Decentralization is a core tenet that guides all blockchain-based dApps. For decades, users trying to access instruments offered in traditional finance have found obstacles. A solution is now being advanced by fine-tuned DeFi options that promote financial inclusion, attractively presenting near-infinite investment opportunities for users, regardless of geographical locations.
Earlier on, retail investors had to comply with what would sometimes be "steel wall" regulations meant to bar ordinary folks from participating and maintain the status quo. The good news is that this is no longer the case. With smart contracts and innovative DeFi protocols, users can earn relatively high yields while retaining control of their assets without caps on investment amounts.
DeFi has, beyond doubt, proven to be immensely beneficial and increasingly becoming a preferred alternative for traditional financial systems. Benefits offered include high levels of freedom, complete transparency of operations, low participation thresholds, low costs, and more.
In DeFi, a big part comprises decentralized exchanges (DEXs). These are platforms for users to trustlessly swap tokens without a third party. A DEX can be deployed on any public smart contracting platform like Cardano or Ethereum and is freely accessible to anyone, globally, using non-custodial wallets like Eternl or MetaMask.
However, before diving in, it should be noted that not all DEXs are created equal. Besides, each protocol is curated, based on many other factors, including how the underlying blockchain is designed. Other factors include liquidity levels, scaling levels of the blockchain, fees, security, and more.
5 Factors to Look Out For Before DEX Trading
Here is a list of five things to look out for before DEX Trading
- Blockchain
DEXs are not run by private companies that require KYC details. Instead, they are deployed on public blockchains where all operations are automated and executed in an immutable environment that requires caution before pressing the swap button. Specifically, the immutability of the public blockchain means that any mistake during swapping can lead to a permanent loss of funds. Accordingly, before trading, a user should ensure that all digits are correct, the swap symbols are as expected, and funds are sent to the valid address before proceeding. Also, before trading, one needs to estimate on-chain trading fees. In networks like Ethereum, a failed transaction will still be charged a fee, which can be high depending on network activity. In networks like Cardano, however, fees are only charged once the transaction has gone through.
- Liquidity
In finance, liquidity refers to how easy it is to swap an asset. As an emerging sector, DEX liquidity is relatively lower than centralized platforms. This is primarily because DEXs are community-driven, where liquidity is directly proportional to the number of users and tokens. Ordinarily, the more popular a DEX is, the deeper its liquidity is. With DEX trading, a portal's liquidity is measured using the total value locked (TVL), whose readings are updated in real-time. There are several trackers which a trader can use before starting. As a rule of thumb, always opt for a DEX with a higher TVL. This guarantees lower slippage and more assets. Slippage in trading is a factor of liquidity. It measures the difference between the ordered token amount and what the trader receives. A trader should also know that liquidity can be affected by the model used by the exchange. Innovative methods of boosting exchanges like concentrated liquidity can drastically enhance the ease of token swapping. Uniswap v3 is already using the Concentrated Liquidity model. Upon launching, the Genius DEX will use the concentrated liquidity uniquely in a decentralized exchange using an order book model leveraging Cardano's unique design.
- Processing Speeds
Processing speed is how fast an exchange can execute orders every second. Centralized exchanges can deploy specialized engines that can simultaneously process hundreds of transactions. This gives them an edge over DEXs, which have relatively low processing speeds. Generally, the processing speed of a DEX is directly dependent on the underlying network. A DEX on Ethereum will process lower transactions every second than one on Solana, for instance. The good news is that progress has been made to fast-track processing speeds using secure off-chain scaling solutions in networks like Ethereum, which can only process 15 transactions every second at optimum conditions. DEXs launching on Ethereum's layer-2 solutions like Arbitrum or Loopring have higher processing speeds and, thus, lower fees.
- Transaction Fees
DEXs are smart contracts reliant. These smart contracts are executed on the mainnet, where fees, mostly on platforms like Ethereum or Solana, vary depending on complexity. The more complicated the smart contract guiding a DEX swapping operation is, the higher the fees. Traders are sensitive to trading fees considering that it fluctuates depending on demand. In account-based networks, fees can rapidly change as demand for block space increases. Therefore, when DEX trading, one should track fees, aware that swaps can be costly when the network is congested, or when the DEX uses complicated smart contracts for swaps. The same is not true for all blockchains however. On Cardano, trading fees are fixed and only charged once a swapping operation is completed, though this could get more complex in the future when platforms start bridging with other blockchains.
- Security
Anyone can launch a DEX. There are no regulations for deployment, explaining why new traders can easily lose funds. Therefore, security is paramount. Before connecting, a trader should ensure that a reputable blockchain security firm satisfactorily audits the DEX. These services scrutinize the DEX's core smart contracts ensuring that the team cannot, for example, unlock trader funds and run away with funds in a rug pull. They also pick out security vulnerabilities that can lead to hacks. As part of security, an ideal DEX should also integrate a decentralized oracle provider such as Chainlink to protect users against attack vectors enabled by flash loans. When connected, it is good practice for traders to carefully check what they are signing (with their wallet) when transacting. Taking some time to get familiarized with the wallet and how transactions are presented is well worth the effort.
Closing Thoughts
DeFi is a game-changer, and DEXs play a critical role in boosting the sphere's liquidity. However, the open-source nature of blockchains and protocols in this realm can introduce vulnerabilities that can lead to loss of funds or impact user experience. A trader should, therefore, consider the above factors before connecting their wallets and diving into DEX trading.