Summary
- A decentralized exchange is a peer-to-peer marketplace where transactions occur directly between users.
- They are effectively a series of smart contracts, with transactions settled on the blockchain.
- Reflecting their lack of oversight, they are regarded as a riskier venture and user knowledge is required to navigate these types of exchanges.
- For more articles like this, please visit our Explainers pages.
Defining a decentralized exchange
A decentralized exchange (or DEX) is a peer-to-peer marketplace where transactions occur directly between crypto traders.
DEXs fulfil one of crypto’s core possibilities: fostering financial transactions that aren’t officiated by banks, brokers, or any other intermediary.
The most popular DEXs — like Uniswap and Sushiswap — utilize the Ethereum blockchain and are part of the growing suite of decentralized finance (DeFi) tools.
How do decentralized exchanges work?
Decentralized exchanges are simply a set of smart contracts. They establish the prices of various cryptocurrencies against each algorithmically and use “liquidity pools” — in which investors lock funds in exchange for interest-like rewards — to facilitate trades.
Unlike centralized exchanges, DEXs don’t allow for exchanges between fiat and crypto. Instead, they exclusively trade cryptocurrency tokens for other cryptocurrency tokens.
How do they differ from centralized exchanges?
Transactions on a centralized exchange (CEX) are recorded on that exchange’s internal database, while DEX transactions are settled directly on the blockchain.
DEXs are usually built on open-source code, meaning that anyone interested can see exactly how they work. This also means that developers can adapt existing code to create new competing projects.
It’s possible to trade fiat for crypto (and vice versa) or crypto-crypto pairs such as Bitcoin for Ethereum via a CEX. It’s also possible to make more advanced moves, like margin trades or setting limit orders. All of these transactions are handled by the exchange itself via an “order book”, which establishes the price for a particular cryptocurrency based on current buy and sell orders — the same method used by stock exchanges like Nasdaq.
What are potential benefits of using a DEX?
- Variety: DEXs offer a virtually limitless range of tokens, from the well-known to the weird.
- Hacking risks can be reduced: All funds in a DEX trade are stored on the traders’ own wallets, making them theoretically less susceptible to a hack.
- Anonymity: No personal information is required to use most popular DEXs.
- Utility in the developing world: The peer-to-peer lending, speedy transactions, and anonymity made possible by DEXs have made them increasingly popular in developing economies, where solid banking infrastructure might not be available. Anyone with a smartphone and an internet connection can trade via a DEX.
What are some potential downsides?
- Navigating decentralized exchanges requires some specialized knowledge and the interfaces aren’t always easy, with explainers generally required.
- It’s possible to make an unfixable error, like sending coins to the wrong wallet.
- Another common issue is known as “impermanent loss”, which can result from pairing a more volatile cryptocurrency with a less volatile one in a liquidity pool.
- Any DeFi protocol is only as secure as the smart contracts that power it and code can have exploitable bugs (despite lengthy testing), which can result in the loss of the user’s tokens.
- With the unvetted, array of tokens available on most DEXs, there are also a greater number of scams and schemes to be wary of.
A version of this explainer first appeared on Coinbase.
