in Decentralized Finance (DeFi), Insights
Blockchains provide a new way to trade cryptocurrency: the Decentralized Exchange (DEX). Little more than a set of smart contracts and a user interface, a DEX provides a host of advantages for an investor.
We’ll take a closer look at how DEXs work and their main advantages and disadvantages. Then we’ll mention several of the most popular DEXs you can use.
What is a DEX?
In traditional stock or commodities markets, buyers and sellers trade with each other. If you want to buy some Tesla shares or coffee futures, there must be someone else willing to sell at a price you both agree on.
A Centralized Exchange (CEX) like Coinbase or Kraken works the same way. You can specify the most you’re willing to pay for a particular coin or just pay the current market price, then wait until a seller comes along to take your offer.
A DEX is quite different. It won’t exchange crypto for fiat currency–only trade one coin for another. For each trading pair, for example Tether (USDT) and Ethereum (ETH), it maintains a Liquidity Pool. A Liquidity Pool is a fund containing equal dollar amounts of each coin or token—for example, $10 million each of USDT and ETH.
Traders who offer to either buy or sell at the right prices (to make a profit on the difference) are called Market Makers. Because a DEX holds the coins you want to trade, it calculates a price (including a fee) according to a formula. This is known as an Automated Market Maker (AMM). Investors who provide liquidity to a DEX by staking crypto are called liquidity providers, and earn a portion of the trading fees for doing so.
Most DEXs use a constant product formula, which adjusts the exchange rate to keep the market balanced. The total value of each coin in the pool, multiplied together, must be a constant value.
So, if you trade USDT to get ETH, the price of USDT falls and ETH rises. This encourages other traders to buy up the now-cheaper USDT, thereby rebalancing the pool.
DEX Pros and Cons
There are strong reasons to choose a decentralized exchange for trading. One is convenience. Unless you’re a big-time day trader, your crypto should be in a secure non-custodial software wallet such as Exodus, or a hardware wallet. You’ll probably have to move it to a CEX, make the trade and move the new coins back to your wallet, although Exodus does feature direct access to the FTX exchange.
To trade with any DEX, you connect a Web3-compatible wallet, define your trade and click a button. Although the Exodus wallet isn’t yet compatible, it also includes an Exchange feature to trade coins on DEXs via a selection of services including AEROSWAP and Switchain.
DEXs also provide much greater privacy, with no need for KYC identification. Nobody but you knows what you’re buying or selling. They’re also more secure; coins remain in your wallet or locked in a smart contract, so you can’t lose funds from hackers.
DEXs are ideal for trading new cryptocurrencies. Getting listed on a reputable CEX takes time and significant market capitalization, whereas most DEXs will list a new coin if a large enough liquidity pool is provided.
On the downside, DEX fees are usually a little higher. And without KYC, transactions can’t be reversed.
Another issue is price slippage. The larger your trade, the more it unbalances the liquidity pool, changing the calculated price. Thus, you should specify the amount of slippage you are willing to accept–the difference between the quoted and final prices. For a well-funded trading pair, this should be 3% or less.
Finally, DEXs are more susceptible to front-running. A trader, often a crypto miner, sees an upcoming transaction and increases his own fee to get his order confirmed first at a lower price. Some DEXs use more complex pricing formulas to mitigate this problem.
Choosing a DEX
With literally hundreds available, how do you choose a DEX? Firstly, most DEXs focus on tokens on the same blockchain. Also, more active exchanges usually have larger liquidity pools and thus more stable prices.
DEX statistics are available on CoinMarketCap and CoinGecko. Because smart contracts can’t be altered, multiple versions of some DEXs do exist.
Here are a few possibilities to consider:
Uniswap (V3) is the latest version of the immensely popular Ethereum-based exchange, with nearly 700 trading pairs generating around $1 billion in daily volume. Launched in 2018 as a marketplace for ERC20 tokens, V3 enhancements include a more flexible fee structure, improved price oracle and a more subtle liquidity model. Its UNI token is used for governance.
SushiSwap forked from Uniswap in 2020 with the goal of “stripping power from VCs and returning it to the community.” A portion of swap fees are distributed in SUSHI tokens as staking rewards.
PancakeSwap (V2) is the foremost DEX for swapping BEP20 tokens on the Binance Smart Chain. Its CAKE token is used to provide liquidity.
TraderJoe is the largest DEX using the Avalanche blockchain, combining exchange services and DeFi lending to offer leveraged trading. LPs earn a share of fees in JOE tokens.
Serum is a DEX built on the Solana blockchain. Holders of its SRM token are charged lower fees. Liquidity is provided by the Raydium AMM, which has access to Serum’s order flow, a strategy to eliminate front-running.
ShibaSwap is a DEX based on Shiba Inu. Continuing its dog theme, users stake (“bury”) SHIB to provide liquidity and earn BONE, its governance token..
1inch Network is a DEX aggregator, functioning much like travel websites that search multiple sources for the lowest airfares. It searches over 120 sources on Ethereum, BSC, Polygon and other blockchains. Users can execute limit orders, provide liquidity and move coins between different pools. Its governance and utility token is 1INCH.
As new blockchains come online ever faster, new DEXs seem to appear almost every day. For better or worse, they embrace the cryptocurrency features of privacy, trustlessness and censorship prevention. These however come at the cost of requiring users to assume greater personal responsibility for the safety of their funds.
This content is for informational purposes only and is not investment advice. You should consult a qualified licensed advisor before engaging in any transaction.