What Is Decentralized Exchange Explained | How It Works, Types &Amp; Features | Dex Crypto

What is Decentralized Exchange Explained | How it Works, Types & Features | DEX Crypto

What is a Decentralized Exchange?

Welcome to the what is bitcoin series of crypto swami. Where we simplify cryptocurrency and blockchain technology terminology with easy to understand whiteboard videos. Today, We/ll be sharing with you what is a decentralized exchange,  how it works, DEX types, and what advantages do they offer?

What is DEX?

To state its definition, A decentralized exchange or a DEX is a place where  people can go to trade cryptocurrencies without an intermediary. Seems simple,  right? Let’s dive deeper…

But first, to better understand what a decentralized exchange is,  it’s important to first understand how centralized exchanges work. So let’s look into them first  well, a centralized exchange such as Binance or Coinbase is a place where people can buy,  sell, or trade cryptocurrencies and tokens listed on that exchange now, Let’s say you want to buy some Bitcoin then, you need to go to an exchange, sign up by providing some banking details  and identifying information, and deposit some cash.

(sometimes this process takes days,  which accounts as one of the drawbacks of centralized exchanges vs decentralized exchanges.)

At such exchange will tell you the price—based on an “order book” of people buying and selling  at different amounts—and you can make the transaction as per your convenience.  We’ll discuss about this later in this video, so let’s move on! now, returning to the steps,  you need to think…

hey! what happens next? well, once you make a purchase, the exchange will show those Bitcoins in your account, and you can trade for other tokens on the exchange.  Are you feeling amazing that you’ve earned your bitcoins? Well, actually, you don’t  really hold them, because you’re entrusting the exchange to act as a custodian on your behalf . Any cryptocurrency trading you do, like swapping Bitcoin for Ethereum, aren’t occurring on a blockchain!  This cryptocurrency trading within the exchange’s database.

Further, exchanges pool users’ cryptocurrencies into wallets which are often claimed as “hot” wallets connected to the internet and are fully controlled by the exchange. The bitcoin exchange even controls your private keys. These cryptocurrency exchanges allow you to transfer your tokens to a private wallet.

But this adds an extra security step,  later on if you wish to trade that cryptocurrency, the appeal of decentralized exchanges, or DEX  is the security they provide. As a centralized exchange can limit your access to your crypto, restrict or halt your ability to trade it, or even fall vulnerable to hackers.

Centralized Cryptocurrency Exchanges

On the other hand, centralized exchanges are generally far easier to use for newcomers, and they can often offer fast trading because they’re not beholden to respective blockchain infrastructure.  Now, as naive as it may sound, this has been Coinbase’s biggest achievement and has helped  them become a household name for crypto-curious folks around the globe who are looking to dip a  toe into buying crypto, but are intimidated by the process.

The majority of these people, let Coinbase or any other centralized exchanges like Binance act as custodian of their funds and are just fine with that.  So, as now you have got the fundamental understanding on centralized exchanges.

   How Do Decentralized Exchanges Work?

As decentralized exchanges use smart contracts and users get to keep the custody of their funds. Here, every trade incurs a transaction fee along with the trading fee. In the same essence, traders interact with smart contracts on the blockchain to use DEXs. A DEX or a decentralized exchange works to handle this in one of three ways.

Order Book DEX

Order book DEXs these type of decentralized exchanges compile records of all open orders to buy and sell assets for specific asset pairs.  Here, buy orders signify that a trader is willing to buy or bid for an asset at a specific price,  while sell orders indicate that a trader is ready to sell or ask a particular price for the asset  under consideration.

The spread between these two prices determines the depth of the order book and the market price on the exchange. In their initial days, the order book decentralized exchanges were typically slow. They offered limited liquidity, and typically required traders to deposit their tokens  to a smart-contract controlled address to ensure orders could be automatically executed. Many would argue these made them partially centralized.

However, things have come along in leaps and  bounds since then, and there are now a wide variety of decentralized orderbook-based exchanges in operation. There are also dozens more in development. Many of these are now able to settle trades in a non-custodial and trustless manner; some of the most popular orderbook-based DEXs for popular platforms include the following. Lastly, order book DEX have two  types: on-chain order books and off-chain order books, which I’ll explain in the future uploads

Automated Market Maker (AMM)

Automated Market Maker (or AMM) Today, the vast majority of popular DEXs fall into the  automated market maker (AMM) category. With AMMs, assets are priced using a simple mathematical formula. Then they are organized into liquidity pools, which are rebalanced when users add or extract liquidity. Liquidity extracted from one side of the AMM pool by trading further, do NOTE that AMMs do not have  an order book and generally don’t support more complex order types like limit, take profit, and  stop-loss orders.

