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What is Decentralized Exchange (DEX) and How Does DEX Work?

What Is Decentralized Exchange (DEX)

Introduction

This piece looks at everything concerning Decentralized Exchange (DEX). With this guide, you will know how Decentralized Exchanges work and even how DEX differs from Centralized Exchange (CEX).

As far as blockchain and cryptocurrency are concerned, it is better first to understand how Centralized exchange works. By doing so, you will be well equipped to understand what DEX is.

So, a CEX is one that involves a middle man or a third party. They validate its transactions on the CEX, while a DEX doesn’t need anyone to do this.

Keep in mind that both DEXs and CEXs are not the same in any way.

Recently, decentralized exchanges are becoming a more common and widely used technology than Centralized exchanges. The widespread use of Decentralized exchanges (DEX) could result from the rise of altcoins creation and how the overall DEX basis solely depends on decentralization.

Also, DEXs features and its decentralized nature appear to push its popularity and mainstream adoption.

Important notice, do not take this Decentralized Exchange article as financial or investment advice. Instead, this article exists to let you know all the ins and outs of Decentralized Exchange and Centralized Exchange to boost your knowledge in crypto. Also, we are keen to provide you with the ideal knowledge you would need for your betterment when dealing with Decentralized Exchanges.

After reading this article, we advise that traders should further do their own due research before investing their hard-earned money in Decentralized exchanges (DEX) trading-related activities.  

As is obvious, crypto enthusiasts’ everyday interaction with crypto and exchanges has had a massive positive influence on the topic of crypto exchange. So, without further delay, join me to explain in detail what a Decentralized Exchange is.

What is Decentralized Exchange (DEX)

Never overthink about how and what DEX is. Instead, understand Decentralized Exchanges with a simpler explanation via this hands-on tutorial.

Decentralized exchanges are self-controlled crypto trading DApps, hence the name. However, DEX is completely based on blockchain. This means that all DEX services are free from control by anyone or any central authority. In terms of their operation, DEX does not take orders to work. This is unlike how third parties manage and control CEX.

With Decentralized exchanges, users can trade many varieties of cryptos with no custodian or intermediary interference or control over your funds. Along with that, DEX comes in different forms when compared to CEX, where crypto holders give their assets to exchanges to control.

The main concept behind Decentralized exchanges is to do away with any third-party involvement in trading activities in crypto exchanges. Instead, with the help of smart contracts, Decentralized Exchanges use an automated order book system. In particular, this is what makes Decentralized exchanges “truly peer-to-peer (P2P)” naturally.

Apart from how DEX mainly focuses on decentralization and can give users more control, it does have a few downsides. Such as, in DEX trading, traders are responsible for their own security, which may not be the best thing.  

Moving on, DEX uses smart contracts technology, commonly known as automatically executed protocols. By using smart contracts, Decentralized exchanges handle the protocol in three different ways. These are on-chain order books, an off-chain order book, and an automated market maker (AMM).

Join me to further dissect the categories as mentioned above of DEXs.

How Does Decentralized Exchange Work?

On-Chain Order Books

The On-chain order book is one key category of DEXs. Every P2P transaction is written, recorded, and directed onto the on-chain order space within the Decentralized Exchange platform.

Not only this, but the On-chain order book method also gives approval when a user requests to buy or cancel an order. It also demands digital assets miners to confirm every transaction via the network solely.

To mention a few, Bitshares and StellarTerm are the major exchanges that use on-chain order books in their operation.

Off-Chain Order Book

Unlike the on-chain order book, every blockchain-based transaction is recorded mainly in an off-chain order book. However, a centralized protocol then hosts the recorded transactions. In this way, the off-chain order book uses “relayers” to aid in supervision.

However, since the off-chain order book transactions are mainly hosted on centralized entities, there is a probability that it will have some of the Centralized Exchanges security issues as well. Still, off-chain order book transactions are not all that expensive like the on-chain order book.

Moreover, Binance DEX, 0x, and EtherDelta are a few examples of DEXs that use off-chain order books.

Automated Market Makers (AMM)

Next on the list above of DEX types is Automated Market Makers (AMM). The AMMs DEX technology do not use any order books like the discussed on-chain and off-chain protocols.

See this scenario, for instance. By using the proposed Automated Market Makers (AMM), users can swiftly change for example their Chainlink holdings to Compound. To do this, any Chainlink user who aims to purchase Compound needs to have someone who also owns Compound tokens.

To successfully make a transaction, the Chainlink token holder has to be willing and readily available to trade based on a well-agreed price. With AMMs, there are no counterparties involved in any transaction that will take place.

