DEXs are the winners right now!! Amidst the prolonged bear market, the famous collapse of the FTX cryptocurrency exchange and other high-profile crypto firms has turned people’s attention to their on-chain competitors.
Decentralized exchanges offer investors more control over their assets, where no one can commingle or gamble it all away. The DeFi revolution promised to disrupt global markets by removing intermediaries. Centralized trading has taken away some of that potential, which is where DEXs come in.
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Simply, decentralized exchanges are peer-to-peer (P2P) marketplaces where crypto buyers and sellers transact directly without having to hand over the management of their funds to any custodian or intermediary. These peer-to-peer transactions are facilitated through smart contracts, self-executing agreements written in code.
Decentralized exchanges are foundational to DeFi, as they brought about innovations that solved its liquidity-related problems, attracted users, and contributed largely to its growth.
Both centralized and decentralized exchanges have a role in crypto trade but have different strengths.
One major difference between CEXs and DEXs is custody. No central or third-party authority is required in the operation of a DEX, which gives users complete control over funds traded and offers a higher degree of security compared to CEXs. While many believe CEXs are faster and provide a better user experience, DEXs have recently improved in those areas.
Another major difference is the method of trade facilitation. On a centralized exchange, buyers and sellers are matched with off-chain order books; a model TradFi exchanges have used for a long time. DEXs use different systems like the order book model, both off-chain and on-chain, and an entirely different model known as Automated Market Maker (AMM).
CEXs benefit users as a ‘fiat onramp.’ This means that they provide simple ways to purchase crypto with government-issued currencies (USD, EURO, or GBP) and sell crypto to receive the same. Although this also allows the government and traditional finance entities to restrict users.
DEXs, on the other hand, are truly open to anyone because no institution dictates the exchange rules. Privacy is one of the main drivers of cryptocurrency use, and DEXs put this at the main. Also, DEXs provide yield-generation opportunities for users that provide liquidity to AMMs.
As stated above, DEXs work with different models and allow users to swap cryptocurrencies easily on or across blockchains.
The order book model is popular with TradFi exchanges to execute transactions. Order books consist of lists of buy and sell orders organized based on prices traders want to transact for specific assets. Institutions manage the list market participants entrust for their orders (sell at a particular price) and connect with matching buy orders (buy at that price). The spread between these prices goes a long way to determine the order book depth and the market price on such an exchange.
The two types of order book DEXs are On-chain and Off-chain order book DEXs.
On-chain order book DEXs are hosted directly on the underlying blockchain network, and orders are automatically executed when the prices of two orders intersect.
Off-chain order book DEXs host their order book outside of the distributed ledger but have to simultaneously update the blockchain for every transaction with reduced gas fees.
Although the order book model is intuitive and efficient, Automated Market Makers are a more popular way of facilitating asset exchange on DEXs. The AMM model was first used by Uniswap in 2018, based on the concept ideated by Vitalik Buterin, founder of Ethereum.
AMMs rely on smart contracts and blockchain-based services known as blockchain oracles.
Blockchain oracles provide access to outside information and a direct way to validate conditions smart contracts are based on. In short, they offer data that triggers smart contracts to execute when the original terms are met.
These oracles provide information from exchanges and other outside platforms to set the prices for traded assets. Then instead of matching buy and sell orders, the smart contracts make use of pre-funded pools of both assets, known as liquidity pools.
Simply put, the model consists of a liquidity pool that holds two tokens and is then governed by an algorithm that maintains the balance of the pool.
The pools can be funded by users, allowing anyone to participate in a permissionless manner by depositing equal value of the two assets. Liquidity providers are entitled to part of the transaction fees charged by the protocol to execute trades on the asset pair.
It is important to note that volatile liquidity pools expose liquidity providers to risk of impermanent loss. Impermanent loss occurs when the price ratio of tokens changes after you have deposited them in the liquidity pool.
Also, slippage — a price difference when an order is placed vs. when its executed — is another risk to be wary of when using DEXs. A lack of liquidity can result in paying above-market prices on orders.
DEX Aggregators exploded onto the scene to solve a prevalent problem DEXes face: handling higher order volume, as large orders cause slippage.
DEX aggregators connect different DEXs and vet them to find the best possible price and option of split trading (splitting the trade across multiple DEXs) to reduce the risk of slippage.
The future is promising for DeFi, as it aims to eradicate the need for centralized entities and mediators. Decentralized exchanges will continue to grow in functionality and user experience to offer real competition to centralized exchanges.
As part of our mission to make DeFi accessible to everyone, Verto DEX will soon be available on the Rebuschain to bring together different worlds of Play2Earn, Metaverse, and TradFi.