A DEX is short for decentralized exchange and is a marketplace where people can trade crypto currencies. The most crucial feature of a DEX is its ability to handle transactions without the supervision of banks, brokers, or similar authorities.
That is exactly what decentralized means; the ability to perform exchanges without a centralized authority to officiate the transactions. Effectively removing the middleman of these transactions. It uses the permissionless nature of the blockchains, which also means that dexes are accessible for anyone without any restrictions.
Popular DEXs include Uniswap, Sushiswap, Serum DEX, and PancakeSwap. Both Uniswap and Sushiswap runs on the Ethereum blockchain, while Serum DEX runs on the Solana blockchain, and PancakeSwap on Binance Smart Chain.
How does a DEX work?
Before we explain to you what a DEX does, it might be beneficial to explain how a normal exchange works.
Take any stock exchange as an example; let’s say NASDAQ.
All transactions processed on the NASDAQ will be handled by an intermediary agent. If person A wants to purchase $100 worth of stock, and person B is willing to sell that stock, person C (the financial intermediary) will facilitate the transaction. Roughly speaking, this is how centralized exchanges work. Both in terms of trading and also in terms of borrowing and lending. The financial intermediary provides liquidity to facilitate the trade. In other words, the financial intermediary is the centralized agent. No transactions will take place without the intermediary being involved. Read more about the function of a financial intermediary here. In decentralized exchange, there is no financial intermediary. Transactions are executed automatically through the use of smart contracts. In other words, on a DEX transactions are facilitated by non-entities, smart contracts, and financially backed by liquidity pools, which are provided by normal users like you and me.
In layman terms, liquidity pools are pools of crypto assets – i.e. tokens. Also keep in mind that you are only able to perform crypto-to-crypto transactions on a DEX – meaning you can’t purchase crypto for fiat money (i.e. government-backed assets like the US dollar).
Say the liquidity pool of Ether is 1,000 tokens. The price of Ether on a given DEX is then decided based on the relative size of your transaction in relation to the relative size of the pool.
Now, you are looking to purchase 1 ETH using a stablecoin – say DAI. The moment we write this, the given DAI/ETH liquidity pool consists of 21.41m DAI and 23.83k ETH on the Uniswap DEX.
As such, the price for 1 ETH is equal to 2.58k DAI based on the current liquidity pool. If we chose to purchase our ETH with another token, say BTT, the price would change to 1 ETH = 1.42b BTT.
In other words, the prices for assets are “governed” by a decentralized liquidity pool using mathematical algorithms for setting the value of given crypto pairs.
Remember, on a DEX you can only exchange crypto for crypto – thus allowing the usage of crypto pair liquidity pools.
Advantages of DEX’s
Maximum freedom. A DEX has no official authority (it’s decentralized), and thus ownership of accounts and assets herein cannot be revoked. This may sound dramatic, but the reality is that your current bank holding your fait money in theory could freeze you out of your account and revoke the ownership of your own assets. At the same time, it is important to be aware of the possibility of making an unrecoverable mistake here, such as sending coins to the wrong wallet.
Maximum privacy. As the exchange does not entail the sharing of data, personal data won’t be shared with third parties as is often the risk with traditional exchanges.
Disadvantages of DEX’s
Smart contract vulnerability
DEX's, just as any other DeFi protocols, are powered by code and smart contracts which can have exploitable bugs. Therefore, in rare cases, hacks can occur that cannot always be predicted by developers.
On a DEX you can’t exchange crypto for fiat. If you had a bunch of crypto tokens and you wanted to exchange these to actual fiat money, still needed to buy most actual goods, users do this on other crypto-to-fiat exchanges like FTX or Coinbase.