In doing this, AMMs start an algorithm that mainly sets up the asset prices. Here, setting up the price of the assets enables traders to trade. For instance, Chainlink for Compound directly. Thus, with the help of the AMMs, you can trade without caring if there is someone interfering in the trade.

To aid in this, AMMs implement and use liquidity pools to pay customers. However, they do this in order for users to keep part of their funds in the exchange’s smart contract. The users’ funds in the smart contracts are used purposely for trading.

Uniswap, SushiSwap, and Kyber Network are few other DEX platforms that use Automated Market Makers (AMM) technology. This shows that AMM is massively driving Decentralized finance (DeFi) projects interests.

Decentralized Exchanges Pros and Cons

Pros

DEXs have great importance. In fact, the DEXs’ use cases and its importance parameters completely outweigh what it cannot offer. On a larger scale, DEXs are evolving into the mainstream because they focus on privacy-consciousness.

Aside from the DEXs enhanced privacy, it also has stronger security. The security features aid it to provide better user control for digital asset owners. Let’s take a look at the DEX features one by one.

Security

As mentioned already, Decentralized exchanges are very secure. This means that when it comes to DEX, vulnerability is low. As it is, it becomes challenging for hackers to alter transactions in DEX.

Based on how often the crypto market usually reports hacks in CEX, it hardly happens in Decentralized Exchanges. CEX keep users’ funds and maintain their liquidy mainly on the platform. This makes them more open to hackers resulting in many theft cases. 

DEX is an easier-going and less-susceptible tech than CEX. With DEX, traders trade without even sharing or using their private keys or recovery seeds in the trading. This way, users have control in securing their accounts when on DEX.

Privacy

Ensuring and maintaining privacy is the major focus of all DEX. In terms of operation, centralized exchanges usually ask customers to complete a sign-up step. For this, every user needs to comply with the network’s Know-Your-Customer (KYC) requirements.

When using CEXs, completing the KYC level becomes a must-do thing for users as they have to share their credentials and data openly to the exchange. However, unlike CEX, the majority of the decentralized exchanges do not use the KYC method.

This is because no central authority regulates DEXs. Therefore, to date, there is no need to even use KYC protocols when selecting DEXs.

Sovereignty

Sovereignty is also of great importance when it comes to DEX. It plays a major role. By exercising Sovereignty, DEXs users gain full custody control over their funds. With this control, users get the option to use their funds in any direction as they want.

Cons

DEX does not only have a good side. Some downsides or misfortunes are also part of the DEX experience. Sometimes, users may be concerned about how exchanges freeze users’ assets holdings. Not this alone, but DEX also face issues with how exchanges sometimes block withdrawals.

Users must take note and also keep in mind that not all DEXs are the same. In terms of how they work, DEXs vary from quasi-decentralized to fully decentralized. In fact, it is advisable to compare and examine all the cons in DEX before deciding which one to use.

With this said, some of the major drawbacks of DEXs are transaction speed, Liquidity issues, among others.

Conclusion

Ensuring and maintaining privacy, security, and sovereignty in crypto trading-related activities is what Decentralized exchanges are keen to offer. These pros help improve fairness and sanitation via how users buy and sell cryptos. Also, DEX minimizes how hackers manipulate exchanges.

In conclusion, DEX protocols increase returns while providing convenience and easy-to-follow privacy by implementing this strategy to reduce downturns. With this in mind, DEX creation and its popularity are constantly spreading every day.

FAQ

What is Decentralized Exchange?

As we have already explained above, Decentralized exchange (DEX) is a cryptocurrency platform that enables direct P2P crypto transactions to take place. All decentralized exchange activities specifically occur securely online between two users’ crypto wallets. More importantly, unlike Centralized exchange, DEX executes all digital assets transactions between two parties’ wallets without any third-party interference.

How does decentralized exchange work?

The short answer to “how does Decentralized exchange change work”? is that DEX mainly depends on automated smart contract protocols for the success of its overall trading. As some DEX differ in operation, note that not every DEX uses automated smart contracts for trading. Others use conventional order book models while many also employ emergent liquidity protocols to execute trading.

What Are the Types of decentralized exchange?

Decentralized exchanges come in several different forms but they all have one goal — thus, securely executing crypto transactions online without any intermediary. Basically, there are three main forms of DEXs. They are On-chain order books and settlements, Off-chain order books with an on-chain settlement, and Smart contract-managed reserves.

Disclaimer: The views and opinions expressed in this article are solely the author’s and do not necessarily reflect the views of CoinQuora. No information in this article should be interpreted as investment advice. CoinQuora encourages all users to do their own research before investing in cryptocurrencies.

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Collins Adane is a writer who follows the crypto industry closely. He loves fish stew and Real Madrid. He believes in cryptocurrency’s potential to transform the money landscape in his native country Ghana.