What Is a Dex and How Do They Work?

DEX fulfils a core crypto possibility – fostering financial transactions. These are transactions that do not get officiated by banks or any intermediaries. Most of the DEXs like Uniswap and Sushiswap running on Ethereum blockchain are a part of the growing range of decentralised finance (DeFi) tools that offer a vast range of services directly from a crypto wallet. And the benefits they offer are the reason behind their exponential growth. In the first quarter of 2021, DEXs started booming, with $217 billion transactions flowing in. There are more than two billion DeFi traders today, with a ten-fold increase from May 2020. But, what exactly is a DEX? Let’s find out.

What is a DEX?

DEX or decentralised exchange is a peer to peer marketplace. Here transactions occur directly between crypto traders.

How do DEXs work?

Unlike centralised exchanges (CEX), exchanges between fiat and crypto are not allowed in a DEX. You can trade fiat for crypto or crypto-pairs via CEX, for example, bitcoin for ETH. Often advance moves like margin trades or setting limit orders can also be done. For example, an exchange uses an ‘order book’ to handle all of these transactions and establish the price for specific crypto based on current buy and sell orders. On the contrary, DEXs are a simple set of smart contracts, establishing the price of various crypto against each algorithmically. They use liquidity pools, where investors lock funds to get rewards.
All transactions made via DEX are settled directly on the Blockchain, while transactions on a centralised exchange get recorded on its internal database. DEXs usually get based on open-source code. That means anyone interested in it can see exactly how it works. It also means that new completing projects can get created by developers easily. All they have to do is adapt to the existing goals. It is also how Uniswap’s code has gotten adopted by an entire host of DEXs. Most of them have ‘swaps’ in their names like sushiswap and pancake-swap.

What are the potential benefits of using a DEX?

DeFi is the correct place to be if you are interested in finding a hot token in its infancy. A virtually limitless range is offered here, from the well-known to the weird and random. That is because anyone can mint an Ethereum based token and create a liquidity pool. So, ultimately there is a greater chance for you to find various projects that are both vetted and unvetted.

Hacking risks can get reduced -

DEX is less susceptible to hacking as all the funds in a DEX trade get stored in the traders’ wallets. (DEX also reduce counter-party risk, which is the likelihood that one of the involved parties will default).
Moreover, to use DEXs, you do not need to provide any personal information.
Characteristics like peer to peer lending, speedy transaction and anonymity have made DEXs increasingly popular in developing economies. Most of these are countries where solid banking infrastructure is not available. And the best part is that anyone can make a DEX trade. All you need is a smartphone and an internet connection.

The potential downsides of DEX -

Some factors require specialised knowledge, such as a difficult to use user interface. And navigating through decentralised exchanges is not always easy. All the more because even minor errors can have huge impacts. For example, it is possible to make an unfixable error like sending coins to the wrong wallet. So, being cautious is crucial. ‘Impermanent loss’ is another common issue. It happens if you pair a more volatile cryptocurrency with a less volatile one in a liquidity pool.

Smart contract vulnerability -

A defy protocol is only as secure as a smart contract that powers it. A code can have exploited bugs that can result in the loss of your tokens. While a smart-contract can work under normal circumstances, errors can always happen. Along with the unvetted and vast array of tokens, some risky coins are also available on most DEXs. And there are also a large number of scams and schemes that you should be wary of and keep in mind. A coin or a token on a hot streak can suddenly get rug-pulled when its creator mints several new tokens. It leads to overwhelming the liquidity pool and tanks the coin’s value. Therefore, it is vital to learn as much as possible before buying a new cryptocurrency or experimenting with a new protocol. And you can research in various ways. That includes reading white papers, visiting developer Twitter feeds or discord channels and looking for audits of any particular project you are interested in or want to understand. Certik, Consensys, chain security, and Trail of bits are a few of the popular auditors.

How do you interact with the DEX?

How do DEX fees work?

Fees are varied. For example, Uniswap charges a fee of 0.3% and that gets split between liquidity providers. You should also know that the DEX charges can get substantially reduced by Gas fees. The ongoing ETH2 upgrade is taking place essentially to lower these fees and speed up transactions (as well as many layer2 solutions like polygon and optimism).

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