When you deposit funds on a centralized exchange, you indirectly lose possession and control of them! Indeed, you do not own the private keys of your funds. This means that when you make a withdrawal, you are asking the exchange to sign a transaction on your behalf. By entrusting your money to an exchange, you are indirectly taking a risk. What happens to your funds if your favorite platform is hacked? Or if a regulation forces it to block your funds for any reason? You are therefore dependent on the exchange in question: not your keys, not your coins!
This problem has encouraged the development of decentralized exchanges. DEXs work in the same way as their centralized counterparts but have some important differences. The main difference is that a DEX is directly hosted on a blockchain. Any transaction performed is executed on the blockchain itself, with the help of smart contracts.
Thus, no one has custody of the users’ funds and you don’t need to trust any exchange. Your funds are placed directly on your crypto wallet such as MetaMask with which you will be able to carry out your transactions directly on the blockchain, called on-chain transactions. All your communications with the DEX will always go through your private wallet. It will allow you, for example, to make a swap on the exchange and to validate the transaction.
DEXs usually run on a single chain, such as Ethereum or the Binance Chain, but developers are working hard to create cross-chain DEXs in the future.
The different types of decentralized exchanges (DEX)
There are three main types of decentralized exchanges today:
- Automated Market Makers (AMM)
- Exchanges with order books
- DEX aggregators
Let’s see how each of them works.
Automated Market Makers (AMM)
An AMM sets the price of the tokens automatically, using algorithms. This price is set according to the liquidity present on the platform. This process allows users to buy tokens at an average price depending on the liquidity available. However, AMMs suffer from the following flaw: in case of lack of liquidity, the price of tokens can vary enormously.
Nevertheless, AMMs remain the most common type of decentralized exchange in the ecosystem due to their ease of use. There is no need to set a price for buying or selling your tokens. This system is used by many well-known platforms such as Uniswap, PancakeSwap, Venice Swap or the excellent Osmosis. If you want to know more about WMAs, feel free to read our dedicated article right here.
Exchanges with orders book
Unlike WMAs, here each user will set a specific buy or sell price and then wait for a seller or a buyer. This is very similar to what centralized exchanges such as Binance offer. The most famous ones to date are dYdX, SpookySwap (in advanced mode) and Injective Protocole.
The two types of decentralized exchanges analyzed above are what we call liquidity aggregators. They allow to “aggregate” the liquidity of all users. DEX aggregators will use these liquidity aggregators to find the best price.
Imagine you want to swap USDT against Ethereum. The DEX aggregator will search, in real time, for the best price, all platforms combined, and this automatically. The aggregator will then perform the swap on the platform that offered the best exchange rate. Think of it as a DEX comparison allowing you to save on each of your swaps.
Advantages and disadvantages of a decentralized exchange (DEX)
After a general overview of the subject, let’s define the concrete advantages and disadvantages of using DEX:
Advantages of DEX
- Sometimes No KYC: Unlike centralized exchanges, no proof of identity is required. Users can therefore operate freely, with respect for confidentiality and privacy.
- Ownership of your funds: as mentioned, you do not entrust your funds to any platform and benefit from total control of them and additional security.
- Variety of tokens: Tokens not available on centralized exchanges can still be traded freely on DEX, provided there is a supply and demand.
The disadvantages of DEX
- More laborious to use: for crypto beginners, interacting with a decentralized exchange is more difficult than with a centralized exchange. The experience on CEX is more intuitive and support is more present (lost password, customer service interactions…)
- Trading volumes and liquidity: CEXs have greater liquidity, which means greater competition between supply and demand and therefore easier to find buyers and sellers.
- Fees: fees can be higher on DEX, especially when the blockchain used is congested, such as Ethereum.
Decentralized exchanges allow for transparent exchanges in total anonymity and enjoy total freedom. These values are more suited to the decentralization philosophy and values advocated by cryptos. The rise of the latter has allowed the development of decentralized finance (DeFi), and they are now an integral part of the ecosystem.
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