What are decentralized exchanges, and how do DEXs work — Broscorp (2024)

The fall of the large centralized crypto exchange FTX has sparked a wave of distrust towards these platforms and a surge in trading activity on decentralised exchanges or DEXs for short. Crypto enthusiasts are increasingly opting for decentralized access to the digital asset markets. This Broscorp article outlines what DEXs are, how they operate, and which pros & cons they add to the cryptocurrency ecosystem.

How DEXs Marked the Spot: A Brief History of Decentralized Exchange Rising

Since the birth of cryptocurrency in 2009, trading has been exclusively conducted via centralized exchanges (CEXs). The first DEX only appeared in 2014, but few people used their services at that time.

The popularity of these platforms grew in 2017-2018 when the ICO fever led to the emergence of thousands of new coins. Most of these tokens were traded on DEX, as listing on CEXs required complex selection processes.

The demand for DEXs significantly increased in 2022, when the bankruptcy of the large centralized FTX sparked a wave of distrust towards CEX and caused capital outflows from them. At the same time, DEX markets recorded a surge in trading activity, increased liquidity pool providers, and the growing popularity of farming.

The beginning of 2024 marked a turning point for DeFi, indicating not only a recovery in demand but also a shift towards a more rational and efficient market. Institutions are increasing their interest in virtual assets, especially with the adoption of EFT BTC.

DeFi investors seek safe investments: According to crypto analytics, 75% of locked funds are currently in pools with 0-5% APY, indicating a priority for predictability and security. The increase in TVL from $26.5 billion to $59.7 billion from 2023 to 2024 indicates a restoration of trust in DeFi.

Key Takeaways

• Among approx. 300 DEXs in the world, Uniswap is now the largest decentralized crypto exchange by trading volume and TVL.
• The lack of central authorities in DEXs adds to their anonymity. Traditional programs necessitate users to entrust them with their assets, which some think may lead to hacking or abuse.
• DEXs engage blockchain and smart contracts to enable P2P exchanges without an intermediary. The decentralized nature keeps at zero the danger of funds being held or controlled by a central body, improving user privacy.
• Most DEXs are launched on Ethereum but eventually have extended to multiple chains including Avalanche, Arbitrum, Optimism, and Polygon which can be observed with the help of on-chain analysis.

What is a DEX?

Let’s begin with answering the question “What is a DEX in blockchain?”. A crypto decentralized exchange (DEX) is an app for trading cryptocoins where coin exchange occurs via smart contracts without using a centralized trading system. Users mostly access DEX either through a web browser or via smartphone apps.

DEX does not store users’ funds or administers transactions. Funds are moved directly from the user’s wallet, which they connect to the platform. Also, there is no user verification procedure (KYC), meaning agreements can be executed entirely privately.

Decentralized exchanges have turned into a core element of the DeFi industry. As of the beginning of 2023, according to data from CoinMarketCap, there are nearly 300 decentralized crypto exchanges working on dozens of networks.

Here are some of the most famous ones:

• OKX
• Uniswap
• PancakeSwap
• SushiSwap
• Dydx
• Curve Finance
• Kine Protocol
• ApolloX

Decentralized Exchanges vs. Centralized Exchanges

The Block, a cryptocurrency analytics platform, gives an interesting analysis of trading volume on both CEXs and DEXs though crypto data collecting. On the below-listed DEX analytics chart, we can see that the volume on decentralized markets is only a part of that on CEXs.

So, what is a DEX specialness? There is no 100% winner between these two types of platforms. Neither is better than the other and some traders may prefer a DEX to a CEX and vice versa. Let’s consider the key differences between these platforms.

How does DEX Work?

In contrast to centralized exchanges such as Coinbase, DEXs operate solely for cryptocurrency token trading, excluding fiat-crypto exchanges. On CEXs, transactions occur between fiat-to-crypto or crypto-crypto pairs that have additional features like margin trading or limit orders. They are managed internally by the platform through an order book system akin to stock exchanges like Nasdaq.

DEXs, however, work through smart contracts, autonomously establishing crypto prices and employing liquidity pools for trading facilitation. DEXs typically rely on open-source code provided by blockchain software, which enables transparency and allows developers to adapt and create competing projects. This adaptability has led to the proliferation of DEXs based on existing code. For example, projects like Sushiswap and Pancakeswap, which leverage Uniswap’s codebase.

