Peer-to-peer marketplaces, also known as decentralized exchanges or DEXs, are peer-to-peer environments in which cryptocurrency traders engage in direct transactions without entrusting the management of their funds to an intermediary or custodian. Decentralized exchanges are also known as DEXs.
The use of agreements that can carry out their own terms and that are written in code and known as “smart contracts”, helps make these transactions possible.
DEXs were developed so that it would no longer be necessary for any authority to supervise and give permission for trades to take place within a particular exchange.
Trading cryptocurrencies one-on-one, or peer-to-peer (P2P), is made possible through decentralized exchanges. A marketplace that connects buyers and sellers of cryptocurrencies is known as peer-to-peer (or P2P for short).
They are typically non-custodial, which means that users maintain control over the private keys associated with their wallets. A private key is a specialized form of encryption that gives users access to the cryptocurrencies they have stored on their devices.
After successfully logging in to the DEX with their private key, users are given immediate access to their cryptocurrency balances.
People who place a high value on their privacy will be pleased to learn that they will not be required to provide any personally identifying information, such as their names and addresses.
Automated market makers are one example of an innovation that has helped attract users to the decentralized finance (DeFi) space, which has been a major contributor to the industry’s expansion.
DEX aggregators and wallet extensions played a significant role in the expansion of decentralized platforms. They did this by optimizing token prices, swap fees, and slippage while simultaneously providing users with a better rate.
What are decentralized exchanges?
In decentralized exchanges, the ability for traders to execute orders without the involvement of an intermediary is enabled by smart contracts.
On the other hand, centralized exchanges are controlled and operated by a single entity, such as a bank or other financial institution that is also engaged in the provision of financial services with the intention of making a profit.
Because they are regulated entities that offer easy-to-use platforms for newcomers, centralized exchanges account for the vast majority of the trading volume in the cryptocurrency market. This is due to the fact that central exchanges hold custody of their users’ funds.
There are even centralized exchanges that offer insurance on assets that are deposited with them.
It is possible to draw parallels between the services provided by a centralized exchange and those provided by a bank.
Because the bank protects the money of its customers and provides services of security and surveillance that private individuals cannot provide on their own, it is much simpler to transfer money from one place to another.
Decentralized exchanges, on the other hand, enable users to conduct transactions directly from their wallets by interacting with the smart contracts that underpin the trading platform.
Traders are responsible for the safety of their own funds and bear the consequences if they mishandle them in any way, including misplacing their private keys or sending money to the wrong addresses.
Customers who deposit funds or assets receive a “I owe you” (IOU) note that can be freely traded on the network through decentralized exchange portals. These IOUs serve as a form of credit. An IOU is essentially a token that is based on blockchain technology and has the same value as the asset that it represents.
On top of the leading blockchains that support smart contracts, popular decentralized exchanges have been built in recent years.
They are built directly on the blockchain as they are constructed on top of layer-one protocols, which means they are built on top of layer-one protocols. The Ethereum blockchain underpins the majority of today’s most popular decentralized exchanges (DEXs).
How do DEXs work?
Every transaction results in the user having to pay a transaction fee in addition to the trading fee. This is due to the fact that decentralized exchanges are built on top of blockchain networks that support smart contracts and where users keep custody of their funds.
To use DEXs, traders essentially interact with the smart contracts that are stored on the blockchain.
Automated market makers, order books decentralized exchanges (DEXs), and DEX aggregators are the three primary categories of decentralized exchanges.
Through their respective smart contracts, all of them enable users to engage in direct commerce with one another. The first decentralized exchanges followed a model very similar to that of their centralized counterparts in that they used order books.
Automated market makers (AMMs)
To address the issue of liquidity, a solution in the form of an automated market maker (AMM) system that is supported by smart contracts was developed.
The paper written by Ethereum co-founder Vitalik Buterin on decentralized exchanges served as a source of inspiration for the development of these exchanges. In the paper, Buterin explains how to carry out transactions on the blockchain by utilizing contracts that hold tokens.
These Automated Market Makers (AMMs) rely on so-called “blockchain oracles,” which are blockchain-based services that provide information from exchanges and other platforms to determine the price of traded assets.
