The wonderful and often wild world of crypto exchanges can get somewhat confusing when it comes to vocabulary. It seems the industry has opted to make up an entire vernacular all of its own, borrowing some words and phrases from the traditional investment environment, and making up new ones for the space along the way.
To add to that confusion, the Internet loves a good abbreviation. The younger, “cooler” technologies all have to come with a catchy phrase or abbreviated nomenclature to stand out and seem hip.
One of those terms is known as “DEX.” Let’s dive into its meaning and further understand the crypto world.
A Decentralized Exchange
In simpler (or, rather unabbreviated) terms, DEX stands for a decentralized exchange. While naming the words sounds easy, understanding the complex system around it takes a bit more digging.
What Are Decentralized Exchanges?
Sometimes, the best way to understand a word or phrase’s meaning is to break it into parts. In the case of DEX, that would require us to look at both decentralization and exchanges uniquely. To have a better grasp of the DEX concept, let’s start there.
What Is an Exchange?
As you may be familiar with by now, the cryptocurrency market relies on exchange spaces. Much like the New York City Stock Exchange or the NASDAQ, such marketplaces are the “location” of the buying, selling, and trading of, in this case, stocks. Stock exchanges are simply the “where”.”
In the case of crypto, the crypto exchanges serve a similar purpose. To sell new crypto, a company has to bring it to the marketplace. Much like a stock means a company is “going public,” when a new cryptocurrency is formed, it must find a marketplace on which to sell its “wares” or tokens in this case.
An exchange is required as a “site” in which to do this business. You may have new crypto that you want to offer up to the market, selling it to buyers (or bidders) in an exchange. You may go on an exchange site to make a purchase. Additionally, you may want to make a trade of one type of crypto for another, much like a foreign money exchange depot.
Whatever your reasons, as each user will have a unique purpose, the “exchange” itself is simply the space in which the business is conducted.
What Is Decentralization?
The second part of the DEX phrase is “decentralized,” which at first glance sounds like a simple word to understand. In basic terminology, decentralized simply means not being centralized.
In the case of exchanges and the servers on which they exist, decentralization means a bit more. To not be centralized exchanges, means that the space in which the business is being done (the exchange) is not hosted on a central server. There is no single, central authority.
Instead, a DEX is an exchange for crypto traders to interact with that operates on a peer-to-peer network. These networks operate on blockchain networks.
The Blockchain Technology
A blockchain has a few key features making it unique to the space. It supports the core values of decentralization through its technology.
A blockchain is a distributed ledger, accessible to all users of the network. It is a log of all the comings and goings of a particular item, which in the case of crypto is often the tokens themselves.
Let’s take Bitcoin, for example, the world’s most popular form of cryptocurrency. That coin operates on its unique blockchain. On that chain, any user can see the transactions of each Bitcoin from its origination to the present.
Data is stored in virtual boxes (blocks) that are chronologically linked (chained) together in a series. The unique method of verifying and securing the data allows crypto to exist in the first place. It is also the tech behind a decentralized exchange.
Not only does the blockchain support the technology required to make crypto and the DEX possible, but it also supports a value system that fuels the industry. The concept of crypto overall thrives on this theory and is the main focus for most of its users.
In short, investors wanted to have options in buying, selling, and trading that did not require the authority of a government, corporation, or powerful entity. Instead, a decentralized blockchain would allow for the “power” to return to “the people,” a fundamental goal of the industry.
Additionally, there is a security in the peer-to-peer concept, allowing for a system of checks and balances (each user can see all transactions), not to mention a complex computational verification system required to even create a block of data.
Cutting Out the ‘Middle Man’
Through its technology and processes, DEXs fulfill one of crypto’s core goals: fostering financial transactions that are NOT overseen by banks, brokers, payment processors, or any other kind of intermediary.
Instead, users can process transactions for themselves, directly from one person to another, without that “power” in between. This can cut down on that sense of authority, but also lowers costs by eliminating transaction fees.
