Decentralized Exchanges offer another way of trading cryptocurrencies, in fact, it provides a real peer-to-peer and trustless model that can be used.
There is a whole new world of online banking that didn’t exist before because of the fact that there are now crypto currencies, and anyone in the world can use this method for transactions. Nonetheless, centralized platforms like those used by most well-established traders that allow them to buy/sell their owned virtual properties also pose a lot of potential danger as well as difficulties somehow similar to regular banks.
Decentralized exchanges
Decentralized exchanges work on decentralized networks and use smart contracts for peer-to-peer exchange of digital assets
Decentralized exchanges allow you to retain control of your private keys and holdings, always contrasting them with centralized exchanges that act as intermediaries safeguarding customers’ holdings. This means transactions are completed between wallets owned by users driven by algorithms thereby eliminating the necessity for third parties.
A major consequence of DEXs’ non-custodial nature is that funds are never deposited in exchanges wallets that would reduce chances of being hacked or stolen or even mismanaged by an intermediary (Centralized) person most likely. This pattern is similar to the basic tenets underpinning blockchain technology hence, this includes: distributing monetary resources evenly among people as well as making them visible while also empowering users themselves.
How do decentralized exchanges work?
Decentralized exchanges work on top of already existing blockchain networks like Ethereum, Binance Smart Chain or Polygon using distributed ledger technology. They are based on these underlying networks that allow for executing smart contracts. Smart contracts are self-executing contracts that make trading of digital assets possible.
Simply Connect your cryptocurrency wallet to the exchange’s interface . Once a user wishes to perform trades on a DEX, then he simply connects his/her cryptocurrency wallet. A trade is then made and executed directly while the assets are moved to another user’s wallet without any centralized exchange taking custodial care of them. Handling the overall trade process consists of order matching, settlement and custody of funds by the DEX smart contracts.
DEXs run on the blockchain platform. Consequently all trades are recorded in a clear and changeless book of account that anyone can access. This high level of lucidity makes it possible for customers to ascertain the credibility of a given system without having trust in one central organization.
DEX Types
Many decentralized exchanges function in several ways and may possess different levels of decentralization, scalability and functionality.
- Order book DEXs,
- automatic market makers DEX
- aggregators
Order Book DEX
An order of the book is a list of both buy and sell requests that sell at the market. The function of the order book is used by exchanges in matching order and executing transactions.
Books that need to be ordered require a large number of transaction processing speeds. Because of this, with the introduction of advanced level-1 blockchain protocols that include ZK-Rollups and the launch of faster-blockchains, decentralized exchanges that operate entirely on-chain have become increasingly feasible.
dYdX, 0x, Loopring DEX, and Serum are some of the decentralized exchanges (DEXs) that are known for their order books which are popular.
Automated Market Makers (AMM)
Automated Market Makers (AMMs) are the most common form of decentralized exchanges because they facilitate instantaneous trading without any intermediary interference. AMMs do not have an order book but instead make it possible for users to swap tokens via a pool of liquidity where prices derive from a predetermined smart contract. On the basis of the tokens proportion in a pool, the algorithm can always offer a price in between token pairs.
Unlike DEXs that require buyers and sellers to wait for their orders before matching, AMMs offer liquidity for tokens and pairs with less trade volume. These traders are encouraged to add their tokens on pools through making passive income from trading fees.
Automated market makers have facilitated quicker growth and development of fresh coins as well as facilitating the creation of marketplaces that concentrate on particular cases, say asset swamping such as stable coin . The AMM design can be employed on non-cryptocurrency tokens just like it can on n-fungible tokens (NFTs), stocks exchanged in form of tokens among other things .
Popular AMM DEXs include PancakeSwap, SushiSwap, Trader Joe, and Uniswap .
Aggregators
During the DeFi boom, DEX aggregators came out because traders were challenged while looking for the best prices or the lowest gas fee across multiple exchanges.
To give users better swap rates than a single exchange, aggregators could compare multiple exchanges at once so they could pay (or split) slippage and swap fees in between.
Therefore, they ensure timely completion of cross-exchange transactions, applying measures that help in shielding users from price impact and cutting down on the probability of order failures.
Advantages of decentralized exchanges
Non-custodial nature: Distributed Exchanges (DEXs) allow customers to maintain control of their private keys and assets round the clock to minimize chances of hacking, theft, or mismanagement by an entity that is centralized, as mentioned earlier.
Transparency and immutability: On a DEX, all transactions are logged to an open and time-resistant block chain, thereby enabling users to authenticate the credibility of the system
Censorship resistance: With operating decentralized networks, DEXs can not be closed down allowing users to trade without being stopped by central governments.
Global Accessibility: There is full access to anybody via internet connection and who has the cryptocurrency wallet for DEXs; therefore, they have become worldwide websites for exchanging digital currencies.
Innovation and composability: DEX tools are grounded on open-source protocols which permits incessant innovation and incorporation into other forms of decentralized fintech applications.
Challenges and limitations of decentralized exchanges
While DEXs offer numerous advantages over centralized exchanges, they also face some challenges and limitations:
Liquidity and Order Book Depth: Centralized exchanges tend to have considerable order thicknesses and increased liquidity—this makes it convenient for making significant trades void of noticeable slippage. The situation is different with DEXs as they may sometimes experience lack of liquidity and order book depth especially in less known trading pairs.
User experience and complexity: Serving as a major impediment towards adoption by less technical users is its high complexity hence being more complicated than centralized exchanges because here you should take charge managing your wallet unlike others where there is a third party involved whom you trust for such process.
Speed and scalability: Decentralized Exchanges leverage the support of the blockchain network to facilitate transactions. The speed does not suffice to say that they perform very well or fast so much as it does that the network itself sometimes goes slow as we can see when looking at platforms like DEXs; moreover there are sometimes capacity issues and other problems occurring within these networks which may hinder speed (in terms of execution).
Regulatory Uncertainty: The regulatory environment of decentralized exchanges has not yet fully evolved. There is some unrest about legal and compliance requirements for DEXs since governments and regulators are dealing with complications of Blockchain technology.
Although there are some difficulties, changes are happening very fast in the decentralized exchange landscape and new solutions to those challenges are being innovated and protocols developed.
DEXs are gradually becoming more important for dealing with digital currencies and assets since the acceptance of blockchain technology cryptocurrencies is expanding.
Conclusion
The world of cryptocurrency trading is undergoing a profound change with decentralized exchanges. Thanks to blockchain technology and smart contracts, DEXs provide an entirely peer-to-peer and trustless manner of swapping digital assets. In other words, DEXs in line with core principles of decentralization and customer sovereignty which cryptocurrencies are built upon were introduced for non-custodial transactions, transparency, and resisting censorship.
Given certain restrictions and hitches that must be disposed of, the scene of decentralized exchanging is changing fast with emerging creative solutions and protocols that take care of questions surrounding liquidity, user-friendly interface, speed and increase in size.
For the foreseeable future , DEXs will be increasingly more important tools for the global trade of digital assets that are secure, transparent, and resistant to censorship – something that could be enhanced by the evolving adoption rates of cryptocurrencies.
About the Guest Author:
Ragunath.T is a digital marketer at BlockchainX, specializing in innovative strategies to drive engagement and growth in the blockchain industry.