The mechanics of how exchange works relies on four pillars: order books, AMM, swaps and aggregators. Below is the explanation.

Order Book

An order book is a fundamental component of exchanges, presenting a real-time collection of open buy and sell orders within a market. This structure enables an exchange’s internal systems to pair buy and sell orders.

Historically, fully on-chain order book DEXs have been less prevalent in DeFi due to the necessity of posting every interaction on the blockchain. This demands higher throughput capabilities than many current blockchains offer or significant compromises in network security and decentralization. Consequently, early Ethereum-based order book DEXs struggled with low liquidity and suboptimal user experiences. Nonetheless, they provided a compelling demonstration of how DEXs could facilitate trading via smart contracts.

Scalability advancements (i.e. Layer-2 networks such as optimistic rollups and ZK-rollups) as well as the launch of higher-throughput and app-specific blockchains, have made on-chain order book platforms more practical, attracting a significant amount of trading activity. Furthermore, hybrid order book designs have grown in popularity, with order book management and matching taking place offchain and transaction settlement – onchain.

Popular order book DEX platforms include dYdX, Loopring DEX, and Serum.

Automated Market Makers

DEXs gained momentum with the emergence of AMM technology. Instead of a traditional order book, they utilize liquidity pools for crypto pairs, and prices are calculated using a mathematical formula based on the asset ratios in the pool. This permitted the development of a decentralized structure and made transactions possible right on the blockchain through smart contracts, which matched the execution speed of centralized exchanges.

While most current AMM designs operate with tokens, they could also be used to simplify swaps of NFTs, tokenized real-world assets, carbon credits, and much more.

Some popular AMM DEXs: Curve, PancakeSwap, Sushiswap, Trader Joe, and Uniswap.

Swaps

The latest generation of decentralized exchanges has moved away from using order books to facilitate trades or establish prices. Instead, these platforms typically rely on liquidity pool protocols to define asset pricing. Operating on a P2P basis, these exchanges execute trades directly between users’ wallets instantly, a process often referred to as a swap. These DEXs are often ranked by their total value locked (TVL), representing the value of assets held in the protocol’s smart contracts. Let’s take a look at some examples:

Uniswap: Users of Uniswap can seamlessly swap any two Ethereum-based assets using its liquidity pools. These accessible pools ensure Uniswap remains permissionless and trustless. They democratize lending and borrowing on the platform.

Curve: Similar to Uniswap, Curve is a DEX utilizing liquidity pools, specifically catering to stablecoin trading. It has stablecoin trading feature, permitting users to trade between them with low slippage and fees — all thanks to the algorithm that optimizes DEX trading pairs.

SushiSwap: SushiSwap, inspired by Uniswap, initially offered liquidity providers the SUSHI token (later also offered by Uniswap with its UNI token). While Uniswap charges a 0.3% trading fee, SushiSwap distributes this fee differently, allocating 0.05% in the form of SUSHI tokens.

DODO: DODO operates as a liquidity protocol like others in this category but employs its Proactive Market Maker (PMM) algorithm to ensure adequate liquidity.

Aggregators

Decentralized exchanges employ various protocols and mechanisms. Despite it enhances security and autonomy, this dynamic often leads to fragmented liquidity across platforms. This fragmentation can discourage institutional investors or high-net-worth individual traders seeking to buy significant volumes of specific crypto assets. In response, DEX aggregators have built tools to bolster asset liquidity pools across both centralized and decentralized crypto exchanges.

• 1inch Exchange: 1inch forms liquidity from multiple DEXs to minimize slippage, which occurs when insufficient liquidity on one platform causes a buyer to pay more for an asset than anticipated. By mitigating slippage, 1inch offers traders access to capital at the best possible prices.
• DeversiFi: This protocol consolidates liquidity from both centralized and decentralized exchanges to enhance overall liquidity. Using StarkWare’s batching technology, DeversiFi can settle over 9,000 trades per second via UI or API. This is how the DEX can guarantee efficient and high-volume trading.

How to Use Decentralized Exchange

Using a DEX doesn’t require registration procedures; you don’t even need an email address. Traders only need a wallet compatible with the exchange’s smart contracts, meaning that literally anyone with a smartphone and internet can access DEXs’ services.

To use DEXs, first, you need to choose the network, as every trade incurs a transaction fee. Then, comes selection of a wallet and funding it with its native token, used for transaction fees.

