Decentralized Exchanges (DEX) and How do They Work?


DEXs, or decentralized exchanges, are peer-to-peer markets where cryptocurrency traders can conduct transactions without entrusting their funds to an intermediate or custodian. Such transactions are made possible via smart contracts, which are nothing but self-executing agreements written and designed in code.

What are Decentralized Exchanges?

Digital currency exchange is termed a Decentralized Exchange (DEX). Owing to a secure internet network that eliminates intermediaries, it allows for direct peer-to-peer bitcoin transactions. It differs from traditional centralized exchanges in which a third party takes custody of people’s funds and regulates the privacy and transfer of assets between the two parties.

DEX allows the blockchain, also known as a distributed ledger, to act as a third party. The foundational cryptocurrency technology eliminates single points of failure by transferring crucial activities to the blockchain, allowing users to retain ownership of their assets and enabling safe and thus more transparent trading.

With the help of smart contract development, DEX can perform market transactions by delegating transactions to autonomous code, however order fulfillment methods with differing degrees of decentralization are available.

Decentralized Exchanges (DEX) vs. Centralized Exchanged (CEX)

Smart contracts are used by decentralized exchanges to enable traders to execute orders without the need for a mediator. Centralized exchanges, on the other hand, are run by a centralized entity, such as a bank, which is otherwise engaged in financial services and aiming to earn a profit. As they are regulated firms that custody of users’ funds and provide easy-to-use platforms for newbies, centralized exchanges account for the vast bulk of transaction volume in the cryptocurrency market. Some centralized exchanges also offer deposit asset insurance.

A centralized exchange’s services are approximate to those provided by a bank. The bank safeguards its clients’ finances and offers security and monitoring services that people cannot do on their own, making it simpler to transfer money.

Decentralized exchanges, on the other hand, allow traders to exchange directly from their wallets by engaging with the trading platform’s smart contracts. Traders are accountable for their funds and are liable if they lose them due to errors like losing their private keys or transmitting payments to the wrong locations.

Popular decentralized exchanges have been formed on top of popular smart contract-supporting blockchains. They’re built on top of layer-one protocols, which means they’re immediately on top of the blockchain. The Ethereum blockchain is used to power the most prominent DEXs.

How does DEX work and its Types!

Every trade imposes a transaction cost in addition to the trading fee because decentralized exchanges are built on top of blockchain infrastructure that supports smart contracts and also where users keep custody of their assets. To use DEXs, traders get to engage with smart contracts on the blockchain.

Automated market makers, Order books DEXs, and DEX aggregators are the three types of decentralized exchanges. All of them use smart contracts to allow users to trade seamlessly with one another. The initial decentralized exchanges utilized order books that were comparable to those used by centralized exchanges.

Automated Market Makers (AMMs)

To address the liquidity issue, an AMM system based on smart contracts was developed. These exchanges were partly inspired by Ethereum co-founder Vitalik Buterin’s article on decentralized exchanges, which described how to perform trades on the blockchain via token-holding contracts.

These AMMs use blockchain oracles, which are blockchain-based services that produce data from exchanges and certain other platforms to set the rate of traded assets. In place of matching buy & sell orders, these decentralized exchanges’ smart contracts can use liquidity pools, which are pre-funded pools of assets.

Other users fund the pools, and they are then liable for the transaction fees charged by the protocol for executing transactions on that pair.

To earn income on their cryptocurrency holdings, these liquidity providers must deposit an approximate value of every asset in the trading pair, a technique known as liquidity mining. If they try to deposit any more of one asset than the other, the transaction is invalidated by the smart contract that runs the pool.

Order Book DEXs

Order books DEXs keep track of all open purchase and sell orders for certain asset pairs. Buy orders show a trader’s desire to purchase or bid for an asset at a certain price, whilst sell orders indicate a trader’s willingness to sell or ask for the asset in question at a specific price.

The depth of the order book, as well as the market price on the exchange, are determined by the spread between these values. On-chain order books and off-chain order books are the two forms of DEXs. Open order information is regularly held on-chain by DEXs that use order books, while users’ funds stay in their wallets.

Traders on these exchanges may be able to consolidate their positions by borrowing money from lenders on the market. Leveraged trading raises a trade’s earning potential while also increasing the danger of liquidation because it increases the size of the stake with borrowed funds that must be repaid even though the traders lose their wager.

DEX Aggregators

To overcome and deal with liquidity issues, DEX aggregators employ a variety of protocols and techniques. These platforms essentially pool liquidity from many DEXs in order to reduce slippage on large orders, reduce swap fees and token prices, and provide traders with the best price in the shortest amount of time.

DEX aggregators’ other primary objectives are to protect users from the pricing effects and to reduce the possibility of unsuccessful transactions. Few DEX aggregators furthermore employ liquidity from centralized platforms to give a better user experience, all while staying non-custodial through the usage of particular centralized exchange integrations.

Major Pros of Decentralized Crypto Exchanges

Many crypto enthusiasts are attracted to the benefits of a decentralized exchange because they do not want to entrust their cryptocurrency to a centralized platform in the first place. DEX is gaining popularity at a quick rate that should not be underestimated. DEX’s key benefits include:

  • Transparency – DEX delivers the same level of transparency as CEX as each and every transaction are publicly tracked through the blockchain.
  • Anonymity – When trading one crypto for another, anonymity is ensured. In contrast to centralized exchanges, users don’t really need to go through the inspection process. This attracts a large number of users who do not wish to be identified.
  • Asset Preservation – Authorities can seize a traditional exchange’s servers and assets, as well as disable user accounts if it shuts down. A decentralized exchange, on the other hand, does not fall into this category because its server is a global network of computers that is difficult to control.
  • Interface – The user interface makes it simple for newbies to the cryptocurrency sector to get up to speed.

To Conclude

Users can now obtain loans to leverage their holdings, lend funds to earn interest passively, or supply liquidity to recover trading fees on decentralized exchanges. Decentralized App development services based on blockchain gained traction, and AMM technology assisted in resolving the liquidity issues that DEXs had previously encountered.

Launching and developing a decentralized exchange from the ground up, especially if you have no prior expertise with decentralized applications, can seem like an interminable ordeal. To learn more about creating a decentralized exchange or to discover the price and development timescale, contact our specialists at AI-Blockchain Corp.


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