If you’re familiar with cryptocurrency, chances are you’ve heard the term decentralized finance or decentralized exchange before. But what is decentralized finance, and how is the crypto world taking advantage of this new economic structure? Here’s what you need to know about decentralized exchanges and your cryptocurrency investments.
What is a DEX?
A decentralized exchange is a peer-to-peer crypto exchange that does not require the use of intermediaries to make direct trades with other users. A centralized exchange will act as an intermediary taking orders between users, while a DEX uses smart contracts to enable free and instant transactions between users.
There are several critical differences between centralized and decentralized exchanges. There are various types of DEXs, including automated market makers (AMMs), DEX aggregators, on-chain order books, and off-chain order books.
Automated Market Makers are DEXs that allow traders to trade directly against a liquidity pool without an intermediary. AMMs rely on automated protocols instead of order books. Users are incentivized to stake their crypto in the liquidity pool of the AMM in return for rewards. Coin owners then trade directly with this liquidity pool rather than with other users. Automated formulas help regulate the value of these pools.
DEX aggregators will aggregate liquidity sourced from several DEXs. DEX aggregators will automatically run complex algorithms to find the best trade on the market. These aggregators can be programmed to make these beneficial trades automatically.
On-chain order books like that being developed by FTXs Serum Project process all transactions and data on the blockchain. This created a highly transparent process that can be time-consuming but ultimately beneficial for users, allowing them to trade directly with each other inexpensively and hold their funds in their wallets.
Off-chain order books process and store orders off the blockchain, which can save time and money but is more centralized than other DEX types. Off-chain order books allow users to lend to other traders in return for fees but could pose liquidity risks, as can on-chain order books.
DEXs provide many benefits that are still being developed to solve and overcome today’s issues facing centralized exchanges.
Though centralized exchanges are more popular than DEXs, they are inherently less secure. Centralized exchanges must invest in complex security measures to protect their users from hackers. If a centralized exchange gets hacked, there could be a tremendous loss for all or multiple users. While decentralized exchanges provide the same security guaranteed with all blockchain transactions, there are minimal risks of being hacked. If a DEX is hacked, it would only impact a single user rather than an entire system of accounts.
Accessibility & Investment Options
Decentralized exchanges can be accessed from anywhere in the world with internet access. Further, without regard for international borders or intermediaries, traders can instantly exchange funds through DEX platforms without fees or long wait periods. While centralized exchanges only offer users the ability to trade in a limited number of cryptocurrencies, DEXs allow traders to invest in and trade in all types of cryptocurrency, including altcoins. This opens more opportunities for investors to diversify their digital portfolios and gives all traders more control over their crypto.
Of course, one of the most critical aspects of decentralized finance is its reduced costs without the need for intermediaries or third parties. Decentralized finance offers many benefits to traders who want complete control over their investments and understand how to navigate the crypto space without centralized exchanges’ user-friendly but costly services.
The DeFi space will continue to grow in the years to come as more and more DEXs are developed to support users with improved security, greater control over their investments, and more affordable trading.