Decentralized exchanges (DEXs) have quickly become the bedrock of the decentralized finance (DeFi) ecosystem. They’re a fundamentally different way to trade cryptocurrencies than centralized exchanges (CEXs). DEXs eliminate intermediaries by leveraging blockchain technology to facilitate direct peer-to-peer trading between users. This obviates the need for a central party to facilitate transactions between buyers and sellers. This disruptive change opens up limitless possibilities. It gives users access to a far broader array of tokens and helps to foster a more transparent and permissionless trading landscape. This guide serves as your map through the winding world of DEXs. It delivers a practical, nuts-and-bolts guide to getting started so you can grasp these powerful tools and make them work for you.
The emergence and rapid growth of DEXs such as Uniswap Protocol represent a transformative change in our entire financial ecosystem. All of these platforms process hundreds of billions of dollars of monthly trading volume, showing both their rapid growth and importance in the market. What sets DEXs apart from centralized exchanges, aside from the controversial ownership of assets, is how they empower users. Because of this, the risk of loss from hacking or malfeasance is drastically mitigated because users don’t ever have to send money to a central account. Further, this self-custodial nature is a big selling point for many users who are attracted to these platforms’ purported security and autonomy.
Although the underlying idea of decentralization is the same on all DEXs, the methods they use to achieve this can differ greatly. Let’s take a look at the most popular models applied in trading. We’ll take a look at Automated Market Makers (AMMs) and order book systems, how they work, their specializations, their advantages and disadvantages. It will explore DEX aggregators and cross-chain solutions. Building on ERC-721 These ideas form the pillars for promising new advancements in the decentralized trading arena.
This guide aims to emphasize the importance of understanding the dangers associated with DEXs. Know the risks, such as impermanent loss and smart contract exploits. To help users avoid falling victim to scams, it offers many practical tips for staying safe and making informed decisions when engaging in decentralized trading. This Build the Movement guide prepares readers by providing them with key information and resources. It gives them the knowledge and tools to move through the world of DEXs with confidence and open up the possibilities of decentralized finance.
Overview of Decentralized Exchanges (DEXs)
Decentralized exchanges are a radical break from centralized exchanges. They work based on the concept of disintermediation, which eliminates the necessity for a central authority to execute trades. This is partly made possible by smart contracts—self-executing agreements written in code that automate the trading process. Users can buy, sell, and trade cryptocurrencies directly on a DEX. This enables them to maintain complete control of their money without needing to rely on a third-party intermediary.
Definition and Purpose
A decentralized exchange (DEX) is essentially a peer-to-peer marketplace. Here, cryptocurrency traders can transact directly with one another without the need for an intermediary. Since centralized exchanges (CEXs) are custodial, they hold users’ funds. They internalize their clients’ orders by matching buys with sells on their own internal order books. DEXs have numerous benefits compared to CEXs, such as improved security, privacy, and access to more diverse tokens. The fundamental idea behind a DEX is to provide a more open, transparent and permissionless trading experience.
The goal of DEXs is much more than just making a new kind of place to trade. These initiatives lower barriers to entry. They give people more control over their money and the ability to engage with the global financial system and promote increased financial inclusion. DEXs offer increased access to a broader array of assets, as well as the removal of third-party intermediaries. Such a measure can help level the playing field and open up new paths to wealth creation. In addition to benefiting users through increased accessibility and liquidity, DEXs are integral to the growth and sustainability of the entire DeFi ecosystem. Thirdly, by offering liquidity for new and emerging tokens, they allow nascent projects to bootstrap their ribbon communities and gain positive momentum.
DEXs offer many benefits, but they come with their own set of challenges. It’s important to understand the other side as well. Considerations like impermanent loss, slippage, and front-running are critical for both profitability and user experience. As such, a keen awareness of these risks is critical to have before participating in decentralized trading. The important thing is to come to DEXs with a realistic yet optimistic attitude, understanding what they can and cannot do.
These platforms are incredibly ubiquitous. They are free to use, and anyone can access them from anywhere in the world. It’s that simple. All you need is an internet connection and a wallet that’s compatible with our platform! This global reach is vital for people living in countries where access to formal financial services is scarce. For users located in countries with strict cryptocurrency bans, DEXs provide an avenue to jump over these walls and enter the worldwide crypto market.
Key Features
DEXs have a few notable features that set them apart from their centralized counterparts. Together, these features make them a unique value proposition and highly desirable to an ever-growing segment of crypto traders. Knowing what these features are and how they work is key to making educated decisions about when to use a DEX and when not to.