Examples of DEX Today
Some of the most popular DEXs — like Uniswap and Sushiswap — utilize the Ethereum network. They are part of the growing industry of decentralized finance (DeFi). (See, we told you the Internet loves a good abbreviated phrase.)
Ethereum offers versatility in DEX aggregators. The network provides access to spot trading, margin trading, ring trades, P2P (peer to peer), and decentralized trade. If you want to allow for crypto trade, the Ethereum network and its DEX aggregators offer assets for any developer willing to sell orders.
To be a DEX, the market must simply be decentralized and offer the exchange of cryptocurrency. Today, there is a huge range of financial services available directly from a compatible crypto wallet.
Some of those most popular decentralized exchanges include:
Features of a DEX
As with any fact of life, there are pros and cons to everything. The DEX brings a great option to the table for traders seeking to operate on a peer-to-peer network, and not have a centralized authority “in charge” of their funds.
Many popular sites, like Coinbase and Binance (and many of the biggest names for exchanges out there), are technically part of Centralized Exchanges. As centralized counterparts to the DEX, they retain custody of user funds held on the platform.
On the opposite, decentralized platforms are generally non-custodial, meaning a user remains in control of their private keys and assets when transacting on a crypto DEX platform. But, without a single authority, how can you be sure your data and transactions are secure?
Instead of a central authority, DEXs use “smart contracts” that self-execute under set conditions and record each transaction to the blockchain. Instead of actual human beings manually entering each transaction by hand, which can lead to errors and omissions, the DEX relies on artificial intelligence, or in this case the self-executing smart contracts.
How Do Smart Contracts Work?
A smart contract is an automated process. It is a program, agreed upon by the users of a specific blockchain, that eliminates the need for human interaction. The smart contract instead operates on an “If/Then” method.
If X occurs, then Y will happen. You can think of a smart contract as an infallible vending machine. If you put in a quarter, then your gum will come out.
Likewise, these smart contracts on a DEX await a certain input. Let’s say a set amount of “A Crypto” must be moved into Joe’s account. Once that amount of “A Crypto” is placed in Joe’s account, then “B Crypto” will be released.
Smart contracts provide security in a peer-to-peer space by allowing the computations to be automated. There is no way someone could short Joe’s account because the B Crypto would not release until the predetermined about of A Crypto was placed in the account.
For a DEX to form and become operable, there must be a set of “rules” or smart contracts. But, additionally, there must be price points set for each crypto permitted on the exchange.
The DEX will establish the prices of various cryptocurrencies against each algorithmically and use “liquidity pools.” A liquidity pool is a “pile” of funds that investors contribute and lock in place in exchange and in turn receive interest-like rewards. Contributors to the liquidity pool, known as liquidity providers, offer the funds as an investment.
That pool for that particular DEX is then used to facilitate trades. Liquidity providers make the DEX possible, and without that base pool of funds, they could not get off the ground.
As previously noted, the DEX often relies on the technology of the blockchain. While transactions on a centralized exchange are recorded on that exchange’s internal database, all DEX transactions are settled directly on the blockchain itself. This supports the elimination of the “middle man,” as previously noted.
In addition to a blockchain being a transparent and distributed ledger, the tech behind a DEX also allows for innovation. By making even its creation data (i.e. how it was made) available to all, there is a flow of information that is unique to decentralized crypto exchanges.
DEXs are usually built on open-source code, meaning that anyone interested can see exactly how they work. By allowing access to such data, improvements can be made, or new exchanges entirely can be created.
Developers can also adapt existing code seen in other DEXs to create new competing projects. For example, by viewing Uniswap’s coding, developers adapted an entire host of DEXs with “swap” in their names, such as Sushiswap and Pancakeswap. Think of these almost as “spin-off” sitcoms. Using the success of the original, the additional “spin-offs” are created to bring even more users to the table.
Another feature of the DEX space is that users are paying lower or even no trading fees on the sites. These trading platform DEX sites allow users to work directly with one another (albeit through a smart contract, not “face to face”).
