A decentralized exchange (DEX) is a market for cryptocurrency that does not rely on any third-party entities or centralized authorities and organizations to hold customer funds.
In this article, we look at the rise of the DEX within the world of decentralized finance (DeFi), how it works, and the various advantages a DEX may offer over a traditional centralized exchange (CEX), as well as any disadvantages.
How Does a Decentralized Exchange Work?
Traditionally, a CEX requires you to forfeit the most vital piece of data: your private keys. When an exchange holds your private keys, like on a CEX, they essentially own your crypto and ultimately have control over whatever you may be storing on their platform. But as the saying goes, “not your keys, not your crypto.“, and this is where the DEX becomes a foundational part of the DeFi ecosystem.
By definition, a DEX is an exchange that does not rely on a third-party service to hold the customers’ funds. Instead, trades occur directly between users (peer-to-peer) through an automated process known as automated market-making. In this way, buyers, sellers, and traders do not need to be located in the same place to transact assets.
Advantages of Using a Decentralized Exchange
Advantages of using a DEX include:
- Self-Custody – Users always retain custody of their funds. Exchange hacks are impossible as there is no central entity storing user funds.
- Permissionless – No centralized entity can deny a user access to their exchange. All that is necessary to access a decentralized exchange is the internet.
- Trustless – No central entity can roll back the order of transactions. Once a trade is confirmed onto the blockchain – it is final.
Lastly, unlike a DEX, a CEX operates with little transparency into how they run their platform, which often leads to nefarious behavior, as there are no checks and balances to their power.
Disadvantages of Using a Decentralized Exchange
Disadvantages of using a DEX include:
- Lack of Oversight – There are no governing authorities to monitor transactions, offer assistance, or provide a legal framework.
- Legal Challenges – As more financial transactions get conducted via DeFi markets, they can pose challenges for regulators and legal enforcement.
Although the disadvantages of using a DEX are few, they tend to gravitate toward legal grey-areas otherwise not experienced by their centralized counterpart. In comparison, the centralized framework of a CEX gives regulators a clear path for taking action, if necessary, regarding trades that might be suspect.
The Most Popular Decentralized Exchange
The most popular DEX, Uniswap (UNI), offers a simple, one-click user interface (UI) to swap any two Ethereum (ETH) assets against an underlying liquidity pool.
Trading with Uniswap is trustless and permissionless thanks to liquidity pools which allow anyone to create a market by supplying it with an equal value of two ERC-20 tokens, called a token pair. Liquidity providers (LPs) earn a portion of the 0.3% trading fee each time the trading pair gets used in a transaction.
Below is a short-list of even more potential advantages to be had by utilizing the Uniswap DEX:
- Aave recently introduced something called the Uniswap money market – allowing users to provide LP tokens as collateral for loans.
- Applications can seamlessly integrate a Uniswap front-end into their product.
- Some projects offer incentives for providing liquidity on UNI.
As you can see from the several reasons mentioned above, utilizing a DEX offers an array of advantages with minimal drawbacks otherwise not available when trading on the more traditional model preferred by a CEX.
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