Non-Custodial: Users retain control of their private keys and funds at all times, reducing the risk of theft or loss due to exchange hacks. This is arguably the most important feature of DEXs, as it addresses one of the primary concerns associated with centralized exchanges.
Permissionless: Anyone can list a token on a DEX without requiring approval from a central authority. This fosters greater innovation and allows for the trading of a wider range of assets, including those that may not be listed on CEXs.
Transparent: All transactions are recorded on the blockchain, providing a transparent and auditable record of trading activity. This transparency can help to prevent market manipulation and increase trust in the platform.
Automated Market Makers (AMMs): Many DEXs use AMMs to provide liquidity and facilitate trading. AMMs rely on algorithms to automatically adjust prices based on supply and demand, eliminating the need for traditional order books.
Smart Contracts: DEXs are powered by smart contracts, which automate the trading process and ensure that transactions are executed according to predefined rules. These smart contracts are typically open-source and auditable, further enhancing transparency and security.
DEXs do not stop at peer-to-peer trading. They often offer sophisticated trading features such as limit orders, stop-loss orders, and margin trading. One key thing to keep in mind is that not all of these features are available on every single DEX. User experience on DEXs can typically be even more intimidating than what’s possible on CEXs. To navigate them successfully, users should have at least a cursory knowledge of blockchain technology and decentralized finance.
These features combined create a trading ecosystem where security and transparency are central values. This means that it is easier to use than the normal, centralized exchanges. Despite the perks, it’s essential to seriously consider the advantages and disadvantages of employing a DEX prior to proceeding. Look at things such as trading volume and liquidity. Consider what features the DEX has to offer.
Understanding Automated Market Makers (AMMs)
Automated Market Makers are one of the most important features powering many decentralized exchanges (DEXs). They make trading more decentralized, removing the need for traditional order books. Together, they make a unique revolutionary new force for change in the finance world. These innovations provide a new, more efficient way to deliver liquidity and make trading continuous and automated, entirely permissionlessly. To get started with decentralized trading, it’s important to understand how AMMs work.
How AMMs Work
AMMs rely on underlying mathematical equations to control the price of assets in a liquidity pool. AMMs make markets in a different way—they don’t rely on buyers and sellers to determine prices through an order book. Rather, they use a formula to dynamically price assets by automatically buying or selling assets against the other pool assets. This is important, as it allows continuous liquidity for traders even when there’s no one actively looking to buy or sell.
The most common type of AMM uses the constant product formula: x * y = k, where x and y represent the quantities of two different assets in the liquidity pool, and k is a constant. This formula allows the product of the two assets to stay constant, no matter how large the trade execution is. Each time a trader buys one asset, they are effectively selling the other asset back to the pool. As a result, the price changes instantly.
Take, for instance, a liquidity pool made up of ETH and DAI. Then, when a trader wants to purchase ETH using DAI, they remove liquidity, adding the DAI to the pool. In return, they are paid ETH for doing this work. To get things started, they will pump significantly more DAI into the pool while pulling back significantly on ETH. As a consequence, the value of ETH will go up. So the AMM will keep iterating the price until ETH * DAI = k constant.
Liquidity providers, or LPs, are the lifeblood of the AMM ecosystem. In exchange for depositing these assets into the liquidity pool, they earn a fraction of the trading fees generated by this liquidity. LPs do real work in providing liquidity that facilitates asset purchases and sales between traders without significant price slippage. This reduces slippage, defined as the difference between the expected price and market price of a trade. LPs assume the risk of impermanent loss. This occurs when the prices of the tokens in a given liquidity pool significantly deviate from one another.
The ease of use and automated nature of AMMs have turned them into a staple feature for DEXs. They do this by removing intermediaries, permitting anyone else in the economy to engage directly in the trading process. Educate yourself on the dangers of AMMs before diving head first. Especially understand impermanent loss and slippage if you plan to provide liquidity or trade on any DEX that uses this model.
Liquidity Pools and Impermanent Loss
Liquidity pools are the foundation of AMMs. These are in effect pools of tokens, locked in a smart contract and utilized to allow trading to occur. Anyone can enter the LP game, simply by depositing tokens into a pool. In exchange, they receive a portion of the trading fees. LPs run the risk of impermanent loss. It’s an important idea to understand when participating in AMMs.