The smart contracts that power these decentralized exchanges don’t actually match buy orders and sell orders; rather, they make use of liquidity pools, which are pre-funded pools of assets.
The pools are funded by the other users of the protocol, who are then eligible to receive the transaction fees that are charged by the protocol for carrying out trades using that particular pair.
The process that these liquidity providers go through to earn interest on their cryptocurrency holdings is called “liquidity mining,” and it requires them to deposit an equal value of each asset that is involved in the trading pair.
The transaction will be deemed invalid by the smart contract that underpins the pool if they attempt to deposit a greater quantity of one asset than the other.
The use of liquidity pools gives traders the ability to execute orders or earn interest in a way that does not require permission and does not require them to trust one another.
Because the AMM model has a drawback that can occur when there is not enough liquidity called slippage, these exchanges are frequently ranked according to the total value locked (TVL), which is another name for the amount of funds that are locked in their smart contracts.
Slippage happens when there is a lack of liquidity on the platform, which leads to the buyer paying prices that are higher than the market for their order. Slippage is more likely to occur with larger orders.
Because large orders are more likely to experience slippage when there is insufficient deep liquidity, wealthy traders may be dissuaded from using these platforms due to a lack of liquidity.
When a liquidity provider deposits two assets for a particular trading pair, they expose themselves to a number of risks, one of which is the possibility of experiencing a loss that is only temporary.
The quantity of one of these assets in the liquidity pool can decrease as a result of trades conducted on the exchange when one of these assets is more volatile than the other.
When the price of a highly volatile asset goes up while the amount of that asset that liquidity providers hold goes down, the liquidity providers suffer a loss that is only temporary.
This loss is not permanent because there is still a chance that the price of the asset will go back up, and there is always the possibility that trades on the exchange will bring the pair’s ratio back into balance.
The ratio between the two assets provides a description of the percentage of each asset that is held in the liquidity pool. In addition, the fees collected from trading have the potential to compensate for the loss over time.
Order book DEXs
Recordings of all open buy and sell orders for specific asset pairs are compiled in order books that are called order books.
When a trader places a buy order, it indicates that the trader is ready to acquire or place a bid for an asset at a particular price. When a trader places a sell order, it indicates that the trader is prepared to dispose of or ask for a particular price for the asset that is being considered.
The depth of the order book and the market price on the exchange are both determined by the spread between these prices.
Order book On-chain order books and off-chain order books are the two varieties of DEX order books. DEXs that use order books will frequently keep open order information on the blockchain, but users’ funds will continue to be stored in their wallets.
It’s possible that these exchanges will let traders use funds borrowed from lenders on their platform in order to gain greater leverage over their positions.
Trading with leverage raises the potential earnings of a trade, but it also raises the risk of the trader’s account being liquidated. This is because trading with leverage increases the size of a position by using borrowed funds, which need to be repaid even if the traders lose their bet.
Traders can still reap the benefits of centralized exchanges despite the fact that some DEX platforms keep their order books in a separate database from the blockchain and only use the blockchain to settle trades.
The use of off-chain order books enables cryptocurrency exchanges to cut costs and increase transaction speeds, thereby ensuring that users’ trades are completed at the prices they have specified.
These exchanges make it possible for users to lend their funds to other traders so that the exchange can provide leveraged trading options.
Lending money earns interest over time and is secured by the exchange’s liquidation mechanism. This ensures that lenders get paid even if traders lose their bets and the loaned money is paid back.
It is essential to bring attention to the fact that order book DEXs frequently experience liquidity issues.
The majority of traders prefer to stick to centralized platforms because decentralized exchanges are essentially in competition with centralized exchanges and incur additional fees as a result of what is paid to transact on-chain.
The requirement that users deposit funds into DEXs that use off-chain order books mitigates some of these costs; however, it also exposes users to risks associated with smart contracts.
DEX aggregators
DEX aggregators will often employ a wide variety of protocols and mechanisms in order to find solutions to issues relating to liquidity.
