The collapse and controversies surrounding FTX, the world’s second-largest centralized crypto exchange, have cast a dark cloud of concern, distrust, and FUD among investors and speculators. Crypto traders have been looking for ways to protect their digital assets from scams, poor financial management, and even centralized control.
The event has also increased the importance of transferring cryptocurrencies from centralized exchanges to private addresses, as well as the use of decentralized exchanges rather than CEXs like FTX, which could go bankrupt and leave investors out of pocket. According to data from blockchain tracking firm Nansen, daily customer withdrawals on Binance, the leading centralized exchange, exceeded $3 billion in just 24 hours between December 12 and 13.
What is a Decentralized Exchange (DEX)?
A decentralized exchange (DEX) is a web platform built on top of one or more blockchains that allows users to buy, sell, and exchange cryptocurrency assets without the use of a central authority or intermediary. DEXs are typically decentralized applications (dApps) that are built on decentralized networks and use smart contracts to facilitate peer-to-peer transactions between users of the exchange.
These platforms, unlike centralized exchanges, are non-custodial, and users who wish to trade retain ownership and control of their cryptocurrencies.
How Do Decentralized Exchanges (DEXs) Work?
Decentralized exchanges use smart contracts with which traders can interact to store or trade digital assets. Many different types of DEXs rely on their own principles to function properly and as intended. Order Book DEXs, DEX Aggregators, and Automated Market Makers are the three main types of decentralized crypto exchanges that exist in the market.
Order Book DEXs
An order book is a digital record of buy and sell orders for a particular asset, such as fiat or cryptocurrency. It also serves as an engine that matches buyers to sellers based on the orders and bid prices. There are two types of order book DEXs:
- On-Chain Order Books: This type of order book DEX automatically executes transactions directly on the blockchain. DEXs such as Stellar and Bitswap use this method.
- Off-Chain Order Books: On the other hand, off-chain order book DEX uses a centralized entity outside a distributed ledger to complete transactions between traders. IDEX and EtherDelta are examples of off-chain order book DEXs.
This type of DEX, also known as a liquidity aggregator, uses data from multiple connected DEXs to increase liquidity, allowing it to accommodate higher order volumes and larger trades. DEX aggregators help to reduce slippage risk by introducing split trading options, which allow a single order or trade to be completed across multiple DEXs. For example, 1inch aggregates other DEXs and helps traders find cryptocurrencies at the lowest price.
Automated Market Makers (AMM)
Automated market makers are DEXs that use smart contracts to create liquidity pools and automatically execute trades without relying on buy/sell requests but rather on algorithms. Liquidity providers or market makers contribute tokens in exchange for rewards, which fill the liquidity pools. Uniswap and Curve are AMMs that make use of liquidity pools in running their DEXs.
Benefits of Using Decentralized Exchanges (DEXs)
- Transparent and Trustworthy: A DEX is a more transparent and trustworthy option because the use of smart contracts to complete transactions ensures that preset rules of exchange cannot be changed by a single entity.
- More Secure: Because users’ assets are stored in hot or cold wallets rather than a central wallet, DEXs can be more secure and less susceptible to hacks and other security issues that typically affect CEXs.
- Better Privacy: DEXs do not require any type of verification, such as Know Your Customer (KYC), so users can complete trades without disclosing personal information.
Best Decentralized Exchanges (DEXs) in 2022
Uniswap is a decentralized AMM-based exchange powered by self-executing contracts. The exchange supports multiple blockchains, including Ethereum, Polygon, Arbitrum, Celo, and Optimism, and it has the second-largest trading Ethereum platform after Binance, with over $3 billion in ETH locked up (TVL).
Users can exchange tokens or provide liquidity for reward by connecting to the DEX using supported wallets such as Coinbase wallet, MetaMask wallet, WalletConnect wallet, and Trust wallet. The exchange’s native token is UNI, which can be used for governance and staking.
PancakeSwap is a top decentralized exchange built on the BNB chain that can be used to ‘swap’ BEP-20 tokens. The exchange also supports the Ethereum and Aptos networks, and it has its own token, CAKE, that can be used for governance, staking, and yield farming.
PancakeSwap, like Uniswap, operates an AMM system that uses smart contracts to complete transactions and supports a variety of wallets such as MetaMask, Binance Wallet, Coinbase Wallet, Trust Wallet, WalletConnect, Opera Wallet, Brave Wallet, MathWallet, TokenPocket, SafePal, Coin98, and Blocto.
Curve is a decentralized exchange based on the AMM model that was built on the Ethereum network but has since expanded to support other networks such as Avalanche, Polygon, and Fantom, as well as several layer-2 solutions. The DEX is ideal for trading stablecoins and other crypto assets with minimal slippage.
Curve currently supports MetaMask, Ledger, Torus, Trezor, Coinbase Wallet, Formatic, Portis, and WalletConnect, and has its own native token, CRV, with which users can receive staking rewards and pay trading fees.
SushiSwap is a fork of Uniswap that was built on Ethereum but grew in popularity as one of the first DEXs for blockchains such as Avalanche, Fantom, Harmony, and Celo. SushiSwap users can currently exchange assets across multiple blockchains and layer-2 protocols such as BSC, lGnosis, Moonriver, Arbitrum, Fuse, Moonbeam, and OKXChain.
The protocol is an automated market maker that operates and completes trades between users by utilizing smart contracts and liquidity pools. SUSHI is the exchange’s native token for staking and governance, and compatible wallets such as MetaMask, WalletConnect, Gnosis Safe, and Coinbase Wallet can be connected to the protocol.
The rise of centralized CEXs has undoubtedly increased the use and trade of cryptocurrency, as well as the introduction of new use cases. However, it has exposed the crypto space to more risks than ever before, as well as weakened one of the fundamental tenets of cryptocurrency—decentralization. Decentralized exchanges continue to be critical in ensuring that ownership and control remain in the hands of the user rather than a third party.