Impermanent loss happens when the price of the assets in the liquidity pool moves drastically in opposite directions. Let’s say an LP deposits ETH and DAI into a 50/50 ETH-DAI pool. For example, if the price of ETH greatly increases in relation to DAI, the LP will now experience impermanent loss. In practice, the AMM rebalances the pool in order to maintain the constant product formula. So, as an outcome, the LP will end up with less ETH and more DAI than they deposited.
Impermanent loss would suggest that this loss is only realized once the liquidity provider (LP) removes their token pair from the pool. Until then, the loss is not fully acknowledged. If the price of the assets in the pool go back to where they started, then the impermanent loss goes away. But if the LP chooses to withdraw their liquidity while the price divergence is still there, they will lock in that loss and lose money.
The extent of impermanent loss depends entirely on how far prices have moved from each other. The larger the divergence, the larger the possible value. In severe scenarios, impermanent loss can exceed the cumulative trading fees gained by the LP, putting them in a net loss position.
To minimize the risk of impermanent loss, LPs can take well-informed steps. They can deposit their assets into liquidity pools with stablecoins or highly correlated assets. They could implement strategies like hedging or supplying liquidity to low-volatility pools.
Finally, it’s worth mentioning that impermanent loss is not exclusive to AMMs. Large price discrepancies may occur across exchanges with an order book structure. This is especially true when there’s a huge spread between the bid and ask prices. The automated nature of AMMs raises the stakes and makes impermanent loss a more frequent anxiety for LPs.
Even if you’re just looking to swap tokens on a DEX, it’s important to understand impermanent loss. It's important to carefully weigh the potential risks and rewards before depositing assets into a pool. With a firm grasp on the mechanics of impermanent loss, LPs can better equip themselves to make smarter decisions and yield the greatest possible returns.
Navigating Different DEX Platforms
The decentralized exchange ecosystem is vast and complex, with many platforms catering to different user needs and preferences. Core principles of decentralization aside, the ways in which users interact with decentralized tools and the tools themselves can differ wildly. Recognizing these distinctions is key to selecting the best DEX for your specific goals and priorities.
Overview of Popular DEXs
Some of the most popular DEXs include:
Uniswap: One of the earliest and most well-known AMM-based DEXs, Uniswap is popular for its simplicity and ease of use. It supports a wide range of tokens and offers a straightforward trading experience.
Curve: Curve specializes in trading stablecoins and other assets that are pegged to the same value. Its AMM is designed to minimize slippage and impermanent loss for these types of assets.
SushiSwap: A fork of Uniswap, SushiSwap offers additional features such as token rewards for liquidity providers and a decentralized autonomous organization (DAO) that governs the platform.
Balancer: Balancer allows users to create and manage their own custom liquidity pools with multiple assets and adjustable weights. This provides greater flexibility and control over liquidity provision.
PancakeSwap: A popular DEX on the Binance Smart Chain, PancakeSwap offers a wide range of features, including trading, staking, and yield farming.
THORChain: THORChain stands out by enabling cross-chain swaps of native assets, such as Bitcoin and Ethereum, without requiring wrapped tokens.
Jupiter: Jupiter is a DEX aggregator on the Solana blockchain that optimizes swaps across multiple DEXs to find the best prices and minimize slippage.
Each of these DEXs offer something different in terms of features, fees, and what tokens you can use. That’s why it is crucial to do your homework comparing features and functionalities of various platforms before selecting one to launch on. Other things to look for are the trading volume and liquidity, security of their exchange, user-friendly layout, etc.
DEX Aggregators and Cross-Chain Solutions
Beyond the individual DEXs, DEX aggregators are playing a huge role. On top of this, cross-chain solutions are broadening the horizons for decentralized trading even further! These platforms fill many of the gaps found in single DEXs and provide their users with a wide-ranging trading experience.
DEX aggregators such as 1inch and Matcha interact with multiple DEXs. For one thing, they automatically route your trades through the platform that has the best price. This further helps users save money and avoid slippage, particularly on larger trades. DEX aggregators improve the trading experience by offering users one interface to access all DEXs.
Cross-chain solutions, like THORChain, allow users to exchange assets from different blockchains without using wrapped tokens. This new addition allows them to easily exchange Bitcoin for Ethereum and vice versa. They can do this without passing through a centralized exchange or a bridge. Cross-chain solutions are starting to gain traction in the DeFi ecosystem. They’re planning to do this by massively improving interoperability.
