What Is Decentralized Exchange and How Does It Work?

02 Aug 2021 updated
15 min read

With the introduction and commonplace adoption of cryptocurrency, users have started enjoying much more hassle-free transactions without verification or lengthy KYC procedures. All you need to do to get or sell some crypto is go through a simple sign-up process without the trouble of proving your identity, the source of your funds, etc. DEX has simplified even this by removing the sign-up process from the crypto trading sector. Now you can trade your assets directly from your wallets, complete transactions in a couple of clicks, and enjoy total anonymity and safety. 

Users worldwide are becoming increasingly digital in their operations, ranging from holding money in Neobanks to opting for safe, instant crypto trading solutions. DEX platforms thus revolutionize the trading space because exchanges have traditionally been pivotal to the crypto sector, allowing users to complete transactions, trade their belongings, sell and buy them instantly, and win some gains on the rate changes. However, even in such a decentralized and deregulated sphere as crypto, large, centralized players have dominated the field, determining price rates and moving markets with large-volume orders. 

With DEX, the situation is gradually changing, giving more users access to instant trading and crypto acquisition. With their help, direct transactions between the seller and the buyer become possible, eliminating the need for third-party involvement. Thus, blockchain-based DEX platforms are the future of the crypto industry, giving users complete control over their assets. In this article, the 4IRE team covers the essentials of DEX functioning, overviews the current landscape of the DEX market, and considers the pros and cons of DEX compared to other forms of crypto exchanges. Based on this data, you can make an informed decision about trading your crypto assets at DEX or creating your own DeFi development project to gain a fair share of the booming crypto market’s revenues. 

What Is a Decentralized Exchange? CEX, DEX, and NEX 

A more traditional exchange platform, centralized exchange (CEX), requires user identification and urges crypto holders to place their assets on the in-house accounts to sell or exchange them. Thus, even with the privacy and decentralization features of crypto maintained, the users cannot enjoy complete anonymity and flexibility in operations with their coins. All CEXs are owned by particular companies or people who still charge some commission for the transactions. Thus, users get the benefits of large trade volumes and user-friendliness but need to forgo privacy to some extent and store their funds on the external website’s system, which increases the risk of hacking and theft. 

Decentralized exchanges (DEX) have emerged as a solution to the undesirable centralization of crypto trading and the users’ desire to hold their crypto assets on their own wallets and preserve full control of their crypto property instead of passing them to an external exchange. However, DEXs also come with cons, such as lower transaction speed and a less user-friendly interface, which is a natural outcome of their “self-service” model. Besides, DEXs do not offer the trade volume you can observe at CEXs because of the lower large-scale player presence.

 

Given that CEXs pose issues in terms of funds security, while DEXs cannot guarantee the speed of operations, a new symbiotic solution has emerged in the form of NEX. Such exchanges employ heightened security measures, such as robust cryptographic protocols, making it impossible to steal funds from the users’ accounts. They guarantee reasonable liquidity and transaction transparency that cannot be forged or manipulated because of encryption. Users can also conduct operations with fiat money here. Another attractive feature of NEXs is the speed of transactions achieved due to the absence of blockchain nodes on the exchange’s server-side. There is no need for lengthy transaction validation. The transaction cost is minimal, so users enjoy a blockchain-like infrastructure but don’t need to pay any commissions to the NEX owners. 

The core features of DEX you might enjoy including: 

  • An ability to sell, buy, and exchange your crypto assets and coins via direct exchanges with other participants 
  • Secure verification of payment methods 
  • Smooth KYC integration 
  • Ability to set your security preferences 
  • Crypto address generation for individual transactions 
  • The use of ETH wrapper 
  • Ability to manage your balance and transactions in a customized, user-friendly way 

In a nutshell, DEXs solve the problem of centralization in the crypto world essentially built on the principles of decentralization. Exchanges controlled by some owner or manager lack that decentralization, though still giving some benefits to users in exchange for the partial loss of the freedom and privacy associated with cryptocurrencies. 

How Does a DEX Work? 

Now let’s take a closer look at how a typical DEX functions to see what the difference from CEX is and what this structure of crypto exchange may have for you. 

 

The overall principle of DEX’s work is similar to that of CEXs in allowing buying, selling, and exchanging crypto assets by the users. However, they operate without intermediaries validating and clearing transactions (which is the CEX itself in the case of centralized exchange use). The basis for exchanges between users at DEXs is the self-executing smart contracts allowed by the non-custodial DEX framework. The latter presupposes that only users control their assets and private keys, so they are the only persons responsible for the wallet and money management. 

The way a specific DEX functions depends on the degree of its decentralization and the underlying blockchain technology, which we consider further. 

Degrees of DEX Decentralization 

The adjective “decentralized” in the DEX name should not misguide users as most DEXs are not entirely decentralized. The majority of currently available platforms differ in functionality, underlying technology, and the degree of decentralization users may enjoy. Here are the common DEX types you can use.

