What is a decentralized exchange (DEX)?

DEX exchanges allow the direct exchange of cryptocurrencies between users, with certain advantages over centralized exchanges (CEX).

A decentralized exchange (DEX) is a space where people can trade cryptocurrencies without intermediaries. To better understand what a DEX is, it is important to first understand how they work.

Operation of centralized exchanges (CEX)

A centralized exchange (CEX) like Gate is a web platform or application where users can buy, sell, or exchange the listed cryptocurrencies and tokens.

Let's imagine you want to acquire Bitcoin.

You could go to an exchange, register by providing bank details and identity information, and deposit funds. (Sometimes, this process can take days, which is a disadvantage of centralized exchanges compared to DEX). The exchange will indicate the price - based on an "order book" of people buying and selling at different values - and you will be able to execute the transaction.

What happens next?

The exchange will display those bitcoins in your account, and you will be able to exchange them for other tokens within the platform. However, you do not actually own them, as you are entrusting the exchange with the custodian function on your behalf. Any operation you perform, such as exchanging Bitcoin for Ethereum, does not occur on a blockchain, but rather in the exchange's database.

Exchanges group users' cryptocurrencies into wallets ( generally "hot" - connected to the internet ) controlled by the exchange. The exchange controls the private keys. ( There are ways to avoid this, as exchanges allow transferring tokens to a private wallet, but this adds an extra step if you later want to trade with that cryptocurrency ).

The appeal of decentralized exchanges, according to their supporters, is security. A centralized exchange can limit access to your cryptocurrencies, restrict or interrupt your ability to trade them, or even make them vulnerable to cyber attacks.

On the other hand, CEXs are often much easier to use for beginners and can often offer quick transactions, as they do not rely on blockchain infrastructure.

Operation of decentralized exchanges (DEX)

DEXs address this in three ways: an on-chain order book, an off-chain order book, or an automated market maker approach.

In an on-chain order book, each transaction is recorded on a blockchain. This includes not only the purchase itself but also the purchase request or order cancellation. It is the peak of decentralization, but the need to record everything on a blockchain can make it more expensive and slower.

"A decentralized exchange facilitates trading between individuals but does not take control of their coins."

With off-chain order books, all of this happens elsewhere, with only the final transaction settling on the blockchain. As the orders are not stored on-chain, this method may present some of the security issues of centralized exchanges, but it is not as slow or costly as on-chain order books.

Automated market makers, or AMM for short, do away with order books. With order books, if you hold Chainlink (LINK) and want to buy Compound (COMP), you need someone with Compound to want Chainlink and be willing to trade at an agreed price.

AMMs eliminate counterparts and introduce algorithms to define the price, allowing you to exchange LINK for COMP regardless of whether there is someone on the other side of the trade. To facilitate this, they typically use "liquidity pools," essentially paying users for keeping part of their funds in a smart contract that can then be used for trading.

Individual users, therefore, play a fundamental role in facilitating operations.

Advantages of DEX exchanges

Decentralized exchanges do not require citizens to provide private information, such as social security numbers or addresses, which centralized exchanges are mandated to request under banking secrecy laws. So far, since DEX do not take control of the assets, they are not subject to these regulations.

Multiple options

DEX like Uniswap allow anyone to create a token pair. You can mint a new token and start exchanging it for a friend's token instantly. In this way, DEXs enable people to own tokens for use in decentralized finance (DeFi), services that allow saving, borrowing, lending, or trading without the need to resort to a bank or other financial institution.

Lower risk

Since your cryptocurrencies are not stored in a centralized exchange, but in a wallet with private keys, you are protected against cyber attacks. And although centralized exchanges may go offline for maintenance, you can continue trading on a DEX.

Disadvantages of DEX

No linked to bank cards

Decentralized exchanges only work with cryptocurrencies and not with fiat coins like dollar, euro, yen, as the conversion from cryptocurrencies to fiat coins would require the involvement of banks. Dollar transactions cannot be settled instantly like those based on blockchain. Therefore, you need to have cryptocurrencies to use a decentralized exchange.

( Complexity

Uniswap and many other DEX are built on the Ethereum blockchain. Any token traded on it must also be on the Ethereum blockchain. This means there will be no Bitcoin and many other popular tokens from competing blockchains.

In fact, this technically means that there will be no ETH. Users must convert their ETH into Wrapped Ether )WETH( - "Wrapped Ether" -, which has a price equal to that of ETH, in order to trade.

) No customer support

Centralized exchanges operate like banks. They have clients that they primarily want to keep satisfied. But in a truly decentralized exchange, there is no actor on the other side.

The developers who created the protocol do not have the same relationship with the users. Although there are entire communities of DEX users, you are responsible for your own money.

Your choice

Decentralized exchanges generally aim to adhere to the principles of blockchain, such as "lack of need for trust" and privacy. Your tokens remain in your possession until the moment of exchange. Some people find this reassuring from a security standpoint. For others, this level of responsibility is intimidating and the risks are concerning.

Most DEX proponents agree: these are the trade-offs for true decentralization.

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