What is a DEX? Its benefits and mechanics

Aug 19, 2022
06:08
2 min reading

Choise.com team

What is a DEX? Its benefits and mechanics

How Do DEXs Work?
What Are the Benefits Of Decentralized Exchanges?
What Are Some Potential Drawbacks Of DEXs?
How Do You Interact With a DEX?
What Are DEX Fees?

DEX is an acronym for a “decentralized exchange,” and it is a blockchain-powered online platform where users can access various crypto-related services. Decentralized crypto exchanges allow you to trade virtual coins and engage in different interest-bearing activities such as savings, staking, and yield farming.

Along with Bitcoin and altcoins (an altcoin is any other cryptocurrency that appeared after Bitcoin), many DEXs support NFTs – non-fungible tokens that present digital collectibles. More advanced decentralized exchanges also offer crypto insurance products, borrowing schemes, lending options, and more.

To a certain extent, decentralized crypto exchanges are similar to a traditional banking system because they allow buying and managing different virtual assets the same way as conventional banks do with fiat and securities. Yet, DEXs are fully automated software solutions where financial operations are executed and controlled by underlying smart contracts.

Smart contracts are basically computer programs coded on top of some blockchain network such as Ethereum or Solana, and they contain the logic of how transactions must be performed on a DEX through the use of if/then algorithms.

According to the DEX definition, these exchanges follow the idea of decentralization – the absence of centralized agencies (banks, brokers, or payment processors) to stand between a buyer and a seller when they want to make a deal. Since there is no intermediary, users can directly do business with each other while paying minimal fees.

Also, decentralized exchanges are non-custodial solutions, meaning they put the custody of user wallets under a person’s only control. Members of DEXs have full control over their digital holdings, passwords, and private keys, and the control of users’ private keys is never transmitted to any third-party.

How Do DEXs Work?

How It Work

In the crypto space, there exist both centralized (CEX) and decentralized (DEX) exchanges. The crucial distinction between the two is that CEX platforms are overseen by centralized (governmental) entities and share your financial information with local tax authorities.

To access a CEX, a user will need to complete the Know Your Customer (KYC) formality and go through a host of verification procedures. If everything is passed successfully, the user can buy cryptocurrencies using the bank card or wire transfer as well as withdraw crypto to the national money.

On the flip side, DEX applications tend to be more private and will save a user from many verification headaches. Verifying your phone number or email is frequently enough to start using a DEX. However, fiat-to-crypto (and vice versa) purchases are impossible on decentralized crypto exchanges, but only crypto-to-crypto trades. Moreover, unlike CEXs, decentralized systems do not allow margin trading or setting limit orders.

On a centralized exchange, operations are executed by the exchange itself through an order book that determines the conversion rate for a particular trading pair based on current buy-and-sell bids – this approach is utilized by NASDAQ and other popular stock exchanges.

Decentralized exchanges, on the contrary, are run by computer codes – smart contracts (also known as automated market makers) – that algorithmically determine the conversion rate for different crypto pairs. DEXs also use so-called liquidity pools – collectively formed pools of electronic assets where users lock up their crypto deposits for a certain time to receive interest-like rewards and facilitate trading on a given DEX.

A centralized exchange will record all its transactions on its internal database, while a decentralized one will keep its entire transaction history on the underlying blockchain.

DEXs are usually open-source solutions where the existing code is publicly available to be seen by everyone. Technically skillful users can even suggest improvements or report vulnerabilities to the DEX developers after verifying the platform’s open-source code. This code can also be leveraged as a foundation to develop other crypto projects.

What Are the Benefits Of Decentralized Exchanges?

Anonymity. The greatest allure behind decentralized crypto exchanges is that they offer more anonymity compared to centralized counterparts. No private information of a person is revealed when trading through a DEX.
Simplicity. Also, getting started with a DEX is a straightforward process that requires little to no effort, while a CEX will demand a user to cope with a complex KYC procedure. It may take a user several days or even weeks since their registration at a CEX before they will actually be able to trade on it.
Variety. Another remarkable advantage of decentralized exchanges is that they offer an extensive selection of tokens, both popular and emerging ones. It is not untypical for DEXs to offer rare or unpopular coins that are still not available on major centralized platforms. In this sense, DEXs offer more opportunities to invest in promising tokens at an early stage, while CEX are very reluctant to list beginner cryptocurrencies and prefer to deal with well-known, thoroughly vetted crypto projects.
Affordability. DEXs operate through self-executing smart contracts. In the absence of intermediaries, decentralized platforms use the same “gas” fee structures as theblockchainthey are built on. DEXs usually establish tiny fees, around 0.3%, per transaction. Although these fees can vary according to the network congestion, they are more budget-friendly than the costs set by centralized platforms.

What Are Some Potential Drawbacks Of DEXs?

The biggest disadvantage of decentralized crypto exchanges is that they do not support deposits and withdrawals in fiat currencies. This means that a beginner crypto user without any previous possessions of tokens cannot trade on DEXs. They are not immediate gateways to the world of cryptocurrencies for anyone who wants to buy their first cryptos. To trade through a DEX, you will first need to buy some popular coins through a centralized exchange using your bank card (wire transfer) and then move the just-bought crypto to the desired DEX to swap your coins for other coins.

Non-custodial solutions, DEXs will also require you to connect your external crypto wallet to the platform’s interface before you can trade coins and access other services of a given DEX. Setting up a crypto wallet and linking it to a particular DEX portal may be quite a challenging process for an inexperienced user.

Moreover, each DEX can support different wallets, so you may end up needing a host of crypto wallets to operate on different decentralized exchanges. Centralized solutions, on the other hand, come with an in-built wallet where you can store your virtual funds, yet beware of these wallets because CEXs are lucrative targets for hackers.

DEXs eagerly list unvetted crypto projects increasing the risk of buying a scam coin. Many people fall victim to rug pullers exactly through decentralized exchanges. Rug pull is a fraudulent scheme where a new crypto company sells its cryptocurrency through a DEX and then suddenly halts the development of the project and disappears with all the money, leaving investors with a worthless cryptocurrency. Users need to do their homework and thoroughly research the project they are interested in before investing in it.

How Do You Interact With a DEX?

Decentralized crypto exchanges require having a connected crypto wallet to get started with them. The most popular options include MetaMask Wallet, Exodus, and Trust Wallet. MetaMask allows you to purchase ETH right from the wallet interface, using Apple Pay (US only), a credit card, or a bank transfer. This saves you from the need to go to centralized exchanges to buy your first tokens.

DEXs also demand that you have an initial supply of Ethereum or another major altcoin to be able to engage in DEX activities. These altcoins can be bought for fiat through a CEX, if your external crypto wallet does not allow fiat-to-crypto purchases. The initial supply of a popular coin is necessary to cover fees (known as “gas”) for a transaction that takes place on a specific blockchain. Bear in mind that gas fees are separate from the DEX platform’s fees, which you will also need to pay.

What Are DEX Fees?

DEXs gravitate toward charging a low fee,around 0.3%for platforms like Uniswap, but this can depend on several factors, including the blockchain network utilization, the liquidity of a given token, etc. When trading through a DEX, you will pay two types of charges:

Blockchain fees (gas). This fee is paid to miners who verify and add your transaction to the blockchain. DEX platforms do not profit from gas fees.
DEX fees. An exchange will also charge a certain fee for its transaction. A portion of the revenue generated through fees goes to the platform’s liquidity providers, and the remaining part of the profits helps to maintain the platform and develop new features according to the project’s road map.