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Home Blog decentralized exchanges for a better crypto market
Article by Yunis
26 November 2022 (Updated 8 February 2023)

The abundance of fiat money in 2021 created extremely leveraged giant centralized companies in crypto. But it didn't last long.

It is time to remember one more time what old Bitcoiner says 'Not your keys, not your coins'. Unfortunate experiences with centralized exchanges paved the way for decentralized exchanges. Decentralized exchanges are going to play a bigger role in the crypto's future.
Ultimate guide to Decentralized Exchanges (DEX) for beginners logo
  • DEXs are non-custodial. It means that you have full control over your funds.
  • You don't need a third party to be involved to swap or trade your coins in a DEX.
  • Users can earn passive income with liquidity pools and staking services.
  • Do your own research and chose a DEX with a proven history.

What is DEX?

Decentralized Exchange (DEX) is a peer-to-peer application that runs on a blockchain network without being dependent on any specific host or server, where individuals can swap, and trade their cryptocurrencies without third parties being involved. We can create decentralized apps (Dapps) thanks to smart-contract-compatible blockchain networks. Traditional apps are hosted from a server that can be shut down or controlled by individuals. But Dapps are different and they are hosted from distributed servers that can not be stopped or controlled even by its consensus mechanism.

DEXs’ market share has been constantly increasing since its invention. The latest numbers show that the DEXs have reached more than 15% of spot trading volume in 2022 and it is still growing. The collapse of many centralized exchanges is a driving power behind this shift but there are many other reasons to start using a DEX.DEXs are peer-to-peer exchanges, so the buyer and seller don't need a third party. The buyer's bid and seller's put will automatically be matched by the algorithm at the best price for both parties. 

The most important aspect of DEXs is that they are non-custodial exchanges unlike centralized exchanges (CEX). Non-custodial means that the fund's original owner doesn't need to trust his assets to any third party. Individuals have full control over their assets. When you use a CEX, your funds are stored and protected by a private company. You trust your assets to a private company and its management.

History has shown us that private companies and their executives can do highly risky investments with their client's funds. Luna crash, Celsius bankruptcy, FTX crash, and BlockFi bankruptcy cases are unfortunate experiences in the history of centralized crypto exchanges. DEXs are getting more popular, especially after the unfortunate events in 2022. Compound Finance, MakerDAO, Synthetix, Aave, Uniswap, Curve Finance, Balancer, and Yearn.finance are good big DEXs with solid fundamentals.

History of DEXs

First DEXs date back to 2016, a little later after Ethereum was announced in 2015. Ethereum network is a smart-contract compatible network, so developers can create apps that run on the Ethereum network. Ethereum network is not like the Bitcoin network. While all computing power in the Bitcoin network is used to record transactions, in the Ethereum network, some of the computing power is used to provide hosting services for the apps. Apps that work on the Ethereum network are decentralized because they are not hosted from a specific location or server, they are hosted by a joint server with united computing power from different locations.

Those apps that are created on Ethereum or any other smart-contract-compatible network are decentralized, permissionless, and trustless. The underlying code works indefinitely and is available to anyone. Decentralized exchanges (DEX) are a kind of those decentralized apps to swap, trade, and exchange crypto assets. Anyone with the proper digital wallet with funds can utilize a DEX.

First DEXs had a very primitive user interface and it was not easy to use and navigate in the app. The user interface of DEXs have shown great development and now anyone with basic knowledge can easily use a DEX. The second biggest problem with DEXs was the lack of liquidity because the first DEXs were using a traditional order book system to match orders and they didn't have enough liquidity. The problem was solved with the AMM model later. Most of the DEXs now work in an AMM model. Modern DEXs can compete with CEXs as they are fast, cheap, and easy to use.

Services that DEXs offer?

-Swap

Swap is the main tool for any DEX on the market. It is a simple tool that allows users to convert cryptocurrencies and tokens. Many exchanges started their business with a simple swap tool and later expand their operations to trading, liquidity farms, and staking. Swapping tokens on an exchange is the easiest way to convert your coins with another one. It is fast, and simple for anyone even with very basic knowledge. The leading swap service providers are UniSwap, SushiSwap, BiSwap, and Dydx.

-Liquidity pool

Liquidity pools (LP) are essential tools for decentralized exchanges with the AMM model. Liquidity was a serious problem to be solved in DEXs before the AMM model was invented. Early DEXs were not convenient because of a lack of liquidity. Liquidity pools are where users lock their tokens and coins in a joint pool to be used as liquidity for the DEX. The DEX makes a profit while serving buyers and sellers to fulfil their orders and receives a small fee in every trade. DEXs generates revenue from trades and share the revenue with liquidity pool contributors.

If you lock 100 ADA coins in a pool, you will receive 100 ADA coins whenever you want to withdraw your funds. But you will mostly be rewarded in the native token of the DEX. For example, if you provide 10 ETH to the ETH/USDT pool in Sushiswap, you always have 10 ETH in the pool. You can always withdraw your 10 ETH. But you will get rewards in Sushi tokens from the pool's revenue. Sushi currently offers 0.25% fee from all trades for liquidity providers.

Centralized exchanges have order books and they match buyers and sellers instantly. But DEXs don't require a third party to be involved in a transaction between two parties.

If a DEX is a stall on a marketplace, tokens and coins in an LP are goods that we lend to the shopkeeper. The shopkeeper has a stall in a marketplace, he wants to buy and sell goods but he doesn't have enough goods to create a bigger turnover. So, the shopkeeper borrows our goods, increases the trade volume and rewards us with a share of his profit. We still own the goods while he is doing business. He owes us goods in the form of as he borrowed. If he borrowed tomatoes, he owes us tomatoes, if he borrowed cucumbers, he owes us cucumbers. The price of cucumber or tomato can fall or increase, but he still owes us the same amount of cucumber or tomato.