DEX with Order Book

This DEX type represents the first generation of DEXs using order books similar to those used at CEXs. The principle of order book use is recording users’ orders for purchases and sales of crypto assets for each specific asset. With automated analysis of spread between user orders, the DEX thus determines the asset’s current market price and the order book’s depth. 

Currently, there are two approaches to order book management at DEXs: 

  • On-chain order books presuppose holding all operations conducted at a specific DEX on the underlying blockchain. Examples of such platforms include Stellar and Bitshares. All transactions taking place on the platform are written down in the blockchain’s ledger, guaranteeing the transparency of operations. At the same time, the on-chain approach is costly since it suggests that every node should perform your transaction’s registration. As a result, the use of DEX with the intent of saving commission money loses its sense. Besides, there is always a risk of front-running, which means that nodes accessing data about pending operations act as insiders and can conduct transactions in their favor based on that insider data. 
  • Off-chain order book-based DEXs perform transactions on the blockchain but store data about the transactions elsewhere. The location of that data is usually at the DEX owner’s discretion. Good examples of such DEXs are Binance and the ETH-based 0x protocol, eligible for the use in transactions with ERC-20 and a variety of tokens. The advantage of off-chain order books is their relative speed and greater privacy. Still, the transfer of transaction records to an external source is always connected with security risks.  

Swaps (Automated Market Makers) 

Swaps are a departure from the CEX and order-book DEX principles of work as they take out the need for classifying users as makers or takers. They have become the next generation of DEXs by achieving peer-to-peer trade execution instantly. Some examples include:

  • Uniswap – a platform allowing instant swapping of ETH-based assets among users and providing democratic lending and borrowing terms
  • DODO – a liquidity protocol employing a Proactive Market Maker (PMM) algorithm to ensure liquidity to its users
  • Kyber – a universal protocol supporting smart contracts built on any blockchain, allowing instant peer-to-peer swaps due to its massive liquidity pool

Thus, the major benefit of AMM DEXs is their reliance on liquidity pools instead of order books. This feature combines reasonable security and usability, which the DEX users appreciate. 

DEX Aggregators 

The need for DEX aggregators emerged with the disjointed, heterogeneous nature of distinct DEXs. A variety of platforms uses different blockchain systems, protocols, and mechanisms of transactions. Thus, to combine the fragmented DEX landscape into a more homogeneous fabric and simplify user operations across platforms, DEX aggregators emerged to smoothen the technical barriers and deepen liquidity pools. Some illustrative examples include the 1inch Exchange and DeversiFi, which both aggregate liquidity across multiple DEXs and allow users to eliminate slippage. 

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Pros and Cons of DEX 

DEXs are a new stage in the technology development of crypto exchanges as they have some valuable advantages compared to CEXs previously dominating the market. Here are some of them:

DEX Pros

User Control of the Funds 

When using a DEX, you don’t need to freeze your assets on the exchange’s account. You can conduct numerous transactions on multiple exchanges while still retaining 100% control of all assets at any point in time. CEXs have been blamed for delaying or blocking user funds on their accounts too often, so this benefit of DEXs is highly valuable for experienced crypto holders conducting frequent trades and wishing more flexibility. 

Privacy and Anonymity 

The majority of DEXs don’t require filling out a KYC form, which keeps your personal data fully private. This level of anonymity is achieved due to the absence of a central regulator who would act as an authority responsible for transactions’ validity and honesty. Thus, with users keeping full control over funds and smart contracts, the need for KYC/AML compliance is absent. 

Zero Hacking Risks 

Everyone remembers the disastrous hack of Bitfinex that cost its users over $72 million, while this year, a massive hack of Coinchecker left users without $530 million. Thus, holding one’s crypto belongings on an exchange’s account may be a severe risk. As the DEX users keep crypto assets on their private wallets, not on the exchange, the risk of their wallets being hacked is limited only to their personal level of cybersecurity and literacy. 

Server Downtime Avoidance 

As funds and transaction data are held on the exchange’s server, users may need to wait for some time to have their inquiries processes. This is not the case with DEX as the latter doesn’t record transactions into its blockchain in most cases; users exchange assets on a peer-to-peer basis. 

DEX Cons 

No technology is ideal, and together with the advantages of using DEX platforms instead of CEX, users still need to keep some drawbacks in mind. 

Liquidity Issues 

Since most DEXs are only starting out and many of them specialize in one or several assets, there is a low level of liquidity users can enjoy. To date, the volume of all crypto assets traded on DEXs doesn’t exceed 1% of the total global volume, thus suggesting that DEXs still need some time and effort to take a fair share of the crypto exchange market. 

