Even before November’s FTX debacle, which drove a record number of investors toward decentralized solutions, decentralized exchanges (DEXs) were carving out an orderly place in the market dominated by centralized exchanges.
A research report co-authored in May by Uniswap and Paradigm, a crypto-focused VC firm, showed that Uniswap, the largest decentralized exchange, had deeper liquidity in several trading pairs, including ETH/USD, than Binance or Coinbase.
The report highlighted the possibility of DEXs hiring their larger competitors in the future due to their ability to “provide higher liquidity than centralized exchanges” with automated market makers (AMMs).
In addition, Citigroup reported this October that DEXs have outpaced CEX in growth over the past two years.
This year’s failures of centralized crypto platforms, such as Voyager Digital, Celsius and FTX, have helped push DEXs further center stage.
Other cryptocurrency investors will likely want to look into DEXs in the coming months and years.
To help our readers on this journey, we’ve made a list of the top three things people get wrong about DEXs.
Misconception #1. DEXs are 100% bulletproof
One of the strengths of decentralized exchanges is that at no time do they take custody of users’ funds. This makes it impossible for bad actors to infiltrate an exchange and steal customer funds.
DEXs live up to the mantra “Not your keys, not your coins,” which warns crypto investors against storing their cryptocurrencies on centralized exchanges. Essentially, you don’t know what will happen to your cryptocurrency in CEXs.
As is evident from the collapse of FTX and other crypto failures this year, an exchange can run into liquidity problems and make customers unable to pull out their money.
But also, decentralized exchanges are only as strong as their smart contracts. Poorly developed code could provide a loophole for hackers to exploit. Therefore, it is advisable to do your research before settling for any DEX.
Unattended storage of DEXs should give users more control over their funds. However, the practicalities of self-custody, such as 12-word backup phrases, private keys, and others, may seem intimidating to some users. Worse, if you forget your 12-word backup phrase, your money is gone forever.
With CEX, cryptocurrency holders don’t have to memorize a passcode, recovery phrases, etc. But you don’t know if your funds are safe. With DEXs, you are fully responsible for your crypto, while relying on the smart contract to be foolproof.
Misconception #2. DEX transactions are untraceable
Due to the perception that blockchain transactions are anonymous, there is a misunderstanding that transactions on DEXs follow suit. This perception is reinforced by DEXs that do not require you to send Know Your Customer (KYC) information.
However, the identities of users of public blockchains, such as Bitcoin and Ethereum, can be learned by tying KYC data to addresses on blockchain. When someone withdraws cryptocurrency from an exchange where they sent KYC, to a wallet they check, they doxxed that address. Any operation performed on a DEX with that address can be reliably tied to a user’s identity.
One way to obscure your transactions is to use a different address each time you make crypto transactions. You may also have different wallets for various purposes. The goal is to make it more difficult to link transactions to each other.
Misconception #3. DEXs are only for experienced traders
On the surface, DEXs can seem intimidating. Remember, your funds are not stored on the exchange, so you don’t just have to log in and trade at the CEX. The way to access DEXs is through a crypto wallet compatible with smart contracts, for example, Metamask for Ethereum.
Since DEXs are blockchain-based, you need to fund your wallet with the blockchain-specific token.
When using DEXs, you also need to know how to adjust slippage. Slippage is the price difference between when you started a trade and when you completed it.
Slippage occurs due to the market movements that occur between the time you started and the time you completed a trade.
Sometimes a slippage can work in your favor. Other times, not so much. Therefore, it is often necessary to manually adjust slippage when using a DEX. This process can be technical and daunting.
So, DEX trading may seem tailored only to experienced traders. But beginner traders should know that experienced traders were there once. The best way to get on nerves about using a DEX is to go out and start using one. Over time, it becomes second nature.
How do DEXs work?
DEXs have the same goals as centralized exchanges (CEX), but this time there is no intermediary. Instead, a DEX relies on smart contracts to execute transactions.
In a CEX, traders rely on the company to store their cryptocurrencies and facilitate transactions/exchanges with other users. On a DEX, transactions are purely peer-to-peer, which makes them “disintermediated” and “trustless”.
Here are other defining features of DEXs:
- Built on the blockchain and are decentralized autonomous organizations (DAOs)
- Users do not give up custody.
- The use of liquidity pools. Liquidity pools are crowdsourced crypto reservoirs that facilitate peer-to-peer trading, yield farming, and other DeFi functions. Users who contribute to liquidity pools are rewarded with transaction fees, profits from yield farming, and so on. Liquidity pools are the lifeline of DEXs.
- Liquidity pools employ Automated Market Maker, which are protocols that automatically execute buy and sell orders on a DEX.
Some of the most popular DEXs include Uniswap, PancakeSwap, SushiSwap, Kyber, 1inch and Bancor. Uniswap is currently the most dominant DEX, commanding over 50% of the market share.
Decentralized exchanges will be increasingly relevant. Their centralized counterparts have played a crucial role in integrating millions of people into cryptocurrencies, but investors who want more freedom over their crypto assets will migrate to DEXs.
Hopefully, this piece will dispel any misconceptions you’ve had about them.