using CEX which execute transactions on your behalf with custodian wallet. 

“DEX are exchanges with no central entity that facilitate cryptocurrencies trading, swapping, or exchange activities without sacrificing users’ custody over their funds using smart contracts” 

Types of DEX

Due to the nature of blockchain, it can be cumbersome and slow for traders to use DEX’s as the crypto market can be volatile and it is in the traders best interest to have fast execution on their orders to capture the market opportunities.

To solve this problem, there 2 popular type of DEX’s in DeFi:

Automated Market Maker (AMM)

AMM is one of the most popular types of DEX’s for traders in the DeFi space. These DEXs do not have any order book and centralized entity to mediate the match between sellers and buyers offers. Instead, it has pools of tokens for users to perform swapping.

AMM consist of smart contracts that hold liquidity of 2 different tokens, these liquidity smart contracts are called liquidity pools. Users will use these liquidity pools to swap tokens and pay transaction fees. Anyone can provide liquidity and receive Liquidity Pool Tokens (LP tokens) as proof of their shares in the liquidity pool. LP token holders receive rewards from transaction fees when swapping occurs from the liquidity pools.

Some DEXs will reward LP token holders governance tokens by allowing them to stake their LP tokens, incentivising them to put their assets for a longer period and ensure stable liquidity. This practice is a new concept and it is called Yield Farming.

DEX’s in DeFi space are community-run projects that use the concept called Decentralized Autonomous Organization (DAO).  Governance tokens allow users to cast votes for any new proposal for the DEX’s improvements using their governance tokens. 

Best example of DEX operating in Binance Smart Chain (BSC) network is Pancakeswap.

Most popular AMM DEX’s are Uniswap, PancakeSwap, and SushiSwap. Although they provide the same services, they have different strategies in token distribution that results in high APY and APR to capture early users.

For example, PancakeSwap allows LP token holders to stake their LP tokens and receive more than 200% to 10% APR.

But bear in mind, most liquidity pools do have risks of losses by impermanent loss, rugpulls, also loss of value in reward tokens..

Uniswap, an AMM DEX, is the most famous DEX in Ethereum blockchain compared to other type of DEXs.

Decentralized Order Book

Order book by definition is a list of open buy and sell offers of an asset that are arranged by price. This allows users to choose what price to buy/sell according to their own preferences or target price.

There are 2 ways where we can utilize blockchain for order book style:

  • On Chain

On-chain order book is when every activity of order books (offer price, listing the price, approve the price, execute transactions) are done on-chain.

This meanseaning every act will need to be recorded to the blockchain network as proof that the users act directly.

Unfortunately, this practice is deemed to be impractical, slow, and quite expensive as every execution will require the network to broadcast the execution and cost users to pay huge fees to the miners. 

  • Off Chain

Off-chain order book is when the activities of order books are done outside of the blockchain network and execute the swap on-chain.

Good example of this method will be the 0x protocol for ERC-20. The protocol provides frameworks for developers known as “relayers” that create an environment to manage order books off chain.

The relayers will find matches for both the maker (person who wants to sell) and taker (person who wants to buy) off-chain and once matched, execute the transaction on-chain.

Uniswap is the biggest DEX currently with almost 20% market share of DEX volume.

Conclusion

DEXs are very new in the financial ecosystem and require some understanding of blockchain as its UI/UX heavily revolve around the blockchain infrastructures. This may be the opposing factor for mainstream users to dive into the exotic crypto world.

Total number of DeFi users in Ethereum blockchain over time has shown accelerating growth since early 2020. Credit: Dune Analytics

Nevertheless, DeFi are growing in number of users each day as most of the DEXs projects bring huge profit returns through yield farming and market opportunities from new exotic tokens that are not offered in CEXs.

Key Takeaways

  • Decentralized Exchange (DEX) are exchanges with no central entity that facilitate cryptocurrencies trading, swapping, or exchange activities without sacrificing users’ custody over their funds using smart contracts.
  • Yield Farming is the practice of providing liquidity in a form of crypto assets to liquidity pools in decentralized exchange in return for transaction fees and governance token.

 

Do you have any experience in using decentralized exchange? Let us know your thoughts in the comments. 

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