With a low transaction fee or low to no trading fee, it is no wonder many investors are shifting digital assets to these decentralized exchanges. No one, no matter the level of investor, likes paying fees to do business.
It is also a positive for those seeking to sell cryptocurrencies, as buyers are more likely to flock to a token or coin with lower or no fees involved. Everyone wants the best price they can get, and everyone is looking for a bargain. These exchanges bring that opportunity.
As the last two features noted, there is an added level of accessibility when it comes to decentralized exchanges. Firstly, the open-source coding allows developers to come up with their unique spin on crypto. You don’t have to have millions of dollars or a massive corporation to get your concept started.
By simply finding funding for your liquidity pools, you can begin the process, and you aren’t sent “back to Go,” forced to start from scratch. You also do have to have institutional investors. Such funds can come from liquidity mining, or simply those users that have a dedication to your success. The open-sourced coding available allows more developers to come to the table with their ideas, with multiple options to provide liquidity.
Additionally, the structure of the decentralized exchanges allows for new sellers to come to the table due to the low fees involved. It can be tough to attract new users to a platform, but with the accessible coding, available liquidity pools, and automated market makers technology, decentralized exchanges are a great way to facilitate trading on all levels.
With the simplicity of an internet connection, some coding background, and open-source data, you can be on your way to being the next crypto mogul in no time.
The Uniswap Success Story
Just take the creation of the world’s most successful DEX, Uniswap, for example. What is now the largest DEX out there was created on the Ethereum blockchain in 2018. It was done by a former mechanical engineer, who had learned to code only after getting laid off by Siemens the previous year.
By late 2021, DEX was processing transactions worth more than $1 billion each day. Not a bad success story when you come to think about it.
As a way of proof of its success, one simply only needs to look at the volume of business DEX sites are seeing every day. As of February 2022, Uniswap (currently operating version 3 protocol) was handling almost $2 billion in trading volume in a single day.
This DEX market typically manages around three times the volume of its closest DEX platforms as competitors, such as PancakeSwap, which usually see $300 million to $600 million in daily volume.
These automated market exchanges buy and sell at a rapid pace, as the execution of the smart contract is automated. That makes such exchanges able to do massive amounts of transactions in a single day. This new way to trade is certainly booming in business.
No Fiat Funds
What some users view as a downside to the decentralized exchange is that fiat money cannot be used to purchase crypto. Instead, crypto traders must first purchase crypto elsewhere (on a centralized exchange) and then bring it to the DEX market.
When a new token hits the market, it will likely have its liquidity pool. However, that liquidity is specific to its particular crypto. Many users are not happy that they must first make a centralized exchanges account to do business later on a decentralized exchange. They enjoy maintaining the authority over their private keys, and having to do business on centralized crypto exchanges at all creates frustration.
Do Your Research
The best advice you will get in the world of cryptocurrency is to do research. Of course, there is no sure thing or guarantee in the space. But when you aim to trade crypto, you need to know the ins and outs of the products you are considering.
Even DeFi protocol can only be secure if the smart contracts that power it are, too. Any code can have exploitable bugs, meaning that in a vast majority of new products, slippage occurs. Yes, there are new codes daily that aim to minimize slippage, but seek sites with low slippage, or ideally none.
When you are in the business to buy and sell crypto, you don’t want any failed transactions. No matter how much deep liquidity is backing that coin, there is a chance for loss.
To execute trades successfully, a site should be bug-free and your platform, as centralized exchanges or decentralized exchanges, as businesses of digital assets, should be as error-free as possible.
When researching decentralized exchanges, (or the centralized exchanges for that matter), be sure to do your due diligence. Find resources that you trust and understand. Decentralized exchanges work because developers take the time to do the research and plan a comprehensive platform on which you can make a trade.
FLOLiO will continue to help you better understand that space, from decentralized margin trading to proactive market maker products, you can trust this reference space for the long haul.