SHORT ANSWER: Decentralized exchanges are peer-to-peer marketplaces where users can exchange cryptocurrency. By using smart contracts and incentives, DEXs securely and efficiently facilitate orders without intermediaries.
A DEX, short for decentralized exchange, is a marketplace that does not use centralized intermediaries to facilitate transactions. These transactions happen directly between crypto traders peer-to-peer. DEXs are necessary for the decentralized finance (DeFi) ecosystem to operate, providing a marketplace for users to buy and sell digital assets. Overall, DEXs hold $22.7 billion in Total Value Locked (TVL) — the amount of money locked into smart contracts. TVL is an important metric when examining DEXs because the more money is locked inside a smart contract, the more reputable it will be. Uniswap, a DEX on the Ethereum network, is the king of DEXs with over $6.38 billion in TVL, a 28% market share. This number used to be over 50% in 2021, but the rise in DeFi has led to other DEXs growing in quantity and quality.
How Do DEXs Work?
An exchange is a marketplace with buyers and sellers. Traditionally, sellers are institutions that facilitate transactions and order books and provide security and liquidity. DEXs fulfill the same objective as centralized exchanges (CEXs), shifting control and responsibility away from intermediaries to users. By implementing smart contracts and programmable logic, DEXs can provide the same financial services as CEXs in a decentralized manner.
A few components make DEXs work properly. Smart contracts facilitate and manage transactions between traders, automating the processes. An important feature of smart contracts is that they do not require trust, allowing parties to transact without knowing each other. To use a DEX, users need a wallet. Wallets hold cryptocurrency and other digital assets and must connect your funds to the exchange. By connecting your funds through a wallet, there is no need to transfer control of your assets to the exchange. On the other side, liquidity providers (LPs) are users who deposit pairs of cryptocurrency into a liquidity pool. This practice allows cryptocurrencies to be bought, sold and swapped. The DEX’s smart contract automatically enforces trades using the pool to swap currencies. Liquidity providers are incentivized with yields to provide vital liquidity services — called yield farming. Incentives are a key requisite in DEXs, as liquidity is necessary for buying and selling. Incentives also ensure the alignment and cooperation between participants, enhancing security in a decentralized environment.
Types of Decentralized Exchanges
Within the DeFi landscape, there are three predominant types of DEXs.
Automated Market Makers (AMMs)
AMMs are one of the most popular frameworks used on DEXs. The top AMM DEXS are Uniswap, SushiSwap, and PancakeSwap. Smart contracts are used to automatically fulfill orders and adjust the prices of assets in the pool. AMMs use liquidity pools provided by the community to execute transactions. Liquidity pools are often made up of pairs of tokens. These pairs are automatically rebalanced by a smart contract depending on the supply and demand of the pooled assets. Providers receive yield as a reward for liquidity, typically annual percentage yield (APY) on liquidity tokens. For example, a user looking to exchange WETH for USDT will head to Uniswap and search for the pool containing the two tokens. After finding the pool, the user will trade their assets with the smart contract, facilitating the order. Upon swapping, the user leaves, and the pool is automatically rebalanced, adjusting the price of assets and fees paid to the liquidity providers. Something to keep in mind is that AMMs use their native liquidity pools, causing token prices to vary across exchanges. When swapping, checking multiple exchanges or using an aggregator to get the best quotes will help maximize your trades.
Order Book DEXs
Order Book DEXs operate similarly to centralized exchanges. On these DEXs, traders place buy and sell orders at the desired price. Smart contracts automatically compile these orders, matching buyers with sellers executing matches. This format attracts traders who want more control over their trades by buying and selling at desired prices. dYdX is considered the most popular order book DEX with over $883 million in daily trading volume. While less popular than AMMs, Order Book DEXs are an important part of the DeFi ecosystem, acting similarly to centralized exchanges but with the added security, transparency and trust blockchain provides.
DEX Aggregators
Because of their high utility, DEX Aggregators have become popular among traders. An issue with using DEXs is that token prices vary. AMMs use their own liquidity pools and Order Book DEXs’ prices are set by sole market makers. This results in prices that don’t always match up across exchanges. The discrepancy between prices throughout the ecosystem can cause confusion. DEX aggregators take data from various DEXs and place them into one platform. Using protocols to aggregate liquidity, users can ensure they get the best prices on their trades. Popular DEX aggregators include OKX and Matcha.
