What Are Decentralized Exchanges?

Decentralized exchanges, also known as DEX, refer to a peer-to-peer marketplace that enables traders to buy and sell cryptocurrencies directly without relying on a third-party interference. By design, DEX replaces intermediaries, such as banks, brokers, or payment services, with self-executing smart contracts.

Introducing Decentralized Exchanges

Developed as an alternative to centralized exchanges (CEX), decentralized exchanges offer direct peer-to-peer cryptocurrency trading along with access to the growing decentralized finance sphere. Instead of a central operation, such as Coinbase, tasked with facilitating the transactions, DEX relies on smart contracts, programs that execute pre-programmed outcomes when certain requirements are met.

The framework is referred to as non-custodial, as DEX users hold complete control over their crypto assets instead of giving custody to a centralized organization and their private keys, which function to sign transactions and prove ownership.

This guide explains how DEX differs from CEX, the processes DEX follow along with how to use them, and lists their benefits and limitations.

CEX and DEX: Key Differences

Development and Management — A CEX is developed using traditional ways of building applications through languages such as Java or Python, much like other applications used daily such as Twitter or Uber. The developer institution is also responsible for its maintenance, transaction processing, custody of funds, and more.

A DEX, on the other hand, is built on a blockchain network and governed by hard-coded regulations called smart contracts. Smart contracts are codes that involve certain requirements that trigger pre-programmed actions when they are met. They are open-source, meaning that anyone can view their code and propose improvements.

Fiat Currency Involvement — It’s only possible to exchange cryptocurrencies through decentralized exchange; they don’t involve fiat currencies. Centralized exchanges, however, offer services to purchase cryptocurrencies using fiat currencies through bank transfer, meaning that users can convert their dollars into the cryptocurrency they choose or vice versa.

Included Cryptocurrencies — Similar to stock exchanges, centralized exchanges typically include all of the major cryptocurrencies, whereas decentralized exchanges are usually specific to a blockchain ecosystem they are built on top of.

Anonymity — As fiat currencies are involved, centralized exchange requires KYC (Know Your Customer) which includes sharing personally identifying information such as full legal name, email address, phone number, and potentially a scan of government-issued photo ID.

Transaction Fees — Types of cryptocurrency transaction fees and amounts vary between CEX and DEX. The centralized exchange typically charges a percentage service fee for each transaction, which typically varies by volume to encourage larger transactions carrying more monetary value.

Decentralized exchange, on the other hand, employs the network fees of the blockchain network they are built on. Network fees as such depend largely on network congestion and the size of the transfer, with transfers requiring more computational power and costing more to process. These fees are distributed to the network participants, or nodes, for verifying the financial transactions.

How Does Decentralized Exchange Work?

A DEX is a type of decentralized application and is governed by smart contracts. Smart contracts, in this context, represent a pool of assets. When users wish to trade or swap assets, they interact with a smart contract, which performs the locking and releasing during a trade. Smart contracts are self-executing programs, and by design, they substitute intermediaries, which are normally responsible for facilitating transactions between two currencies.

How to Use a Decentralized Exchange Platform

1. Independent listers like CoinMarketCap lists all decentralized exchanges along with the cryptocurrencies they support. Users may view the page and based on their crypto assets, choose a trading platform most suitable for their needs.

2. Decentralized exchanges are accessed through decentralized wallets, through which they can fund their exchange with cryptocurrencies. When landing on a DEX page, users can connect supported wallets, which they can fund through centralized exchanges beforehand if needed.

3. As users input an amount to be converted, they will receive a breakdown of the transfer detailing the associated transaction fee, trading fees, and the expected amount the beneficiary will receive.

Benefits and Limitations of DEX

Will Exchanges Be Decentralized?

Despite being a relatively new trend, decentralized exchanges have gained significant traction recently. The trading volume among DEX on the Ethereum network, for example, shot up to a staggering 620 billion USD in 2021 from only 3 billion USD in 2019. In early 2019, DEX transactions only accounted for 0.11% of global volume, which has gone up to 6% by August 2020.

Despite having unique drawbacks, decentralized exchange provides great value to the end user while staying true to blockchain’s, and thus cryptocurrencies’, the core philosophy of complete decentralization.

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