-Yield Farming

Yield Farming is a very simple method to generate a yield from your crypto assets. You can lock your idle crypto assets in a yield farming pool and let the platform or smart contract lend it for profit. The platform lends funds to borrowers in return for interest and small transaction fees. The platforms share some of their revenue with crypto asset holders who provided funds to be lent.

Yield farming is a trustless mechanism. Funds are lent against certain collaterals. Once the collateral is secured, the funds are released, but of course, collateralized assets will be used to cover losses in case of a failure in payments. The important detail with yield farming is that you should be aware of in which cryptocurrency you will be rewarded. Most DEXs tend to pay users in their own native tokens instead of the original underlying asset.

Impermanent Loss

Impermanent loss is a key risk when investing in liquidity pools because of the AMM model. When you lend assets to a pool, you earn income from trading fees and commissions. But the price of the assets may decrease in time while the assets were locked in a liquidity pool. You can still increase the number of the underlying assets but the dollar value of the assets can be lower than the time when you deposited them.
 
Liquidity pools are created with token pairs, so you need two underlying tokens to be coupled in a pool. One of the tokens is mostly a stablecoin and stablecoins bear less risk of price changes. In crypto markets, there is always a risk of defaulting price so you must be careful with the token you choose. There are good examples of defaulted coins, such as Luna, FTT and some other rug-pull tokens. If you choose a reputable coin with a strong project behind it, you can avoid defaulting risks, but you may still face a decrease of value which is called impermanent loss.

How to use a DEX?

How to connect your web wallet?

There are numerous DEXs with different designs and functionalities. Most DEXs operate on a web app while some others also have a mobile app for both IOS and Android. You can easily launch the app from the official website of any DEX. Once you opened the web-app page, you can connect to the exchange with your web wallet, mobile wallet, or by sending funds to an in-app wallet.

The most convenient way to connect to a DEX is to have a web-wallet on the browser you use on your computer. There is a «connect wallet» button on the DEX web-app page, when you click on the button, you will be directed to choose what type of web wallet you want to connect with. There are many web wallets you can download, install and use for free. MetaMask, Phantom, Guarda, Coinbase, MyEtherWallet, BitKeep, and Coin98, are the leading web-wallet extentions you can use on a Chrome browser.

Types of DEXs?

DEXs use different methods to ensure that both parties receive the best price they can get in a trade. The most common two methods of price matching are Automated Market Maker (AMM) and Order Book. Besides two types of DEXs, there are also DEX aggregators that function as a medium between DEXs to provide the best price for a user at the moment of transaction.

Order Book

The order book is the traditional way how exchanges work. You can see the seller's ask on the left and the buyer's bids on the right side of the book. Asks and bids are matched most efficiently but, of course, order book exchanges require deeper liquidity. There must be enough players on the market on both sides to create a supply and demand. Since the crypto markets are not mature enough, DEXs have a liquidity problem. That is why most DEXs don't prefer order book models.  

Automated Market Maker (AMM)

First DEXs were built with a traditional order book matching system as an exchange. But primitive DEX examples were facing a problem with liquidity. AMM model solved the problem. In an AMM model, there are liquidity pools that are created with contributions from other users. Users who provide liquidity, also benefit from the fees and commissions from trades. Thanks to the AMM model, It is much easier to find liquidity for cheaper and faster transactions.   

DEX Aggregators

DEX aggregators are connected to other DEXs and use their swap services for end-users. What a DEX Aggregator does is find the best price by scanning various DEXs. There is always a difference between the prices of the same asset on a different platform. The price difference can sometimes be used for arbitrage by traders.

Advantage of DEXs

The very first advantage of a DEX is anonymity. You can use a DEX with no Know your customer (KYC) or anti-money laundering (AML) rules. You don’t need to verify your ID. Everyone is equal in a DEX
 
Another reason for DEXs to be appealing is that users have full control over the funds. No one will have your coin’s custody but you. Your coins will stay in your wallet and won’t be used by a third party. DEXs provide better security in terms of asset mismanagement. Because you will be solely managing your own coins.

Risks of DEXs

DEXs are less riskier than CEXs in terms of mismanagement and defaulting. CEXs are managed by individuals and they can make mistakes or they can be very ambitious. But DEXs are built as a piece of code and rules never change. A DEX will always operate the same way without breaking any rules. But the biggest risk about DEXs is hacking and exploits. Since DEXs are relatively new and don’t have a long proven history, they might be subject to a hack issue. Users must be aware of that and choose a DEX with solid fundamentals and proven history.
 
DEXs are non-custodial so users have control of their funds. But if you lock your coins in a liquidity pool, liquidity pools can sometimes be attacked and drained by hackers. Make sure you read the news about the pool you are investing in.

Default Risk and Rug Pulls

Extreme volatility in price is also another risk factor. If you choose a coin with a small market cap and lock them in a liquidity pool, you may face severe losses. The price of the asset can default because of several reasons. There have been some bad experiences in the market before. The very first reason for defaulting is rug pull. When the creators of a coin stop operating and supporting, or simply abandon their project, it will cause the coin or token price to go zero. This is called rug pull. 

Another major risk is hacking. The DEXs use unproven algorithms and they are still in the development phase. Since the DEXes are automated codes operating permissionless and trustless, hackers can find a way to steal funds from the contracts or exploit the algorithms.

 

PROs CONs
No KYC or AML regulations Requires basic knowledge of crypto
Non-custodial Unproven history and codes
Permissionless and trustless  

 

 

 

 

 

 

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