Cryptocurrency

What Is a DEX and How It Works

Anyone who wants to invest in cryptocurrencies needs a secure marketplace where they may purchase and sell their crypto tokens. Although centralized crypto exchanges receive much of the people’s scrutiny, traders may benefit from decentralized crypto exchanges as well (DEXs). In the latest years, DEXs on blockchains have emerged, providing a straightforward method for trading crypto assets without disclosing private information. Let’s look at exchanges as a concept before we get into what a DEX is and how it works. Scroll down!

What Are DEXs?

DEX is an abbreviated term used for Decentralized exchanges that function as peer-to-peer marketplaces letting cryptocurrency traders conduct deals without giving their assets to a middleman. By allocating independent code, smart contracts make transactions on decentralized exchanges easier to complete. Users may also take use of various options for order fulfillment on decentralized exchanges with varying degrees of transparency. Examples include:

  • Uniswap
  • Kyber
  • dYdX
  • PancakeSwap
  • Curve Finance

How Decentralized Crypto Exchanges Work?

Blockchain networks are used to establish decentralized exchanges, and they are incredibly important in understanding how a decentralized exchange works for cryptocurrency. Well, the working of DEX is determined by reflecting various types of DEX, which are explained here:

1: Automated Market Makers

The first and foremost type of decentralized exchange is the Automated market maker, abbreviated as the AAM system. The idea behind developing AMM cryptocurrency exchanges was to use token-holding contracts to execute trades on blockchain networks by using smart contracts. Automated market makers rely on blockchain services, commonly referred to as cryptocurrency oracles, to gather data from other markets and networks to determine the value of assets transacted on the system. AMMs operate quite differently from decentralized exchanges, which pair buy and sell orders.

2: Liquidity Pools

The liquidity pool includes two crypto assets in decentralized exchanges, a user must contribute a similar amount of cryptocurrency to the pool to become a liquidity provider. For every trade made on the relevant pair, liquidity providers would get a certain percentage of the transaction costs. Liquidity providers must deposit an equivalent quantity of each currency in the transaction pairs in order to profit from liquidity mining.

Liquidity pools are vital to the operation of a decentralized exchange because they give traders the ability to execute trades and earn interest without a third party’s approval or a sense of confidence. Such trade pairings are ranked according to the total value locked (TVL) or the quantity of cash locked in smart contracts on AMM-based DEXs.

3: Order Book DEXs

Order Book DEXs is another way to work on a decentralized exchange, including the gathering of necessary documents related to open orders. Two types of orders are usually made, one is buying orders which specify the purchase of assets at the price given, and sell orders which specify the selling of assets at an actual price. The distinction between buy and sell orders aids in determining the depth of their order book, influencing how much a particular item on the exchange is worth in the market.

Moreover, on-chain and off-chain order books work on decentralized exchange as well. On-chain order books ensure the safety of funds of users in their wallets, assisting the traders in utilizing money they have borrowed from lenders whereas off-chain order books keep the order on a blockchain, by improving the speed of transactions and lowering the cost.

4: DEXs Aggregators

The DEX Aggregators on a decentralized exchange are based on various protocols to solve problems related to liquidity.  To lower slippage on big orders, such platforms might publicly advocate the consolidation of liquidity from many DEXs. DEX aggregators might potentially optimize token pricing and swap costs in addition to providing traders with rapid price predictions. Aside from lowering the risks of unsuccessful transactions, aggregators also protect users from the negative effects of the price impact.

What Are the Benefits of Decentralized Exchange?

Users of decentralized exchanges are not obligated to send their funds to a foreign entity. As a result, there is virtually no chance that a business or organization will be compromised, and clients may be confident to be more secure from hacking, failure, fraud, or theft.

The following are the advantages of DEXs:

  • Id verification
  • No counterparty risks
  • All tokens can be traded
  • Reduced security risks
  • Utilities in underdeveloped countries

What Are the Risks of Decentralized Exchange?

The cons of DEXs are:

  • Specific knowledge is required
  • Smart contract vulnerabilities
  • No recovery ability
  • Unvetted token listings
  • Low liquidity
  • Limited speed
  • Scalability issues
  • Limited trading functionality

Conclusion

Decentralized exchanges are a trustless alternative that let users buy and trade crypto without the need for a middleman. Although complete decentralization has not yet been achieved, many DEX variants provide crypto traders with a range of security, privacy, and efficiency options. DEXs strive to offer more liquidity as they expand, change, and become more useful for users. The good news is that there are many other methods to enter the crypto sector; DEXs is only one of them.

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Talha