Decentralised exchanges (DEXs) are leveraging the unique features of blockchain to address the counterparty risk and ensure a seamless trading experience. While the trading process per se might look similar to the experience on centralised exchanges (CEXs), the two are completely different when it comes to anything else behind-the-scenes.
Here are 10 things you should know about DEXs that make them differ from CEXs:
While CEXs act like banks, DEXs build on the promise of decentralisation by leveraging blockchain smart contracts. They employ a unique infrastructure with distinctive aspects:
As the name suggests, a DEX isn’t run by a single entity, such as a company. While it’s true that there must be a team putting the DEX together and improving it, all the transactions are handled by smart contracts, which are self-executing programs on a blockchain. At one point, the development team can choose to transfer the decision-making power to the community. In this case, the DEX would be run by a Decentralised Autonomous Organisation (DAO).
No order book
The greatest innovation of DEXs is that they completely remove centralised order books, which match buyers with sellers. DEXs act as automated marker makers (AMMs), letting buyers and sellers swap tokens thanks to so-called liquidity pools.
Without order books, the liquidity on DEXs is provided by liquidity pools, which are pools of funds locked in a smart contract. A standard liquidity pool involves two tokens with an equal weight that make a trading pair. Thus, buyers and sellers trade against liquidity pools rather than their counterparts.
DEXs employ a unique business model and approach in which everyone involved is interested in expanding the ecosystem:
While DEXs enable users to exchange tokens, we would call these transactions token swaps instead of trades. This is because the assets are swapped straight away, with the smart contract extracting the tokens from a user’s wallet and providing the equivalent value in another token from the liquidity pool.
Both DEXs and CEXs charge trading fees. However, if CEXs are the main beneficiaries of the commissions, in the case of DEXs, the fees are distributed to liquidity providers (LPs), who are incentivised for contributing with funds in liquidity pools.
DEXs are secure because they rely on blockchain and cut all intermediaries. Here is why they’re more secure than CEXs:
The token swap occurs directly between the wallet and the liquidity pool, and the DEX doesn’t hold users’ funds at any moment. That means users have full control over their funds. When trading on CEXs, users are forced to entrust their private keys to third parties.
No KYC/AML requirements
Since DEXs don’t hold user funds, they don’t impose KYC/AML verification procedures. Users can access DEXs without creating an account and sharing personal data.
Trading and Earning Possibilities
DEXs not only provide a seamless trading experience but also offer investment opportunities. The two main types of players on DEXs are traders and LPs. Thus, anyone can benefit from:
Fast and low-cost token swaps
While some DEXs may automatically import the issue of their underlying blockchains, such as Ethereum, they are generally faster and cheaper than CEXs. For example, QuickSwap is powered by Polygon, which is Ethereum-friendly while being faster and offering lower gas fees.
DEXs enable everyone to become a market maker and earn passive income by locking funds in liquidity pools. LPs are incentivised from the fees paid by traders plus additional rewards for staking their tokens. For example, on QuickSwap, LPs earn from the 0.25% fee on all trades, which is distributed proportionally to their share of the pool. Fees are added to the pool, accrue in real-time, and can be claimed at any time by withdrawing liquidity. Thus, the annual percentage yield (APY) figure, including both rewards and fees, can reach 100% and sometimes exceed 500% for specific pools.
The health of a DEX is dictated by the liquidity in its pools, with deeper pools reducing the risk of price slippage. Thus, traders are encouraged to consider well-established DEXs, such as QuickSwap. Nevertheless, most DEXs, irrespective of their size, cannot avoid the impermanent loss.
While LPs can secure generous returns, they should also be aware of the so-called impermanent loss risk. It happens when the price of their tokens changes compared to when they deposited in the pool. Even though the weight of tokens in the pool must be equal, the impermanent loss risk is unavoidable due to arbitrage traders who are leveraging the price volatility. Nonetheless, in most cases, the fees cover any potential loss caused by volatility.
DEXs win more market share thanks to their efficiency, security, and privacy. These trustless solutions have no border limits and help digital assets materialise the promise of true decentralisation.
About the Author: Sameep Singhania is a professional programmer with 10 years of experience. He’s a co-founder and lead developer at QuickSwap.