We have talked about decentralization before in previous posts but lets dive deeper into what a decentralized exchange is exactly. Here is a basic definition:
DEFINITION
A decentralized exchange (DEX) enables users to trade crypto assets using blockchain technology without the need for a custodian or centralized intermediary like a bank.A decentralized exchange commonly knows as DEX is a type of cryptocurrency exchange that operates in a decentralized manner, meaning that it operates on a distributed network of computers, rather than relying on a central authority to manage transactions. In a DEX, buyers and sellers trade cryptocurrencies directly with each other, using smart contracts and blockchain technology to execute trades and settle transactions.
Decentralized exchanges are different from centralized exchanges in that they do not rely on a centralized order book or matching engine. Instead, they use automated market makers (AMMs) or other decentralized protocols to determine the price of assets and facilitate trades. Because they are decentralized, they are often seen as more secure and transparent than centralized exchanges, as they are less susceptible to hacking and manipulation.
Some examples of decentralized exchanges that you may have heard of already include Uniswap, SushiSwap, and PancakeSwap.
As mentioned above at a higher level, a DEX operates on a distributed network of computers, with no central authority controlling the exchange of assets. Instead, buyers and sellers trade cryptocurrencies directly with each other, using smart contracts and blockchain technology to execute trades and settle transactions.
But how do they do it?
To achieve this, DEXs typically rely on one of two approaches: order book-based trading or automated market making.
In an order book-based DEX, buyers and sellers can place orders for specific cryptocurrencies, specifying the amount they wish to buy or sell and the price at which they are willing to trade. The exchange matches buyers and sellers based on these orders, and once a match is found, the assets are exchanged, and the trade is settled on the blockchain. This is similar to how centralized exchanges like Coinbase and Binance operate.
On the other hand, automated market maker (AMM) based DEXs use algorithms to set prices and facilitate trades. In an AMM-based DEX, liquidity providers (LPs) pool their assets into a smart contract and receive liquidity provider tokens in return. These tokens represent the LP’s share of the liquidity pool and can be traded on the DEX. When a user wants to make a trade, they execute a transaction on the blockchain that swaps one asset for another, with the price determined by the ratio of the assets in the liquidity pool. This means that trades can happen even if there are no existing orders on the DEX.
Decentralized Exchange Fast growth
The usage of decentralized exchanges (DEXs) has grown significantly in recent years. According to Dune Analytics, a website that tracks decentralized finance (DeFi) protocols, the total volume traded on DEXs in 2021 exceeded $1.5 trillion, a huge increase from the roughly $65 billion traded on DEXs in 2020.
The number of unique wallets interacting with DEXs has also been steadily increasing. For example, Uniswap, one of the most popular DEXs, has seen the number of unique wallets trading on the platform increase from around 40,000 in January 2020 to over 2 million in December 2021. Similarly, SushiSwap, another popular DEX, has seen the number of unique wallets trading on the platform increase from around 500 in August 2020 to over 300,000 in December 2021.
Overall, the growth of decentralized finance and the increasing popularity of cryptocurrencies have contributed to the growth of DEXs. DEXs offer benefits like increased security, transparency, and trustlessness, which make them an attractive alternative to centralized exchanges. As the crypto market continues to grow and mature, it is likely that more people will start using DEXs as a way to trade cryptocurrencies.
Other decentralized exchange uses
In addition to trading cryptocurrencies, there are several other things you can do on a decentralized exchange (DEX). Here are some examples:
Provide liquidity: Liquidity providers (LPs) can deposit their assets into a liquidity pool on a DEX and earn fees for providing liquidity to the platform. This is a way to earn a passive income on your cryptocurrency holdings.
Vote on governance proposals: Some DEXs have a governance token that allows holders to vote on important decisions, such as protocol upgrades, fee structures, and other changes to the platform. This gives users a voice in the direction of the platform and can help promote decentralization and community-driven decision making.
Yield farming: Yield farming is a way to earn additional rewards by providing liquidity to specific pools on a DEX. Users can earn additional governance tokens, or other incentives such as a percentage of the trading fees generated by the pool they are providing liquidity to.
Access decentralized finance (DeFi) applications: Many DeFi applications, such as lending and borrowing platforms, are built on top of DEXs. By using a DEX, users can access a range of DeFi applications and services.
Participate in initial token offerings: Some DEXs offer a platform for new cryptocurrency projects to launch their tokens. This is known as an initial DEX offering (IDO), and it allows users to purchase new tokens and participate in the launch of a new project.
Overall, decentralized exchanges offer a range of functionalities beyond just trading cryptocurrencies, and their ecosystem is constantly evolving with new features and opportunities.