What Is Decentralized Exchange? What Is Dex? Crypto

But they do generally allow users to contribute their assets to liquidity pools and earn a share of the fees generated by trades that source liquidity from these pools.  Some of the popular examples of AMM protocol-driven DEXs are Uniswap,  Balancer, and Curve. The exchanges are often ranked according to the amount of funds locked in their smart contracts called total value locked (TVL), as the AMM model has a downside when there is not enough liquidity in the pool.

This is what we call as slippage problem, and occurs when  a lack of liquidity on the platform results in the buyer paying above-market prices on their order. Further, cryptocurrency investors are also exposed to problems like impermanent loss.

DEX aggregators

Now, these use several different protocols and mechanisms to solve problems associated with the liquidity of the network. Essentially, these platforms aggregate liquidity from several different DEXs. To minimize slippage on large orders, optimize swap fees and token prices. Dex aggregators offer traders the best price possible in the shortest possible time.  Further, just so you know, protecting users from the pricing effect and decreasing the likelihood of failed transactions are two other significant goals of DEX aggregators. Some DEX aggregators use liquidity from centralized platforms to provide users with a better experience. This happens, while remaining non-custodial. By leveraging specific integrations with specific centralized exchanges. I believe that you have got a fair idea about what are decentralized exchanges or how they generally function.

Advantages of using a DEX

  1. Anonymity as when users exchange one cryptocurrency for another, their anonymity is preserved on DEXs
  2. Token availability centralized exchanges have to individually vet tokens and ensure they comply with local regulations before listing them. Decentralized exchanges can include any token minted on the blockchain they are built upon. Meaning that new projects will likely list on these exchanges before being available on their centralized counterparts.
  3. Reduced counterparty risk counterparty risk happens when the other party involved in a transaction does not fulfill its part of the deal and defaults on its  contractual obligations. Because decentralized exchanges operate without intermediaries and are based on smart contracts, this risk is eliminated.
  4. Reduced security risk;  Experienced cryptocurrency users who custody their funds are at a reduced risk of being hacked using DEXs. These exchanges do not control their funds, instead traders guard their funds and only interact with the exchange when they wish to do so. And if the platform gets hacked, only liquidity providers face at risk, not traders.

Disadvantage of Decentralized Exchange

Further, despite the discussed advantages, there are various drawbacks or disadvantages of using decentralized exchanges. Smart contract vulnerabilities we have seen in the past. A decentralized exchange vulnerability has cost millions to platforms in the crypto world.

DEXs are no exception. Though there are security audits done in a decentralized exchange, auditors may even be unable to foresee potential new exploits that can cost liquidity providers their tokens. Demand of Technical knowledge DEXs are accessible using cryptocurrency wallets that can interact with smart contracts. Users have to know how to use these wallets, they  also have to understand security-related concepts associated with keeping their funds secure.

That’s why without the fundamental technical knowledge, users can commit various errors  which may lead to a loss of their valuable funds. Withdrawing coins to the wrong network,  overpaying transaction fees, and losing out to impermanent loss are just a few examples of what  could go wrong.

No Customer Service DEX

No Customer Service we all can realize that centralized exchanges work much like the way banks do. They have customers whom they mostly want to keep happy and provide dedicated service in doing so.

But in a truly decentralized exchange, there is no actor on the other end. The developers who created the protocol don’t have the same relationship with users, the way a centralized exchange like Coinbase acts. You only have a DEX community you can turn up to in case faced any difficulties. I would like to bring it to your notice that you’re responsible for  your own money while dealing with a decentralized exchange

Unvetted Tokens

Anyone can list a new token on a decentralized exchange and provide liquidity by pairing it with other coins. This can leave investors vulnerable to scams such as rug pulls that make them believe that they are buying a different token. Scary, right? Now, to solve this, some Decentralized exchanges ask users to verify the smart contract of the tokens they are looking to buy. While this solution works for an experienced users, it circles back to specific technical problem for others.  Lastly, I’d like to say that Decentralized exchanges keep evolving and try to embrace blockchain’s ethos of “trustlessness” and privacy. While some people find it reassuring from a security perspective that their tokens remain in their possession until they trade them. Some find it troublesome as that level of responsibility is intimidating, and the risks are concerning.

Read More: DEFY GRAVITY: What is Defi? Decentralized Finance 2021

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