These platforms, in essence, aggregate the liquidity offered by a number of different DEXs in order to reduce the amount of slippage that occurs on large orders, maximize the efficiency of swap fees and token prices, and provide traders with the best possible price in the shortest amount of time.
DEX aggregators have a number of important goals, one of which is to shield users from the pricing effect, while another is to reduce the likelihood of transactions failing.
Some DEX aggregators use liquidity from centralized platforms in order to improve the user experience while maintaining their status as non-custodial exchanges by leveraging integrations with specific centralized exchanges. This allows the aggregators to provide users with a better experience overall.
How to use decentralized exchanges
It is not necessary to sign up in order to use a decentralized exchange; in fact, you do not even require an email address in order to communicate with users of these platforms.
Instead, traders will need a wallet that is compatible with the smart contracts that run on the network of the exchange.
The financial services made available by DEXs are accessible to anyone who possesses a smartphone and a connection to the internet.
Because a transaction fee is associated with every trade, the first thing a user must do before using a DEX is to determine which network they want to use.
The next step is to select a wallet that is compatible with the network that was previously chosen and then add its native token to that wallet.
A native token is a token that is specific to a network and is used to pay for the fees associated with transactions on that network.
It is made much simpler for users to interact with decentralized applications (DApps) such as DEXs by wallet extensions that can be added to browsers and give users direct access to their own funds.
These must be installed like any other extension, and users must either import an existing wallet by entering a seed phrase or private key or create a new wallet. Installation is performed in the same manner as for any other extension. A password is required to access the secure area, which adds another layer of protection.
Because these wallets come equipped with preconfigured browsers that are ready to interact with smart contract networks, they may also come with mobile applications that allow traders to use DeFi protocols while they are on the move.
Wallets can be synchronized across devices for users by importing the contents of one wallet into another. After picking a wallet, it will need to be funded with the tokens used to pay for transaction fees on the chosen network.
These tokens can only be obtained through the use of centralized exchanges, and it is simple to recognize them due to the ticker symbols that they employ, such as ETH for Ethereum.
Once the user has purchased the tokens, all that is required of them is to withdraw them to wallets that they own.
It is of the utmost importance not to transfer funds to the incorrect network. Because of this, users are required to withdraw their funds to the appropriate one.
When a user has funds in their wallet, they have the option to either connect their wallet by responding to a pop-up prompt or clicking the “Connect Wallet” button that is located in one of the upper corners of the DEXs website.
The benefits of using a DEX
When network transaction fees are high at the time trades are being executed, trading on decentralized exchanges can be an expensive endeavor. Despite this, there are a plethora of benefits that come with utilizing DEX platforms.
Token availability
Before listing tokens, centralized exchanges are required to conduct individual due diligence on them and ensure that they are in compliance with any applicable local regulations.
Because decentralized exchanges are able to include any token that is minted on the blockchain they are built upon, it is likely that new projects will list on these exchanges before they become available on their centralized equivalents.
Despite the fact that this may imply that traders have the opportunity to participate in projects at the earliest possible stage, it also suggests that various types of scams are listed on DEXs. A “rug pull,” also known as a typical exit scam, is a well-known type of cons.
Rug pulls happen when the team behind a project dumps the tokens used to provide liquidity on these exchanges’ pools when their price goes up, making it impossible for other trades to sell. This drives up the price of the tokens.
Anonymity
On decentralized exchanges (DEXs), users’ anonymity is protected even when they are exchanging one cryptocurrency for another.
In contrast to centralized exchanges, users do not need to go through a standard identification process known as Know Your Customer (KYC) (KYC).
KYC processes involve collecting traders’ personal information, including their full legal name and a photograph of their government-issued identification document. As a direct consequence of this, DEXs are frequented by a significant number of individuals who would prefer not to be recognized.
lowered potential dangers to security
Because DEXs do not have control over their users’ funds, experienced cryptocurrency users who keep their money in cold storage have a lower risk of having their funds stolen if they use these exchanges.
Instead, traders are responsible for the safety of their own funds and only engage with the exchange when they have a specific purpose in mind. Only liquidity providers are potentially at risk in the event that the platform is hacked.
