How do DEXs work?

DEXs have existed in crypto in one form or another as early as 2012 to 2014, depending on how you qualify a DEX. Which DEX was the first might be in dispute, however it seems clear that one DEX in particular changed the landscape forever: Uniswap. Uniswap brought with it the first working decentralized automated market maker (AMM). Before AMMs, DEXs struggled with liquidity problems. AMMs made it easier and more attractive to add liquidity.

Read more: What is liquidity?

Before Uniswap came along with a working AMM, trading on a DEX was slow, and cryptoassets on the exchange often traded at a premium to the same cryptoasset on a CEX. This is because prior to AMMs, DEXs tried to mimic the way centralized exchanges facilitated trades. The problem is that the methods used by CEXs use techniques that require lots of computation with low latency. Translating the same methods to DEXs meant they were much much slower, and still required some centralization. To make matters worse, the poor experience of early DEXs scared away people from providing their funds to be traded against, which prevented those DEXs from gaining traction and gathering the needed liquidity.

AMMs solved this by incentivizing the creation of pools of liquidity, and enabling those pools to be  algorithmically traded. The incentive takes the form of fee sharing. Specifically, people who add liquidity to a DEX receive a share of the fees generated when other participants trade. As for the trading algorithm, it involves a formula that balances the remaining balances of the two assets in a trading pair. The important thing to remember is that two assets aren’t actively paired in real time, rather a program determines the price depending on the remaining amount of both assets.

What are the advantages of DEXs?

Decentralization brings with it many advantages over centralized counterparts. First,  new cryptoassets almost always appear considerably earlier on DEXs than CEXs. This is because CEXs must manually add cryptoassets to their system. Adding new projects typically entails layers of compliance, testing, and authorization by layers of management. With a DEX, any new token can be automatically added to the exchange without asking anyone.

DEXs do not require Know Your Customer (KYC) or anti-money laundering (AML) measures. The exchange itself does not exist in any one jurisdiction, so there isn’t a regulatory framework that applies to it. This has a number of implications. Firstly, DEXs conserve privacy. You can use DEXs anonymously without having to divulge information about yourself, including financial information such as your account balances. Furthermore, you can start trading immediately at a DEX. There is no lengthy verification process to pass before you can trade.

DEXs can benefit everyone, but they have the most utility in the developing world, where a lack of robust financial infrastructure has hindered traditional financial businesses from accepting many customers. The World Bank estimates that 1 billion people do not have an official proof of identity. These people would be unable to pass the loosest of KYC AML measures, yet with access to the internet they’d be able to trade on a DEX.

Lastly, you don’t have to trade to earn money on a DEX. There are several ways to earn, for example, anyone can provide liquidity on a DEX and earn a portion of fees. Additionally, many DEXs integrate bonus rewards. These are typically paid in the DEX’s governance token.

What are the disadvantages of DEXs?

By far the biggest barrier to using DEXs is the UI/UX difficulty. It is confusing and hard to get cryptoassets into a wallet, and then navigate the user interfaces of most DEXs. There’s a lot of up-front learning involved before you will be able to execute a single trade. This can be made more difficult by the fact that transactions often fail for a variety of reasons, and the support sometimes isn’t particularly helpful.

Because anyone can add a cryptoasset to a DEX, scams are ever present. Any legitimate project will spawn dozens of scam projects with the same name or slightly different names to try and trick you into swapping your cryptoassets. Additionally, since none of these projects need to be vetted beforehand, projects that seem legitimate can turn out to be scams that take your money. In order to participate in this unregulated, wild west space, it’s necessary to do research before trading a new coin. You can read white papers, join Telegram groups and Discords, search Twitter, or read Medium blogs and articles.

Every action you take on a DEX requires the usage of gas, which can be expensive. On Ethereum, the most popular blockchain by far, simply swapping on a DEX can cost upwards of $100 dollars (depending on the state of congestion at the time of trade). Other chains have lower fees, though far less activity too. Another drawback is that AMMs, particularly where liquidity is limited, still suffer from slippage. The more you wish to trade, the more likely the price will slip from what you want to pay. Lastly, since DEX activity is all on-chain it is public, programs (bots) can monitor what people are trying to trade, and front-run their orders. This means you end up paying more for your trade than you would have otherwise.

Finally, providing liquidity in a liquidity pool comes with some amount of risk compared to centralized exchanges. This is largely because adding or removing liquidity from a liquidity pool costs some amount of gas, takes longer to execute, and the tools available to actively manage liquidity pools even for modest actions like removing liquidity, require more technical expertise than centralized exchanges. For less sophisticated investors, it is likely more profitable to simply hold your cryptoassets, rather than putting them in a liquidity pool.