DEXs: The What, The Why & The How of Decentralized Exchanges

Industry InsightsMarch 19, 2024

In this article, we dive into Decentralized Exchanges. We explore the benefits, challenges, and differences between this model and classic centralized ones. Read through and understand why DEXs are gaining popularity with web3 users, what market makers are, and much more.

A Decentralized Exchange (DEX) is an exchange platform to trade tokens that operates without a central authority or intermediary. Instead of relying on a centralized entity — like a bank or another financial institution — to facilitate trades and hold assets, it allows users to trade directly with each other using smart contracts or other decentralized protocols. This approach offers greater privacy, security, and control over assets compared to centralized exchanges, which are vulnerable to hacking, regulatory scrutiny, and other risks. In this article, Hackernoon calls DeFi the “Wild West” of the finance world because it opens the door to a more global, free, and speculative world where users have control over their assets.

CEXs & DEXs: Main Differences

The first crypto exchanges to emerge were centralized, meaning they were controlled by an entity — much like any other financial hub like the housing market or the stock exchange. Convenient, secure, and offering high liquidity, and a wide pool of different assets, this kind of exchange is still the most popular amongst crypto traders.

However, DEXs are also making their way to the top, mainly due to its decentralized nature. Blockchain maximalists believe this is the way to go when it comes to trading — there are no intermediaries, so users have total control over their assets. It’s more private and secure. There are hundreds of DEX projects and although you might not know all of them, you’ve probably heard about UniSwap, PancakeSwap, SushiSwap, Curve, and HydraDX, which are the hottest decentralized exchanges right now.

Benefits of DEXs

In a way, DEXs are more secure because they operate with non-custodial wallets (a type of crypto wallet where the user has total control and responsibility over its private keys) and aren’t managed by an intermediary, thereby minimizing the risks of hackers accessing it. Since these exchanges are operated via algorithms and smart contracts, there’s no need for middlemen, thus eliminating the fees market makers request in CEXs. Trading in DEXs has a trustless nature because users don’t need to trust a central authority. Privacy is yet another benefit largely connected to decentralized platforms as you don’t have all the KYC requirements presented in CEXs.

Challenges in DEXs

However, there are a few things that can make trading in DEXs challenging. Decentralized exchanges offer a more limited offer of tokens, and the fact that it’s not regulated by an entity might make it less trustworthy — banks and other financial institutions operate under strict laws and regulations. DEXs typically have lower liquidity compared to centralized exchanges. This can lead to issues such as slippage, where the execution price of a trade differs from the expected price due to insufficient liquidity. Another disadvantage is related to the user experience — DEXs may not be as polished or intuitive as centralized exchanges. This can deter less experienced traders from using them. When it comes to transactions on DEXs, slowness and lack of scalability can also be an issue, especially when networks are congested, thus resulting in delays in order execution and confirmation times. Centralized exchanges have a wider availability when it comes to token diversity, which is better for traders who value variety in crypto. Another obstacle to the use of DEXs is the price fluctuation from platform to platform.

Market Making & Liquidity: A Match Made in Blockchain

Market makers were always fundamental pieces in the world of trading and exchange, but perhaps the most well-known ones are brokerage houses. These firms act as intermediaries between house buyers and sellers, ensuring both parties find what they want and get a fair deal. What do they gain with each business? A commission over every sale.

The same happens with market makers in blockchain. These firms or individuals are key in centralized crypto exchanges — they act as intermediaries as well, with the main goal of providing liquidity (by ensuring optimal demand and supply) to traders. In this The Block article, Tim Copeland sums it up pretty well: Market makers set offer prices and bid prices for trading pairs, and can step in as a buyer or seller in a transaction when there’s no suitable counterparty available (…) By continuously providing offer prices and bid prices, they ensure a high level of liquidity in the order books, which is essential for the smooth execution of trades”. In simpler words, market makers are wholesalers of the financial markets — this includes cryptocurrency ones. These people also shape market prices and behaviors in the sense that they are the ones setting the tokens’ values. Just like in every other financial market, a currency will be cheaper if the demand is low and the supply high, but it will become more expensive as the latter decreases, and the demand increases. In a way, market makers work as a market regulator.

However, traditional ones now have competition: the Automated Market Makers (AMMs), which operate in the decentralized exchanges. The main difference between these two models is that the latter works via an algorithm rather than actual people. It’s also more secure because the algorithm factor ensures continuous liquidity. AMMs are also open to more people — everyone can participate in trading and fees are much lower than the ones presented by traditional market makers. Decentralization is yet another attractive element of AMMs: they operate without intermediaries, making it a more autonomous service that can be controlled by the users themselves. There are also downsides to using this automated tool, namely price slippage.

Liquidity Provider and Their Role in DEXs

Anytime one opens a DEX app or website, there’s that expression: Liquidity Providers (LPs). But what are they and why are they so important in the context of decentralized exchanges? LPs are people (traders) who ensure the market’s liquidity by depositing cash (in the form of tokens) in a pool. That money represents the amount of each contribution in the liquidity pool’s total. In return for helping increase liquidity, LPs get LP tokens.

UniSwap: Three Versions, One Goal

UniSwap is the most popular and trusted DEX nowadays. It’s interesting to look at the evolution of this platform since v1 was released by Hayden Adam, in November 2018. Since then, two more versions have been launched, and although v2 and v3 present updates and improvements to v1 all three are simultaneously operational. Like in many other DEXs, Uniswap also has LPs adding liquidity and the exchange allows the LP tokens to be staked or burned to get rewards — there’s a trading fee of 0.3% associated with the process of redeeming these.

There are major differences between them: the first one — also known as beta — was mostly a proof-of-concept. Users could trade and there was a high level of liquidity, but things weren’t as flexible as in v2 or v3. Its use of AMMs took the trading industry by storm.

Uniswap V1 only allowed the swapping of ETH (the Ethereum token) and ERC20 tokens. If you wanted to trade a different crypto, you first had to convert it.

UniSwap V2 solved this bridging issue and introduced more liquidity pools, greatly reducing trading costs. The updated version offers a more user-friendly experience and takes on the ETH bridging issue by implementing ERC20-ERC20 pools. V2 also introduced a novel tool: Flash Swaps transactions. It basically eliminates the need for collateral, enabling access to higher volumes of liquidity without minimal funds. This type of transaction allows traders to borrow assets from a decentralized protocol, execute arbitrary logic, and then return these assets in a single Ethereum transaction. The second version of Uniswap introduced a protocol fee where traders have an active role in the DEX’s development — 0.05% of the 0.3% trading fee goes to exactly that.

Uniswap V3 introduced the concept of concentrated liquidity — providers can specify a price range for their liquidity. This allows for much higher capital efficiency and returns. With this new version, LPs can design their price curves according to their preferences to enhance liquidity. V1, V2, and V3 also present differences in the fees’ structure. While V1 had a flat trading fee of 0.3%, V2 reserves part of this value for platform developments. In V3, the trading fee varies — stablecoins have a fee of 0.05%, standard non-correlated pools are subject to 0.3%, and non-correlated pairs, to 1%. In the latest version, the protocol fee (available in V2) is off by default, but users can set it to a value between 10 and 25%.

The Polkadot ecosystem also offers a variety of different DEX solutions like HydraDX, Snekswap, Polkadex, Stellaswap, Zenlink, Polkaswap, and Solarbeam. We will dive into these in another article soon.

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