THORChain allows users to swap assets directly between different blockchains, like Bitcoin and Ethereum. It functions as a direct connection, cutting out the need for wrapped tokens or a bridging step entirely. This is a big deal, and it’s a big step forward for DeFi. It removes the need for trusted third parties and reduces the threat of hacks and exploits.
As a final note, don’t forget that like other DEX aggregators, DODO has its own risks. Cross-chain solutions bring their own challenges that users should consider. DEX aggregators can be susceptible to smart contract exploits and cross-chain solutions can be overly complicated and clunky. It is very important that you research and know the risks involved before using these platforms.
Ultimately the best DEX or DEX aggregator to use comes down to what you need and want. Look at the assets you plan to exchange. Consider the transaction fees you are comfortable with paying and the degree of security and ease of use that you need.
Step-by-Step Guide to Trading on a DEX
Trading on a DEX may seem daunting at first, but the process is generally straightforward once you understand the basic steps. This portion of our DEX tutorial will walk you through the process step-by-step and enable you to confidently initiate your first trade on a DEX.
Setting Up a MetaMask Wallet
First, create a crypto wallet compatible with the DEX. Once your wallet is set up, you’re ready to start trading! MetaMask is the most popular and widely used wallet for interacting with DEXs and other DeFi applications. With this simple browser extension, you can buy, send and receive crypto all in one place. More importantly, it opens the door to a world of decentralized, Web3 goodness.
First, you’ll want to install a MetaMask wallet and deposit it with some cryptocurrency. Finally, you’re ready to start trading on a DEX!
- Download and Install MetaMask: Go to the MetaMask website (https://metamask.io/) and download the browser extension for your preferred browser (Chrome, Firefox, Brave, etc.).
- Create a New Wallet: Once the extension is installed, click on the MetaMask icon in your browser toolbar and follow the prompts to create a new wallet.
- Secure Your Seed Phrase: MetaMask will generate a 12-word seed phrase that is used to recover your wallet if you lose access to your device. It is crucial to write down this seed phrase and store it in a safe and secure place. Do not store it on your computer or phone, and never share it with anyone.
- Confirm Your Seed Phrase: MetaMask will ask you to confirm your seed phrase by entering the words in the correct order. This ensures that you have properly recorded the phrase.
- Set a Password: Choose a strong password to protect your wallet from unauthorized access. This password will be required to unlock your wallet each time you use it.
- Fund Your Wallet: To start trading on a DEX, you'll need to fund your MetaMask wallet with some cryptocurrency. You can either purchase cryptocurrency from a centralized exchange and transfer it to your MetaMask wallet, or you can receive cryptocurrency from another wallet.
Once you’ve configured your MetaMask wallet, you’re ready to connect it to a DEX and begin trading. The precise steps will differ a bit based on the particular DEX, but the overall method is identical.
Making Your First Trade
Regardless of the platform used, most DEXs follow the same five steps:
Once you click the button to approve the transaction, it enters a queue to be processed by whatever blockchain network you’re using. The processing time may be very different, depending on how congested the network is and what gas fees you set. After confirming the transaction, the tokens should show up in your MetaMask wallet.
- Connect Your Wallet: Visit the DEX website and click on the "Connect Wallet" button. MetaMask will prompt you to authorize the connection.
- Choose Your Input Token: Select the token you want to trade from the dropdown menu. This is the token you will be selling.
- Choose Your Output Token: Select the token you want to receive in exchange for your input token. This is the token you will be buying.
- Select the Amount to Swap: Enter the amount of input token you want to trade. The DEX will automatically calculate the amount of output token you will receive based on the current exchange rate.
- Confirm Your Transaction: Review the details of your trade and click on the "Swap" or "Confirm" button. MetaMask will prompt you to sign the transaction. Review the transaction details in MetaMask and click on the "Confirm" button to submit the transaction to the blockchain.
It’s worth mentioning that DEXs facilitate trading with a small fee for each trade executed. This fee goes to paying liquidity providers and operating the platform. Make sure to consider the fees when determining the profitability of your trades.
Though DEXs provide distinct benefits, they introduce their own, unique risks. So it’s really important to be aware of these risks and actively safeguard your dollars. Here’s a look at some of the biggest dangers with using DEXs and how you can hedge your risk to get smart about being safe.
Staying Safe on DEXs: Risks and Precautions
There are a number of risks and misconceptions at play here that are specific to DEXs. Understanding these can help users make informed decisions and avoid potential pitfalls.
Common Risks and Misconceptions
Several common risks and misconceptions are associated with DEXs. Understanding these can help users make informed decisions and avoid potential pitfalls