Wallet extensions facilitate interaction with DApps like DEXs, installed in browsers and offering options to import existing wallets or create new ones. Some wallets have mobile apps for DEX DeFi protocols on the go, with built-in browsers for smart contracts.

So, after choosing a wallet, fund it with tokens acquired on centralized exchanges, identifiable by ticker symbols like ETH for Ethereum. Withdraw them to your wallet. To avoid errors, check whether you are withdrawing funds to the correct network. Once your wallet is funded, connect it to DEXs through a pop-up prompt.

Advantages of Using a DEX

Below are the premise strengths of decentralized exchanges that can benefit you.

Asset Security Level

Security is a tremendous drawcard for a DEX. It is non-custodial. As a result, when doing an asset transfer with DEX, users are not required to provide their private key.
Instead, smart contracts enable users to set up personal external wallets that communicate with the DEX and trade automatically.

Lower Cost

A decentralised cryptocurrency exchange uses smart contracts to facilitate trading without intermediaries, resulting in a low charging cost. In this situation, DEX employs a gas fee structure similar to that used on the Ethereum network. DEXs impose minor fees, usually around 3%, for platforms like Swap. A DEX’s fees are far cheaper than those of a CEX, although they vary subject to the network’s circ*mstances.

Privacy

As the crypto wallet is stored externally, decentralized exchanges no longer need traders to disclose their private keys and are not responsible for the assets. When using DEX, users are not required to complete KYC or AML procedures. Legally, this may be advantageous in terms of convenience, but it could be troublesome in some instances.

Disadvantages of Using a DEX

Although decentralized exchanges have huge advantages, they also feature a raw of limitations that users should be aware of. Here are some of the drawbacks of using a DEX:

Liquidity Level

The plethora of trading pairs on decentralized platforms usually leads to market fragmentation, impacting liquidity. However, since the DeFi sector rose, liquidity for assets on DEXs has greatly improved.

On and Off-Ramps

Nowadays, it’s not possible to directly trade crypto with fiat on decentralized exchanges or withdraw funds to bank accounts. The stablecoin concept is an alternative to fiat currencies in DeFi. But the lack of a fiat currency on and off-ramp is still a barrier to entry for new market players.

Development Stage

DApps are still in their early stages of development. Beginners, especially those unfamiliar with blockchain technology, should be aware of these limitations. Interacting with a DEX requires users to work with external wallet apps, fund their wallets through fiat currency or crypto asset transfers, and link their wallets to the exchange interface for trading on DEX. Contrasted to CEXs, this process is not that easy as it seems.

How will the Future of Exchanges Look Like?

To make the long story short, the future of trading is decentralized. And here is why.

• Self-Custody of Assets. “Not your keys, not your coins” is a popular expression in crypto, and a vital one. Unlike CEXs, where the exchange controls your funds, DEXs allow investors to keep direct control over their funds. This self-custody model significantly lowers the risk of asset theft stemming from exchange breaches, which have plagued many centralized exchanges.
• Early Access to New Assets. DEXs also democratize access to new and potentially lucrative digital assets. New cryptocurrencies and tokens are always available on a DEX as soon as they launch. For investors, this provides a critical advantage — early access to potentially high-yield assets before they reach mainstream platforms. This feature attracts a more forward-thinking investor base and creates a market environment where innovation is rapidly rewarded.
• Last but not least, investors can enjoy all the benefits of decentralization: interoperability, privacy and financial inclusion.

Conclusion

Decentralized exchanges are an interesting technology that is growing along with decentralized finance. They have seen increased use in recent years as a result of the immediate liquidity they can provide for newly issued tokens, their frictionless onboarding experience, and the democratized access to trading and liquidity provision they offer. It remains to be seen whether the majority of trading activity will shift to DEXs, and whether present DEX designs will enable long-term growth and institutional acceptance. However, DEXs are projected to remain critical infrastructure for the cryptocurrency ecosystem, with ongoing advances in transaction scalability, smart contract security, governance architecture, and user experience.

If you are thinking of developing on-chain analytics solutions or bringing a customized DeFi application to life, contact our Broscorp team.

Our development team will provide you with comprehensive blockchain analytics for decentralized exchanges like Uniswap, liquidity pool analysis, and insights into your crypto portfolio. With our solutions, it is easy to track your earnings, identify areas for reallocation, and minimize commissions.