Complicated UI 

CEXs are user-friendly, intuitive platforms where the designers went the extra mile to attract users paying generous fees for the platform’s use. DEXs, due to their promise of zero or minimal fees, take little regard for usability, thus presenting a challenge for laypersons without in-depth technical knowledge. To operate on a DEX successfully, you need to install some browser extensions (like Metamask), learn more about smart contracts for their independent execution, and spend some time shopping around to understand each DEX’s interface. 

Slow Execution Speed 

CEXs ensure that trades take place in real-time (if you establish a reasonable market price). DEXs function a bit slower as peers execute the operations in the network, but the latter take place only after the DEX miners confirm the transaction. Combined with low liquidity, such delays often cause unfavorable price slippages for the transaction parties and invite front-runners to conduct operations with the pending transaction’s data in mind. 

Top DEX Platforms

The top popular DEX platforms users currently prefer include: 

1. Binance DEX

The subsidiary of the world’s largest crypto exchange, Binance DEX allows users to involve in decentralized trading and guarantees lower commissions coupled with better security of assets. 

2. IDEX 

IDEX promises the speed and set of features equal to those of CEXs, while at the same time providing the high edge of DEX security and community ownership of their assets. It also enables IDEX staking and gives users the possibility to utilize a variety of advanced order types. 

3. EscoDEX

This Estonian-based DEX supports numerous cryptocurrencies and tries to deliver intuitive, user-friendly services like those of a CEX. 

4. Switcheo 

Switcheo is not a DEX in the full sense of this word, but rather a blockchain ecosystem allowing the construction of DEXs and other DeFi solutions. It features a Switcheo TradeHub, Demex, ZilSwap, and Switcheo Development Fund as its primary products. 

5. Bisq 

Bisq specializes in BTC exchange only, being an open-source desktop app for BTC sale, purchase, and exchange for other cryptocurrencies or fiat currency. 

Considering DEX Development?

The rise of DeFi and crypto-asset popularity has led to the ever-increasing interest in DEXs as a sound alternative to CEXs. Thus, if you want to embrace the new, rapidly evolving industry and establish your own DEX project there, you can consider creating a custom DEX to attract crypto users with unique benefits and features. DEX maintenance costs are much lower than those of CEX, and you can also take advantage of the hype around this emerging sector within the crypto exchange industry.

  • First, you need to involve the team with in-depth blockchain and DeFi expertise to create a viable, well-functioning product. 
  • Second, you need to determine an approach to embedding DEX smart contracts and strategize about other decentralized protocol integration. 
  • Third, brainstorm the main features to be included in your DEX’s infrastructure. 
  • Fourth, don’t neglect the security mechanisms to ensure that users of your DEX are reasonably protected. 

You can contact the 4IRE Labs team and make the most of our blockchain development services to build and refine your DEX project. We’re happy to help you bring the new idea to reality, giving you free consulting services and comprehensive technical advice. 

FAQ 

Is full decentralization possible on DEXs? 

Yes, it is, though many DEXs officially claiming to be decentralized in fact are not. If the exchange uses its servers to store trading data and orders of users for asset purchases and sales, it cannot be characterized as fully decentralized. Only platforms that don’t store such data and provide only a platform for matching users’ inquiries can comply with the definition of DEX. 

How do DEXs handle the dispute resolution process? 

Since DEXs do not have any central controller, all responsibility for transactions’ validity lies on the users. Thus, there is currently no uniform dispute resolution process on this type of exchange, with the violations or frauds hardly detected and rarely punished. 

Is using DEX safe for users? 

Users flock to DEXs as they want more anonymity and security for their funds, coupled with low commissions. However, we recommend using a DEX only for those who have a reasonable level of digital literacy and know how to validate transactions to avoid fraud or theft. 

What do I need to launch my own DEX? 

You need to engage a development team with profound experience in blockchain, communicating your DEX vision, key features, and technical constituents. After that, the team will work on the front-end and back-end architecture to create a well-functioning, appealing DEX project for you. 

What blockchains are DEX-compatible? 

Choosing a blockchain for your DEX project is a subjective affair as all blockchains supporting the smart contract feature can potentially serve as a basis for DEX development. Uniswap, Yield, and WrappedLayer are the blockchains that can fulfill all the needed functions. Ethereum has for a long time been a default DEX choice, but its high cost of transaction processing urges developers and clients to look for other solutions. The most suitable ones to date are Tron and BSC, but the final choice of the blockchain depends on your project’s anticipated features and needs. 

How does DEX resolve load and security issues? 

With the load problem being the key bottleneck of CEXs and security issues troubling the users of DEXs, the most optimal solution is the use of NEXs for crypto operations. These platforms employ more rigorous security protocols and robust cryptography, which makes fraud impossible. Besides, they guarantee transactions’ transparency and fund liquidity. At the same time, the server-side of NEXs does not hold nodes, so there is no need to waste time on validating operations. As a result, using NEXs is both secure and fast. 

Slava Malchenko CMO at 4IRE

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