What is a DEX? How Decentralized Crypto Exchange Works?

Introduction

Decentralized crypto exchange, also known as DEXs, are peer-to-peer marketplaces where crypto traders can deal without committing the management of their funds to a middleman or custodian. These transactions are accelerated by smart contracts, which are self-executing contracts created in computer code.

Automated market makers, for instance, were among the technologies that solved liquidity-related problems and considerably benefited from the establishment of the decentralized finance (DeFi) sector. Decentralized platforms expanded due to DEX aggregators and wallet extensions, optimizing token prices, exchange fees, and slippage while providing customers with a better deal.

Read on to learn more about decentralized crypto exchange and its working.

What is a Decentralized Crypto Exchange?

Smart contracts are used in decentralized crypto exchanges to let traders place orders directly with one another. Centralized exchanges, on the other hand, are managed by a central organisation, such a bank, which also works in the financial services sector and aims to make money.

The overwhelming majority of trading volume in the crypto market is conducted on centralized exchanges since they are licenced organizations that guard users’ money and provide beginner-friendly interfaces. Even insurance on assets put there is offered by some controlled deals.

The services offered by a centralized exchange are analogous to those of banks. Money can be moved around more quickly because the bank protects its customers’ cash and provides security and monitoring services that individuals cannot supply on their own.

Decentralized exchanges, in contrast, enable users to engage with the smart contracts that power the trading platform immediately from their wallets to conduct transactions. Traders are in charge of protecting their cash and are accountable for their loss if they commit errors like misplacing their private keys or transmitting money to the wrong locations.

Through decentralized exchange portals, the customers’ deposited money or assets are transformed into an “I owe you” (IOU) that may be freely exchanged on the network. A blockchain-based token with the same worth as the underlying asset is what an IOU essentially is.

Top-tier blockchains enabling intelligent contracts have formed the foundation for developing well-known decentralized exchanges. They are constructed directly on the blockchain since they are created on top of layer-one protocols. The most well-known decentralized crypto exchanges are built on the Ethereum blockchain.

How Does a Decentralized Crypto Exchange Work?

A trading cost and a transaction charge are associated with every deal because decentralised exchanges are developed on blockchain networks that enable smart contracts and let users maintain custody of their money.Trading on DEXs mainly involves interacting with blockchain smart contracts.

Order books and computerized market participants Decentralized exchanges can be divided into DEXs, DEX aggregators, and DEXs. All of them allow users to do direct business with one another using smart contracts. Order books used by the first decentralised exchanges were identical to those used by centralised exchanges.

Automated Market Makers (AMMs)

An intelligent contract-based automated market maker (AMM) system was developed to address the liquidity issue. Part of the inspiration for these exchanges came from a paper on decentralised exchanges produced by Vitalik Buterin, an Ethereum co-founder, which described how to conduct trades on the blockchain with contracts holding tokens.

These AMMs depend on blockchain-based services known as blockchain oracles to determine the price of traded assets by gathering data from exchanges and other platforms. Instead of matching buy and sell orders, the smart contracts of these decentralised exchanges use pre-funded sums of assets called liquidity pools.

Other users contribute money to the pools and are then eligible to receive the transaction cost that the protocol levies for carrying out trades on that pair. These liquidity suppliers must contribute an equal quantity of each asset in the trading pair, a process known as liquidity mining, in order to profit from their cryptocurrency holdings.

The intelligent contract powering the pool invalidates any attempts to deposit more of one investment than the other.

Traders can execute orders or collect interest in a distributed and untrusted manner using liquidity pools. Total value locked (TVL), a measurement of the amount of money locked in these platforms’ smart contracts, is usually used to rank these exchanges since the AMM model has a flaw when there is insufficient liquidity: slippage.

Larger orders are more likely to slip when a system’s lack of liquidity leads customers to pay the above-market cost for their charges.

Oversized orders will likely experience slippage without substantial liquidity, which can prevent wealthy traders from using these platforms.

A risk that liquidity suppliers also face is impermanent loss, which comes about directly from putting two assets for a particular trading pair. Trades on the exchange may reduce the amount of one of these assets in the liquidity pool if it is more unstable than the other.

