What is a Decentralized Exchange or DEX?

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And how does it work?

A decentralized exchange or DEX is the increasingly popular way to get your hands on new cryptocurrencies. Today, virtually every internet-savvy individual has heard about cryptocurrency and blockchain technology. A crypto exchange offers a platform where cryptocurrency owners and intending buyers meet to transact. However, these platforms of exchange come in two major forms: centralized and decentralized exchanges.

Let’s first look at the centralized exchange, or CEX. The centralized exchange has a central control, more like traditional financial institutions but with blockchain applications. It leverages the services of third parties and intermediaries to execute transactions. It is completely different from decentralized exchanges (DEX). This brings us to the question, what is a decentralized crypto exchange?

A decentralized exchange or DEX is a crypto trading platform that does not rely on intermediaries to help execute transactions between two different individuals. No desks, no office employees. User interactions on a DEX happen through smart contracts, pieces of software on the blockchain. Thanks to these smart contracts users can transact value while keeping full control over their own funds.

How does a DEX work

A decentralized exchange operates automated order books or automated market makers (AMMs) by leveraging smart contracts. It is these AMMs that make these crypto exchanges to be truly peer-to-peer. It makes swapping tokens efficient and transparent for traders. 

Decentralized exchanges are anonymous since no KYC (know your customer) is needed from users to participate in any transaction. Most times, users only require a public address to conduct trading or swapping tokens, unlike centralized exchanges where users are required to undergo a KYC procedure. In addition users of a decentralized exchange have full control over their private keys, and therefore over their funds. No government or other entity can claim access to the user’s funds.

Also, the security of decentralized exchanges is miles ahead of their centralized counterpart. In the past decade, hackers have stolen more than $1 billion from centralized exchanges. Binance, Cryptopia and many others have seen hackers steal funds, sometimes causing major financial damage.

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Different elements of a DEX

There are three different parts to a DEX, and they work differently from one another. 

  • Automated money makers (AMMs) – AMMs became popular in 2020, and they have been making waves since then by driving the DeFi boom. It is used by notable DEXs like Uniswap, SushiSwap, etc. They don’t use order books; rather, they leverage smart contracts to create liquidity pools that automatically execute transactions. Today’s AMMs are relatively user-friendly and have integrated with wallets like TrustWallets, MetaMask, etc. 
  • On-chain order books – They are the decentralized cryptocurrency exchanges where every order is written to the blockchain. Although this is arguably the most transparent approach to DEX crypto trading, it is highly impractical. Every node on the blockchain network keeps a record of the order forever, thus incurring high fees for users. Users have to wait for miners to add their message to the blockchain. Such a process can be complex and frustrating to execute. 
  • Off-chain order books – In some aspects, these categories of order books are still decentralized. However, they are more centralized than their on-chain counterparts. Here, their orders are hosted somewhere and not on the blockchain network. A good example is the 0x protocol for ERC-20 and other tokens hosted on the Ethereum blockchain. Instead of functioning as a single DEX, it creates a framework where parties called “relayers” can handle off-chain order books. 

The majority of these decentralized crypto exchanges are built on Ethereum, Binance Smart chain, or Polygon blockchain protocol. Other blockchain protocols like NEAR, Avalanche, Tezos and Polkadot are also attracting DeFi protocols to create value for their users.

The most prominent Decentralized Exchanges

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