DEXs, or decentralized exchanges, represent one of the biggest categories of DeFi applications in crypto. A DEX is a peer-to-peer marketplace that allows users to trade crypto assets using blockchain technology with no intermediary.
In traditional finance, the ability to easily trade your cash for assets of value electronically has existed for over 30 years with stock exchanges. You can utilize exchanges like Robinhood or Binance to buy or sell stocks or cryptocurrencies. However, these exchanges are considered CEXs, or centralized exchanges, because transactions go through an intermediary or have a centralized authority who can control or restrict the use of the exchange. CEXs like Binance are part of CeFi, which are typically regulated by governmental entities and are required to follow KYC (Know Your Customer) / AML (Anti-Money Laundering) regulations, which require you to give personal identifying information such as your driver’s license ID or passport number in order to use their exchange.
While KYC/AML regulations may be effective in reducing the use of CeFi and traditional finance platforms for illicit activity, regulation and public policy has been used to exclude many people from financial opportunity. Blanket economic sanctions and nationality bans from governments have restricted hundreds of millions of people from participating in the global financial system through CeFi and traditional finance even though they haven’t committed a crime.
DEXs, in contrast, are permissionless and don’t have KYC/AML regulations. Anyone with a crypto wallet and internet connection can utilize a DEX.
How a DEX works with Blockchain
First, a DEX utilizes a decentralized public blockchain, which allows validated transactions which are immutable. Next, DEX uses smart contracts, instead of an intermediary like a clearinghouse, to execute trades. Smart contracts self-executing digital agreements, written in code using a programming language like Plutus, that verifies, tracks, and executes the agreement between the parties. Each smart contract stage is executed automatically by the code when a predetermined condition is met. The transaction is added to the blockchain after a node validates the transaction and the transaction is confirmed by a certain number of validators. After the confirmation(s), the transaction becomes immutable and irreversible. A DEX could be used to do transactions with digital assets such as limit orders, stop orders, or derivatives. Many of these orders, or Smart Swaps, can be utilized on the Genius DEX.
Benefits of using a DEX
- Pseudonymity — No KYC or personal information required to use DEXs.
- Security of blockchain — Due to security of public blockchains like Cardano, an extra layer of security is added for transactions.
- Expansion of global financial system — Citizens in the developing world, previously unable to obtain financial services, now have access to peer-to-peer lending at lower interest rates, various cryptocurrencies, and staking rewards.
Potential downsides of DEXs
- Smart contract risk — While the blockchain may be secure, the smart contract code is only as good as the developer who wrote the code. If a smart contract has bugs and attack vectors, users’ funds can be stolen. DeFi hacks are costing users’ billions of dollars each year. Users must do research on the quality of the code, the developers behind the code, and any audits. For this reason, participants should make sure any dApp they are about to use has been audited by a reputable firm and that the project has released their audit report.
- Rug pulls and meme coins — Unfortunately, being a permissionless pseudonymous DEX has its downsides. Anyone can create assets and list them on a DEX. There is no vetting process required that would eliminate fraudulent companies. A rug pull is when a person or group of people make a fraudulent company and token. After marketing the fake company’s business plan and token, they add their token to a permissionless DEX and provide liquidity to allow trades. After the price of token has gone up, the scammer trades out all their tokens and withdraws their liquidity. People who bought tokens lose a substantial amount of money after the rug pull. A meme coin is a coin that has no apparent business plan or strategy, but originated from an internet meme, celebrity, or humorous characteristic. Meme coins are risky because most have no real utility.
- Regulation — DEXs and other DeFi coins offer direct services already offered by banks, stock exchanges, and lending companies in traditional finance. However, traditional finance companies are heavily regulated while the DeFi applications like DEXs are not. In addition, some tokens have characteristics that resemble a security, which requires registration with the proper governmental agency. Allowing tokens that are securities or that mimics actual securities to trade on non-registered exchanges is illegal in some countries. Regulators are also concerned about DEXs not offering consumer protection, hacks stealing billions in user funds, and the ability of criminal or sanctioned entities to use DEXs.
- Market Manipulation — Due to the anonymity of trades and numerous exchanges, DEXs are subject to market manipulation by illicit actors.
- Financial Stability Risk — As DEXs grow, they will inevitably become correlated and linked with the broader CeFi and traditional finance systems. A hack or a run on a stablecoin could have risks for financial stability due to its inherent links with traditional finance.
- DEX fees — DEXs depend on liquidity providers (LPs) who provide their capital in exchange for trading fees. These fees must be high enough to get LPs to provide liquidity. In addition to the LP fee, trade fees may include a DEX fee that goes back to the DEX and will include a network transaction fee that is charged by the blockchain network to do the on-chain transaction. The DEX fees can be anywhere from 0.03% to 1% for many platforms. The network fee can vary depending on blockchain. Exuberant fees can reduce potential returns for LPs and traders and fees that are too high can eventually reduce liquidity.
Smart contract risk, scams, and uncertain regulations are all factors that will affect DEXs going forward. However, the benefits of financial disintermediation and hundreds of millions of people joining the global financial system seemingly outweighs the risks for DEXs going forward.