Definition
A decentralized exchange (or DEX) is a peer-to-peer marketplace where transactions occur
directly between crypto traders. DEXs fulfill one of crypto’s core possibilities: fostering
financial transactions that aren’t officiated by banks, brokers, or any other intermediary.
Many popular DEXs, like Uniswap and Sushiwap, run on the Ethereum blockchain.
A decentralized exchange (better known as a
DEX) is a peer-to-peer marketplace where transactions occur directly between crypto traders.
DEXs fulfill one of crypto’s core possibilities: fostering financial transactions that aren’t
officiated by banks, brokers, payment processors, or any other kind of intermediary. The most
popular DEXs — like Uniswap and Sushiswap — utilize the Ethereum blockchain and are part of the growing
suite of decentralized finance (DeFi) tools, which make a
huge range of financial services available directly from a compatible crypto wallet. DEXs are booming — in the first
quarter of 2021, $217 billion in transactions flowed through decentralized exchanges. As of
April 2021, there were more than two million DeFi traders, a ten-fold increase from May 2020.
How do DEXs work?
Unlike centralized exchanges like Koinmex,
DEXs don’t allow for exchanges between fiat and crypto — instead, they exclusively trade
cryptocurrency tokens for other cryptocurrency tokens. Via a centralized exchange (or CEX),
you can trade fiat for crypto (and vice versa) or crypto-crypto pairs — say some of your
bitcoin for ETH. You can also often make more advanced moves, like margin trades or setting
limit orders. But all of these transactions are handled by the exchange itself via an “order
book” that establishes the price for a particular cryptocurrency based on current buy and sell
orders — the same method used by stock exchanges like Nasdaq.
Decentralized exchanges, on the other hand,
are simply a set of smart contracts. They establish the prices of various cryptocurrencies
against each algorithmically and use “liquidity pools” — in which investors lock funds in
exchange for interest-like rewards — to facilitate trades.
While transactions on a centralized exchange
are recorded on that exchange’s internal database, DEX transactions are settled directly on
the blockchain.
DEXs are usually built on open-source code,
meaning that anyone interested can see exactly how they work. That also means that developers
can adapt existing code to create new competing projects — which is how Uniswap’s code has
been adapted by an entire host of DEXs with “swap” in their names like Sushiswap and
Pancakeswap.
What are potential benefits of using a DEX?
Vast variety: If you’re interested in
finding a hot token in its infancy, DeFi is the place to be. DEXs offer a virtually limitless
range of tokens, from the well-known to the weird and totally random. That’s because anyone
can mint an Ethereum-based token and create a liquidity pool for it, so you’ll find a greater
array of projects, both vetted and unvetted. (Buyer definitely beware!)
Hacking risks can be reduced: Because
all of the funds in a DEX trade are stored on the traders’ own wallets, they are theoretically
less susceptible to a hack. (Relatedly, DEXs also reduce what is known as “counterparty risk,”
which is the likelihood that one of the involved parties — including potentially the central
authority in a non-DeFi transaction — will default.)
Anonymity: No personal information is
required to use most popular DEXs.
Utility in the developing world: The
peer-to-peer lending, speedy transactions, and anonymity made possible by DEXs have made them
increasingly popular in developing economies — where solid banking infrastructure might not be
available. Anyone with a smartphone and an internet connection can trade via a DEX.
What are some potential downsides?
Trickier user interfaces Navigating
decentralized exchanges requires some specialized knowledge and the interfaces aren’t always
easy — be prepared to do a lot of research and don’t expect the DEX itself to offer much
handholding. You’ll generally have to look offsite for a walk-through or explainer. Caution is
required because it’s possible to make an unfixable error, like sending coins to the wrong
wallet. Another common issue is known as “impermanent loss,” which can result from pairing a
more volatile cryptocurrency with a less volatile one in a liquidity pool. (The main takeaway
here? Do your own research.)
Smart contract vulnerability Any DeFi
protocol is only as secure as the smart contracts that power it — and code can have
exploitable bugs (despite lengthy testing) that can result in the loss of your tokens. And
while a smart contract might work as intended under normal circumstances, not all rare events,
human factors, and hacks can be anticipated by developers.
Riskier coins With the unvetted, vast
array of tokens available on most DEXs, there are also a greater number of scams and schemes
to be wary of. A token that’s on a hot streak could suddenly be “rug pulled,” when its creator
mints a bunch of new tokens, overwhelming the liquidity pool and tanking the value of the
coin. Before you buy a new-to-you cryptocurrency or experiment with a new protocol it’s important to learn as much as you
can — read white papers, visit developer Twitter feeds or Discord channels, and look for
audits of any particular project you’re interested in (some bigger auditors include Certik,
Consensys, Chain Security, and Trail of Bits).
How do DEX fees work?
Fees vary. Uniswap charges a 0.3% fee that is
split between liquidity providers, and a protocol fee could be added in the future. But it’s
important to note that the fees the DEX charges can be dwarfed by gas fees to use the Ethereum
network. The ongoing ETH2 upgrade (as well as a number of “layer 2”
solutions like Optimism and Polygon) are designed in part to lower fees and speed up
transactions.