How Crypto Decentralized Exchange Works
Cryptocurrency exchanges offer liquidity pools to the global market, with transaction volume amounting to billions of dollars daily. With the expanding crypto market, the demand for exchange platforms to execute various trades, access different digital assets, and get complete asset custody is increasing.
Exchanges thrive on disintermediation or DeFi, and that has been the core ideology of blockchain technology. The technology relies on protocols that enable decentralized transactions and eliminate the middlemen. However, centralized exchanges defeat this philosophy by having a central authority and full custody of customers’ assets. Hence, the reason for the growing popularity of decentralized exchanges.
What is a Decentralized Exchange?
A decentralized crypto exchange or DEX is a type of crypto exchange that enables a direct peer-to-peer transaction without an intermediary. Unlike centralized exchanges that have a central authority, DEXs don’t require you to transfer assets to the exchange before transacting, giving you more security and control over your assets. Records of all trades executed on DEXs are kept on the blockchain for transparency.
Transactions that occur on decentralized exchanges do not require a third party entity, such as banks, government institutions, to oversee the transactions. Instead, DEXs use a distributed ledger technology comprising smart contracts to execute trades. This dynamic approach ensures that trades are instantaneous at lower costs compared to centralized exchanges.
Due to the absence of any intermediary or authority, DEXs use a non-custodial infrastructure that enables users to retain custody of their cryptos, manage their wallets and private keys. With a private key, a user has complete control over their assets, which makes it convenient to manage. Hence, the famous crypto mantra “not your keys, not your coins”.
Decentralized Exchanges Mechanism
DEXs implement a different mechanism to facilitate trades. These include Automated Market Maker, Swaps, and Aggregators.
Most DEXs use Automated Market Maker or AMM, similar to order books that most centralized exchanges use. Order books put together all the open buy and sell orders for a particular asset. The differences between these prices influence the depth of the order book and the market. Information about orders is usually held on-chain while your funds remain in your wallet. This implies that users can transact without their funds being revealed — Only the buy and sell orders are visible.
Unlike order books, DEX uses algorithms to set asset prices. These algorithms determine crypto prices based on the supply and demand metrics. Market makers are organizations that oversee the market and offer liquidity for traders to transact. The benefit of these market makers is to make available crypto assets to buyers and sellers (A buyer can always find a seller in a given session, and the seller can always find a buyer). This makes it easy to execute trades at any time.
DEXs provide liquidity but don’t have to hold the assets. Instead, they create pools of various popularly traded tokens. Investors provide these tokens in exchange for a fee. However, these fees are subjected to the demand and supply dynamics; thus, the prices are not fixed. The AMM model provides liquidity to financial instruments that help traders to execute business transactions on the spot by matching buyers and sellers.
Some DEXs employ swaps or liquidity pool trading protocols to set prices. This protocol executes deals between wallets instantly because of its peer-to-peer nature. Exchanges using this protocol are ranked according to total value locked or TVL, which is the total value of assets held in various smart contracts.
Aggregators are not very common but an effective mechanism for providing ample liquidity. Aggregators solve the issue of slippage, where there is insufficient liquidity on an exchange. Slippage can deter institutional investors or traders from purchasing large volumes of cryptos, but aggregators solve this problem. Aggregators compile liquidity from various DEXs to help execute large orders.
Benefits of Decentralized Exchanges
The non-custodial infrastructure is one of the most significant benefits of decentralized exchanges. Having complete control over your assets means that you don’t have to worry about manipulation or hacks on centralized exchanges. Traders’ risks are minimal on decentralized exchanges because they don’t need to move their assets before transacting. This gives a sense of responsibility to traders because they are completely in charge of their funds.
Since decentralized crypto exchanges don’t have a central server, users’ data are not stored, minimizing the risk of data being stolen or used without approval. In essence, users that trade through a DEX maintain anonymity, as transactions are encrypted, and the identity of participants is reduced to only their wallet details.
Transaction costs are also low since there’s no intermediary compared to centralized exchanges. However, swapping fees can be relatively high, regardless of the volume of transactions.
In addition, you can trade a wide range of crypto assets on DEXs, provided that market makers are willing to provide liquidity for them. If you become a liquidity provider, you would get compensated for being a market maker.
Addressing the Challenges of the DeFi Ecosystem
Blockchain technology has been on the hype for providing solutions to lots of real-world issues in recent times. From solving the problem of documentation and record-keeping to removing the barriers to finance through DeFi. Due to the numerous purposes it could serve, new projects in different niches keep coming up on the blockchain every day. Despite this enthusiasm, there remains one major problem that has not been solved. This is nothing other than the fact that blockchains exist independently of each other. By implication, all projects on one blockchain cannot scale onto another. Ethereum, Polkadot, Solana, and the likes do not interact, thereby creating an interoperability issue.
Recent trends, however, have shown that cross-chain networking is the ultimate solution to this dilemma. Effort towards achieving this result has so far been minimal, but the promises are encouraging. Just days ago, Solana’s stablecoin UXD raised $3 million to expand DeFi outside Ethereum. If this comes to fruition, it is expected to lay a rock-solid foundation for creating such networks. The aim of cross-chain will particularly favour DeFi in a way that cannot be fully explained yet.
Similarly, the DeFi project — Composable Finance — announced that its Mosaic solution has been successfully integrated with Layer 2 protocols of Arbitrium, Avalanche C-Chain, Polygon, ZkSync, the Ethereum mainnet, and Moonriver, thereby removing the barriers to cross-layer/chain scalability and interoperability. The integration will not only expand the capabilities of DeFi, it further provides a developer-friendly interface to interact with different bridges, handling aspects such as routing, callbacks into smart contracts.
We are still in the early stages of cross-chain interoperability, but everything points to it as the ultimate solution and the next big trend in the blockchain.
Also read: How Liquidity Pools work in Decentralized Finance