Liquidity providers experience a transient loss if the price of the highly volatile asset rises while their holdings decline. The asset’s price may still increase, and transactions on the exchange may balance the pair’s ratio. Thus, the loss is temporary. The pair’s ratio indicates the fraction of each asset held in the liquidity pool. Additionally, trading commissions can eventually make up for the loss.

Order Book DEXs

Order books record all active buy and sell orders for particular asset pairs. Sell orders show that a trader is prepared to ask for a specific price to sell an asset, whereas buy orders show that a trader is eager to acquire or bid for purchase at that price. The size of the order book and the current value on the market is determined by the difference between these values.

Request book On-chain order books and off-chain order books are the two categories of DEXs. When DEXs use to order books, the open order information is frequently kept on-chain while user funds are held in their wallets. These exchanges might permit traders to use money lent to them by lenders on their system to leverage their bets. By enlarging the position size with borrowed money, which must be repaid even if the dealers lose their stake, leveraged trading raises the profit potential of trade but also increases the danger of liquidation.

To give traders the advantages of centralized exchanges, DEX systems, which keep their order books off the blockchain, only execute trades there. Off-chain order books enable businesses to operate more quickly and cheaply while ensuring that transactions are performed at the pricing consumers want.

These exchanges enable users to lend money to other traders to provide leveraged trading alternatives. Lenders are paid back even if dealers lose their bets since borrowed money accrues interest over time and is guaranteed by the exchange’s liquidation process.

It is crucial to note that order book DEXs frequently experience liquidity problems. Traders typically stay to centralized platforms because they effectively compete with centralized exchanges and incur additional costs due to what is paid to transact on-chain. DEXs with off-chain order books lower these expenses, but because money must be deposited in them, there are hazards associated with smart contracts.

DEX Aggregators

DEX aggregators utilize a variety of protocols and strategies to address liquidity-related issues. To minimize slippage on large orders, optimize swap fees and token prices, and provide traders with the lowest price in the shortest amount of time, these platforms essentially pool liquidity from many DEXs.

Two other important objectives of DEX aggregators are safeguarding consumers from the pricing effect and reducing the possibility of unsuccessful transactions. By utilizing a connection with particular centralized exchanges, some DEX aggregators additionally use liquidity from centralized platforms to improve user experiences while staying non-custodial.

How to Use a Decentralized Crypto Exchange?

A decentralized exchange does not require registration because you can connect with these platforms without even providing your email address. Trading participants will need a wallet that works with the network’s smart contracts instead. Anyone with a mobile phone and an internet connection can use the financial services offered by DEXs.

Before using DEXs, users must decide which network they want to utilize since each trade has a transaction fee. The next step requires choosing a wallet compatible with the selected network and financing it with the native token of that wallet. A native cryptocurrency covers transaction fees in one network.

Interacting with decentralized applications (DApps), such as DEXs, is made simple by wallet extensions that let clients access their money directly in their browsers. The user must create or import these into a current wallet using a seed phrase or private key, just like any other extension. Password protection further tightens security.

These exchanges come with built-in browsers prepared to communicate with intelligent contract networks. They may also feature mobile applications so traders can use DeFi protocols while on the go. Users can import their wallets from one device to another to synchronize them.

After selecting, a wallet must be financed with the tokens required to cover the network’s transaction costs. These tokens, which must be purchased on controlled exchanges, are easily recognized by their ticker sign, such as ETH for Ethereum. After buying tickets, users only need to deposit them into their wallets.

Avoiding sending money to the wrong network is essential. Users must thus withdraw their money to the proper account. Users who have funded their wallets can connect them via a pop-up window or by clicking the “Connect Wallet” button on one of the top corners of the DEXs’ websites.

Conclusion

These days, decentralized exchanges allow users to lend money to earn interest passively, borrow money to leverage their holdings, or supply liquidity to earn trading commissions.

These systems’ reliance on self-executing intelligent contracts may lead to the development of different use cases in the future. Flash loans are an example of how innovation in the decentralized finance sector can produce goods and services that were previously impossible. Flash loans are defined as loans taken and returned in a single transaction.