What exactly is a decentralized exchanges (DEX)?

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Study how decentralized exchanges operate and how to use them for your wallet.

Explanation

A decentralised exchange (or DEX) is a peer-to-peer marketplace where crypto traders conduct trades directly with one another. DEXs perform one of crypto’s primary functions: they facilitate financial transfers that are not mediated by banks, traders, or any other intermediary. The Ethereum blockchain is used by several common DEXs, including Uniswap and Sushiwap.

A decentralised exchange (or DEX) is a peer-to-peer marketplace where crypto traders conduct trades directly with one another. DEXs perform one of crypto’s primary functions: they facilitate financial transfers that are not mediated by banks, traders, payment processors, or some other kind of intermediary. The most common DEXs, such as Uniswap and Sushiswap, use the Ethereum blockchain and are part of the growing suite of decentralised finance (DeFi) tools, which allow access to a wide range of financial services directly from a compatible crypto wallet. DEXs are thriving, with $217 billion in trades passing through them in the first quarter of 2021. There were more than two million DeFi traders in April 2021, a tenfold rise from May 2020.

 

How do DEXs work?

 

What are potential benefits of using a DEX?

Vast variety:If you want to find a hot token in its early stages, DeFi is the place to be. DEXs have a nearly infinite variety of tokens, ranging from the well-known to the strange and completely unexpected. Since anybody can build an Ethereum-based token and a liquidity pool for it, there would be a wider range of ventures, both vetted and unvetted. (Warning: buyer beware!)

Hacking risks can be reduced: Since all funds in a DEX exchange are deposited on the traders’ own accounts, they are less vulnerable to a hack. (Relatedly, DEXs minimise what is known as “counterparty risk,” which is the probability that one of the concerned parties, including the central authority in a non-DeFi contract, would default.)

Anonymity: No personal information is required to use most popular DEXs.

Utility in the developing world: DEXs’ peer-to-peer lending, quick transfers, and anonymity have made them successful in emerging economies where strong banking infrastructure might not be present. A DEX is accessible to anyone with a smartphone and an internet connection.

What are some potential downsides?

Trickier user interfaces Navigating decentralised exchanges takes certain specialised expertise, and the interfaces aren’t always simple — be prepared to do a lot of homework, and don’t expect the DEX to have much assistance. In most cases, you’ll have to look elsewhere for a walkthrough or explanation. Caution is expected because it is easy to make irreversible mistakes, such as sending coins to the wrong wallet. Another common problem is “permanent loss,” which may occur when a more volatile cryptocurrency is combined with a less volatile one in a liquidity pool. (What is the key point here? Conduct your own research.)

 Smart contract vulnerability Any DeFi protocol is just as stable as the smart contracts that run it — and code may have exploitable vulnerabilities that result in the failure of the tokens (despite extensive testing). And, although a smart contract can perform as expected under standard conditions, developers cannot predict all rare events, human factors, and hacks.

Riskier coins Because of the unvetted, large variety of tokens accessible on most DEXs, there is often a larger amount of scams and schemes to be aware of. A hot token could be “rug pulled” as the founder mints a large number of new tokens, flooding the liquidity pool and tanking the coin’s value. Before purchasing a new cryptocurrency or experimenting with a new protocol, it is critical to understand as often as possible — read white papers, visit developer Twitter streams or Discord networks, and search for audits on any specific project you are involved in (some bigger auditors include Certik, Consensys, Chain Security, and Trail of Bits).

How do you interact with a DEX?

  • You can connect to a DEX like Uniswap using a crypto wallet such as Metamask (for your web browser) or Coinbase Wallet (for mobile).
  • While you can interact with DEXs directly from the browser built into Coinbase Wallet, an easier way is to pull up the website up on your computer’s web browser (in the case of Uniswap, the address is app.uniswap.org) and click “Connect to a Wallet.”
  • A QR code should pop up, which you can scan with your phone’s camera (tap the upper-right corner of the Coinbase Wallet app to access the camera). Once scanned, your wallet will be connected to the DEX.
  • You’ll also need a supply of Ethereum to start trading on most DEXs, which you can get from an exchange like Coinbase. The reason you need some ETH is for paying fees (known as gas) that are required for any transaction that happens on the Ethereum blockchain. These are separate from the fees the DEX itself charges.

How do DEX fees work?

Fees differ. Uniswap charges a 0.3 percent premium, which is divided among liquidity suppliers, and a protocol fee can be included in the future. However, it is important to remember that the fees levied by the DEX can be dwarfed by the gas fees levied by the Ethereum network. The current ETH2 update (as well as a host of “layer 2” technologies such as Optimism and Polygon) was intended to reduce fees and speed up transactions.

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