How to Use a DEX
Using a DEX is simple and doesn’t require any signup. Users only need a wallet to connect to the DEX to transact. After connecting your wallet to an exchange, choose the crypto you want to swap to and from, along with the amount. Then, execute the transaction by hitting the swap or trade button. The trading fees vary depending on the supply and demand of the tokens you are swapping. Using a DEX aggregator can help you find the best price to swap your assets to ensure you are making the best trade possible.
What Are the Advantages of DEXs?
DEXs boast a few benefits. Here are some of the most notable.
- Decentralization: DEXs eliminate the need for intermediaries to facilitate transactions, allowing users to stay in control of their assets.
- Security: Users use wallets to control their assets without relying on centralized institutions to hold their funds. Wallets use private keys, a cryptographic function that minimizes the risk of being hacked. However, users must remember their private key passphrase — if lost, you will lose access to your wallet and funds.
- Privacy: Users receive enhanced anonymity using DEXs, as only the wallet's public address can be seen.
- Transparency: All transactions made on DEXs are immutable and can be viewed and verified on the blockchain.
What Are the Disadvantages of DEXs?
DEXs have drawbacks in addition to the advantages they offer.
- Usability: While the DEX user experience is straightforward, it can be more complicated than centralized platforms. Users must understand a wallet and how to use it, which can be complex.
- Liquidity issues: DEXs rely on community-provided liquidity. A lack of liquidity for specific currencies can lead to higher price slippage than centralized counterparts. Slippage is when the price your trade executes is different than you expected. Most DEXs ask you to include a slippage tolerance when placing orders, and if this isn’t done correctly, you could lose value on a trade.
- Transaction speed: Order processing on DEXs can be slow because the trade must first be sent to the network to be confirmed before execution. The constant price shifts of cryptocurrencies can cause transactions to fail — you may need to try a few times before your order goes through.
- Smart contract vulnerabilities: While unlikely, smart contracts can be hacked or manipulated, causing users to lose funds. While contracts undergo rigorous auditing to mitigate this scenario, it has happened in the past. Sticking with exchanges with a higher TVL is the best way to reduce this possibility.
Top 3 Decentralized Exchanges
With a sea of DEXs, choosing the right platform is essential to maximize your trades. Below are some of the best choices in the ecosystem.
1. Best Overall: Uniswap V3 (Ethereum)
Uniswap V3 operates on the Ethereum network, boasting the highest 24-hour volume of $1.86 billion. As the market leader, Uniswap is a reputable exchange established in 2018 that provides users with numerous asset pools and high liquidity. Given the large volume of transactions on Uniswap, it tends to be the safest, with $6.38 billion TVL.
2. Best Aggregator: OKX
OKX is notably one of the better aggregators in the ecosystem, supporting over 70 blockchain networks. OKX ensures you get the best asset price by providing different quotes for your swaps in a simple user interface. OKX also supports cross-chain functionality, allowing traders to bridge assets across various networks making it a great all-in-one platform.
3. Best UX: SushiSwap
SushiSwap has emerged as one of the best clones of Uniswap. It is available across 30 blockchain networks, has highly attractive liquidity rewards and offers a smooth user experience. SushiSwap has excellent liquidity and a strong community.
DEXs: The Pillar of DeFi
DEXs remain a pillar in the DeFi ecosystem, providing critical financial services in a decentralized format. DEXs facilitate transactions between users without an intermediary, giving users more control over their assets. Smart contracts are a key component of DEXs used to facilitate transactions automatically and follow protocol rules. Protocols incentivize users to contribute liquidity through yields, whereas institutions provide liquidity on CEXs. Enhanced with blockchain security, DEXs offer a decentralized medium to exchange cryptocurrency, which has advantages and disadvantages. As the crypto market heats up, DEXs remain an essential medium of exchange and are likely to grow in volume and quantity. Using reputable DEXs like Uniswap and aggregators like OKX can help you stay safe and maximize the value of your trades.
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About Gianluca Miller
Gianluca Miller’s crypto journey started in 2019 when he sought alternative assets to diversify his investment portfolio. With a keen interest in innovative technologies, he became increasingly involved in Web3 through trading crypto and participating in DeFi protocols. Over the last few years, he has become a blockchain evangelist, fascinated with the tech’s utility and impactability. Gianluca contributes to Benzinga, is working on a Defi research project through Blockchain UCSB, and continues to expand his Web3 acumen daily. He loves learning, analyzing new projects and market conditions, and building relationships with industry leaders.