Every day billions of dollars worth of cryptocurrencies change hands on different platforms. Increasingly, a big chunk of these assets is swapped in decentralized exchanges in leading blockchains like Ethereum, the BNB Chain, and Cardano.
With increasing crypto adoption and users' preference to take complete control of valuable assets and privacy, more are using decentralized exchanges for convenient, instant, and permissionless trading.
What Is A Decentralized Cryptocurrency Exchange?
A decentralized exchange, also known as DEX, is a protocol launched on a blockchain network like Cardano or Ethereum to facilitate swapping tokens without intermediaries.
DEX can enable users to swap tokens because platforms like Ethereum or Cardano are equipped with smart contract capability. Smart contracts are unique scripts that self-execute transparently once certain conditions have been met.
Popular DEXs include Uniswap on Ethereum and Polygon, PancakeSwap on the BNB Chain, and many more.
In Cardano, common ones include SundaeSwap, Minswap or Muesliswap. Genius Yield plans to launch the Genius DEX to take advantage of Cardano's unique smart contracting design to allow swapping, autonomous execution of various trading strategies, and more.
What is a Centralized Cryptocurrency Exchange?
However, to understand how far crypto trading has evolved, we must first look at how a centralized exchange like Coinbase or Binance operates. A clear understanding of this will give you a better comprehension of how a DEX functions.
A centralized exchange has a third party that monitors all trading operations. Since most are compliant with regulators' rules, a user must first register by submitting identifying details such as email address, phone number or identity documentation such as a passport or driver's license as proof of address. Depending on their location, they can access a wide range of approved digital assets.
The centralization of their operations gives owners more latitude. For instance, users can trade assets for fiat currencies and vice versa. This provision is lacking in most DEX. Also, centralized exchanges are relatively more liquid than even the most liquid DEX. It is because they can rope in market makers who supply liquidity, making trading easier and cheaper.
Nonetheless, for all the positives, the centralization of operations strips the trader of asset control. If an exchange gets hacked or goes under and there is no protection, a user will permanently lose their assets. Clients of QuadrigaCX, a Canadian crypto exchange, lost hundreds of millions of dollars when its CEO died mysteriously in India.
Furthermore, all centralized exchanges use the order book model. In contrast, only a few DEXs use or deploy this method. Genius DEX will use the order-book model while most, including Uniswap, operating in Ethereum and other account-based blockchains, use the automated market maker (AMM). While this model is advantageous and drastically pumps a DEX’s liquidity, there are limitations such as exposure to impermanent loss or the ability to only swap at the current spot rate for the pool (rather than placing an order for a certain price).
How DEXs Work
Now that you know what a CEX is, how does a DEX enable a user to swap tokens? What guides the process, and why has it become successful over the years, allowing some protocols to manage the billions of assets? Having a clear grasp of this will go a long way in understanding all details of DEX trading.
As mentioned earlier, a functional DEX depends on smart contracts. DEXs use fine-tuned and often thoroughly audited smart contracts to successfully connect a user to tradable assets through an easy-to-use interface. Since anyone with a non-custodial wallet like MetaMask or Nami can connect to swap, operations must be secure and automated.
The reason DEXs use non-custodial wallets and smart contracts is to put trading into the hands of people. This way, they don't need to register by submitting personal details, compromising privacy. Instead, by using non-custodial wallets, users retain complete control of their assets, and privacy is always preserved.
Traders are in charge of their security because the private keys generated by their non-custodial wallets are in their possession. Private keys are a combination of specific words/phrases given to the wallet holder during initialization. Users should always keep these private keys safe and never share them with unauthorized persons or entities.
In cases where you misplace your device and can't access your wallet, private keys will allow the user to restore the content of their wallets. That anyone can restore and access the wallet by having all the correct private keys explains why it is vital for the wallet user to keep them safe.
Why DEX Trading is Popular
Since 2017 when the first rudimentary DEXs were launched, the sector has grown by leaps and bounds. By late Q4 2021, the total DeFi market cap, of which a big chunk comprised DEXs, had over $250 billion in total assets under management.
DEXs are rising into prominence because they are:
- Community facing and open source: Most popular DEXs are open-source and actively enhanced by the community. Their adherence to the blockchain's rallying call of decentralization is best espoused by the absence of listing fees in creating any pool and facilitating trading.
- Transparency: Since all operations are executed on-chain on a public ledger, it is easy to track transactions. For these reasons, it is nearly impossible for a crypto team to cheat or steal without triggering sirens.
- Liquidity Boost: The success of DEXs has significantly boosted the sphere's liquidity. Unlike before, when teams had to pay millions of dollars to list in a centralized cryptocurrency exchange, any project can crowdfund and list directly on their preferred DEX. They don't have to pay steep listing fees and immediately get access to liquidity.
- User Control: All DEX operations are decentralized, and the user retains control of their assets, even protecting their privacy. There is better privacy preservation in DEX trading because of the default cryptography in public chains. Meanwhile, since swaps are peer-to-peer, the trade retains control of their private keys.
Crypto is growing, but with tireless innovation by the building community and the launch of modern blockchains tuned to meet ever-rising traders' expectations, DEXs are expected to steal significant crypto trading market share in the years ahead.