Reduced exposure to risk from counterparties
The risk of a counterparty occurs when one of the parties involved in a transaction does not live up to its end of the bargain and reneges on its contractual obligations.
Because decentralized exchanges operate without intermediaries and are based on smart contracts, this risk is eliminated.
Users can quickly conduct a web search to determine whether the exchange’s smart contracts have been audited, which enables them to make decisions based on the experiences of other traders and ensures that using a DEX does not expose them to any additional risks.
Disadvantages of using DEXs
In spite of the benefits discussed above, there are a number of disadvantages associated with decentralized exchanges. These disadvantages include a lack of technical knowledge that is required to interact with these exchanges, an abundance of smart contract vulnerabilities, and unvetted token listings.
There is a requirement for specific knowledge.
DEXs are accessible using cryptocurrency wallets that can interact with smart contracts.
Not only are users required to be familiar with how to operate these wallets, but they must also have a fundamental comprehension of the security-related concepts that are associated with the safekeeping of their funds.
These wallets need to have the appropriate tokens for each network deposited into them before they can be used. If a network does not have its own native token, it is possible that other funds will become stalled because the trader will be unable to pay the necessary fee to move them.
It is necessary to have specialized knowledge in order to select a wallet and then properly fund it with the appropriate tokens.
In addition, preventing slippage can be difficult even for experienced investors, and it can be next to impossible when purchasing tokens that have a lower level of liquidity.
When placing an order on a DEX platform, the slippage tolerance will frequently need to be manually adjusted. Additionally, adjusting slippage can be technical, and some users may not fully understand what it means.
Traders who lack specific knowledge are more likely to make various mistakes, any of which could result in a loss of funds.
Withdrawing coins to the wrong network, overpaying transaction fees and losing out to impermanent loss are just a few examples of what could go wrong.
Smart contract vulnerabilities
The source code for smart contracts running on blockchains such as Ethereum is open to public scrutiny and can be accessed by anyone.
In addition, the smart contracts of large decentralized exchanges are audited by trustworthy companies, which further helps to secure the underlying code.
To err is human nature. As a result, vulnerabilities that can be exploited can still make it through audits and other types of code reviews.
It’s even possible that auditors won’t be able to anticipate any potential new exploits that could cause liquidity providers to lose their tokens.
Unvetted token listings
On a decentralized exchange, any user can list a newly created token and provide liquidity for the token by trading it for other cryptocurrencies.
Because of this, investors may be susceptible to cons such as rug pulls, in which they are led to believe that they are purchasing a different token than what they actually are.
Some DEXs counter these risks by asking users to verify the smart contract of the tokens they are looking to buy.
Even though this solution is effective for users with experience, it brings specific knowledge issues back up for users with less experience.
Traders can try to obtain as much information as they can about a token before buying it by reading the token’s white paper, joining the token’s community on social media, and searching for potential audits on the project.
This kind of due diligence helps avoid common scams in which malicious actors take advantage of users who are unaware they are being targeted.
Decentralized exchanges are evolving
The first decentralized exchanges were launched in 2014, but the popularity of these platforms didn’t really take off until decentralized financial services based on blockchain started to gain traction and AMM technology started to help solve the liquidity problems that DEXs had been experiencing up until that point.
It is difficult for these platforms to enforce Know Your Customer and Anti-Money Laundering checks because there is no central entity verifying the type of information that is traditionally submitted to centralized platforms. These checks include identifying customers and preventing money from being laundered.
However, regulators may try to implement these checks on decentralized platforms in the future.
Because those platforms that do accept deposits from users still require users to sign messages on the blockchain in order to move funds off of their platforms, regulations that are applied to custodians would not apply to these platforms either.
Decentralized exchanges of today give users the ability to borrow funds in order to leverage their positions, lend funds in order to earn interest passively or provide liquidity in order to collect trading fees.
Because these platforms are based on self-executing smart contracts, it is possible that in the future, more use cases will be developed.
Flash loans, which are loans that are taken out and repaid in a single transaction, are one example of how innovation in the space of decentralized finance can create products and services that were previously impossible to achieve.
