How does a Decentralized Exchange (DEX) work?

A decentralized exchange, or DEX, is generally for the crypto native. Why? Because they exclusively trade in crypto assets, and hence don’t allow you to exchange between your fiat (cash) and cryptocurrencies. As such, cryptocurrencies are absolutely necessary to use DEXs. Hence, at least for the time being, centralized exchanges, or CEXs, are still an important part of getting funds inside the crypto ecosystem.

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Decentralized exchanges use a set of smart contracts to set up the prices of different cryptocurrencies against each other through algorithms. This is in direct opposition to brokers who run managed ‘order books’ instead.

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Liquidity pools are funded by platform users termed as Liquidity Providers (LP). The pools are then used to facilitate trades and portions of the trading fees are redirected to the liquidity providers as rewards in exchange for both providing liquidity and bearing the risks that come along with it.

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Transactions on a DEX are directly recorded on the underlying blockchain meaning that anyone who wishes to do so can check and confirm trades. Most of the DEXs are built with open source code and blockchain developers can utilize existing code to generate new and better projects. For example, Uniswap has various popular spin offs through this exact same mechanism, such as PancakeSwap, QuickSwap, and SushiSwap.

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What are the pros and cons of DEXs?

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Pros of decentralized exchanges:

• You can maintain a higher level of anonymity as there is no KYC (Know Your Customer) or AML (Anti-Money Laundering) needed.

• As you maintain control of your funds the whole time, there is no counterparty risk.

• You can enjoy access to unlisted tokens before they are added to CEXs. This means that you can enjoy purchasing those tokens at a lower price before it increases once they get listed on CEXs.

• It has especially strong utility in developing countries that lack proper banking and financial services.

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Cons of decentralized exchanges:

• DEXs are often not as user-friendly or easy to use as CEXs.

• As they are not regulated, they have fewer fail-safes. This increases the risk of lost funds for users.

• DEXs generally have lower trading volumes and liquidity than CEXs, leading to a larger gap between the bid and ask prices.

• Vulnerabilities in the smart contracts can easily lead to loss of funds through protocol hacks.

• It’s easier to get scammed or ‘rug-pulled’ due to access to unvetted coins on DEXs.

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How can you use a DEX?

A majority of today’s decentralized exchanges need you to connect with them through a hot cryptocurrency wallet, such as MetaMask, or a cold wallet, such as Trezor. Generally, you should be able to access a DEX through its official website on a desktop browser. The official website usually has a ‘Connect to a wallet’ or ‘Enter the app’ button

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Generally, a decentralized exchange’s official website has a ‘Connect to a wallet’ or ‘Enter the app’ button which you can click on a desktop browser to access the DEX. When you connect your wallet, you also need to keep in mind that you own enough cryptocurrency of whichever blockchain you’ll be interacting with. For example, ETH for Ethereum, MATIC for Polygon, BNB for BNB Smart Chain, and so on. This is so that you are able to pay for the transaction fees, better known as gas. Once you connect your wallet and have enough funds, you can conduct swaps between any crypto asset that you have and token that the DEX offers.

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How much are the fees for using DEXs?

While fees differ depending on the DEX, they usually range from 0.3% to 0.5%. The fees are then split between liquidity providers and the protocol. The other main fee in a DEX is the gas fee. In Ethereum’s situation, the gas fees can often be much larger than the swap fees charged by the decentralized exchange. Fortunately, a coordinated effort has been made to create cross-chain bridges between various blockchain networks. In fact, a lot of popular DEXs now offer multi-chain support which gives crypto trades multiple options of what networks to conduct trades on. This includes both layer 1 networks, such as Avalanche and BNB Smart Chain, as well as Ethereum layer 2 solutions, such as Arbitrum and Polygon.

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