Decentralized Exchange (DEX): The Doorway to Crypto Investment
DEX stands for Decentralized Exchange and is an exchange that allows you to trade your coins and tokens without a central authority. A DEX only enables users to swap cryptos on the same blockchain. DEXs are made up of smart contracts, and liquidity pools are also made up of smart contracts. A liquidity pool is a ‘storage’ containing a pair of assets. These pools start with an exact ratio of 50/50 with the two assets, and they mostly use the constant product automated market maker algorithms to manage that ratio. There are a lot to know on DEX; let’s read together.
DEX Put Simply
Throughout your residence in the world of crypto, you’ve probably heard of Uniswap, Pancakeswap, and other “swap” platforms. These dapps are called DEXs. DEX or a Decentralized Exchange allows you to trade your coins and tokens without a central authority. Instead, the central authority is replaced with smart contracts. These smart contracts allow two people to enter an agreement with each other. Check our blog post to learn more about smart contracts and why they’re so important.
A DEX has limitations and it only allows users to swap crypto for crypto, and these cryptos have to be on the same blockchain as well. Uniswap is a well-known DEX that allows swaps for Ethereum-based tokens. Sushiswap is another DEX that has expanded to other blockchains, but the coins you want to swap still need to be on the same blockchain. If you wish to do inter-blockchain swaps, you need to use blockchain bridges.
Pros And Cons Of A DEX
There’s no doubt that DEXs are an excellent tool for traders; however, nothing comes without some downsides. Let’s elaborate on the benefits and drawbacks of a DEX.
Decentralized Exchange Pros
A DEX doesn’t need KYC (Know Your Customer) info, unlike centralized exchanges like Binance and Coinbase. Since the centralized authority is replaced with a smart contract and smart contracts are open-source, you can check their code and find bugs and errors. DEXs are also much faster than Centralised Exchanges (CEXs), allowing you to transfer coins and tokens in seconds with cheap fees.
Decentralized Exchange Cons
DEXs typically don’t have a support group behind them, meaning if you have an issue, there’s no one to message about it. Although there are forums where people help each other, these people are helping voluntarily and it isn’t their job to do so. Another downside of a DEX is if you send your coins to the wrong address, you can’t get them back anymore. Also, you need to connect a wallet to use a DEX, unlike CEX. On centralized exchanges, your tokens sit on the exchange, and it doesn’t require you to use a wallet; however, we recommend you to connect a wallet both in DEXs and CEXs for extra security.
How Does A DEX Work?
To learn more about the exact mechanics of a DEX, we’ve broken them down into small, digestible topics as follows.
The Order Book Method
The Order Book method is the method used by the US stock market for buying and selling stocks. In simple terms, if you want to buy or sell something, you choose a price you want to buy or sell it for, and you put an order and give it to a third party. The third party finds someone willing to perform the exact trade you’re offering. It then swaps the two assets (stock with money in this case) and gives the two parties what they want.
A liquidity pool is a ‘storage’ containing a pair of assets. Currently, liquidity pools can contain only two types of assets. They are made up of smart contracts that allow traders to trade even when there are no buyers and sellers. The pool starts with an exact ratio of 50:50 with the two assets. If the pool needs to start with $1000, you need to provide $500 on an asset and $500 on another asset. Most liquidity pools use the constant product automated market maker algorithms.
Automated Market Makers (AMM)
As the name suggests, Automated Market Makers are systems that provide liquidity to the exchange they operate in through automated trading. In the case of liquidity pools, their main goal is to keep the 50:50 ratio. Let’s check the example of the ETH/AAVE pool. If you buy AAVE from the pool by giving it ETH, the price of AAVE that the pool is offering increases slowly. As you buy more AAVE, the pool charges you more for each token. It is to encourage traders to keep the 50:50 ratio. Also, every transaction has a tax fee, a tiny percentage of your trade that is allocated to the liquidity providers.
You can easily become a liquidity provider by putting money and investing in a liquidity pool. As more people trade with the tokens LPs have provided, their transaction fees start to add up and are then allocated to the LPs. Some DEXs offer up to a 500 annual percentage rate because of the fees. As more money is put into a liquidity pool, the pool’s prices become more stable since it takes more money to move the price from the original price.
We hope this educational post has answered your questions about DEXs and has connected some terms you’ve heard here and there so you can better understand them. At Cryptologi.st we educate you on different projects and crypto terms and strategies. We believe knowledge is the key to maximizing your gains and making confident investment decisions! Stay tuned!