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A decentralized exchange (DEX) in cryptocurrency refers to a peer-to-peer marketplace in which the traders trade cryptos in a non-custodial way. There is no intermediary involved in facilitating the custody and transfer of funds. DEXs substitute intermediaries including payment processors, brokers, banks, as well as other institutions. In addition, blockchains have smart contracts facilitating asset exchange.
DEX does not allow exchanges between crypto and fiat. Instead, they trade crypto for other cryptos. It is different from a central exchange where you may trade fiat currency for cryptocurrency or even crypto to crypto. The DEX is a set of smart contracts. They are the ones who establish different cryptos prices against each algorithm and they use liquidity pools.
DEX transactions are usually recorded in the blockchain. Besides, they are built on open-source code which means that any person interested may see the way they work. This also means that the developers may adapt the existing code in building new competing projects. DEX exchange does not need traders to deposit funds in starting trading. Instead, the investors directly trade from their wallets.
Decentralized provides some advantages to the users or rather traders. Some of the top pros include trustless transactions, diversity, custody, privacy, and lower fees.
DEXs utilize self-executing smart contracts. Therefore, it means that there are no intermediaries involved in the process. Because of this, DEX utilizes the same gas fee structure just like the Ethereum blockchain which they are built on. Additionally, DEX charges low fees. It is about 0.3% for exchanges such as Uniswap.
Currently, there are over 15,000 cryptos in the markets. In Centralized Exchanges (CEXs), they exercise control over the cryptos they list. Besides, they list the ones that have adequate trading activity, effective security standards, and prevalence in ensuring legal compliance and profitability. Moreover, most altcoins are accessible through DEXs. This is where P2P transactions take place without high trading volumes. It offers a greater opportunity for digital asset engagement as well as enhancing financial inclusion.
The traders and investors who use decentralized exchange do not need to disclose their private keys. The reason is that the wallets are externally held. Besides, DEX is not liable for the funds. The users are also not typically needed to complete the AML (Anti Money Laundering) and KYC (Know Your Customer) procedures when utilizing DEXs. This is highly beneficial in terms of convenience.
DEXs are not under any custody. In short, it means that the traders and investors do not need to relinquish the control of their private keys in order to transact. Therefore, in this case, the wallets that are held externally interact with DEXs. Additionally, trades are self-executed through smart contracts. DEXs are different from centralized exchanges because for them they play the function of being custodian over your funds. They are the ones who control your private keys. However, in DEXs you are the one who controls your private keys.
While in CEXs, central authority records and oversees the transactions, in DEXs transactions are recorded through a blockchain. Thus, enhancing trustless transactions. You can read more about this on ‘how crypto is creating a trustless system.’ Besides, since the DEXs do not hold the trader’s funds, there are low chances that hackers will target them.
In DEX, there is no personal information needed before you trade. The anonymity is great since their wallet is not connected to their identity or name. This is very useful in countries that do not have progressive crypto regulations like China. Besides, it works well for any person across the world. In short, it removes the limitations of developing nations’ backward ruling or banking infrastructure.
Despite DEX having its benefits to a trader, it has some limitations. One of the limitations is liquidity. Since DEXs support different trading pairs and new, market segregation has a negative influence on the liquidity of the market. Asset liquidity has also been increasing with DeFi growth.
In DEXs, your keys mean your losses. Having control over your crypto is great till you mess up. In DEX there is no support that may help you recover your keys. Basically, you are on your own. Also, transactions cannot be refunded or canceled.
Furthermore, there is the issue of scalability. The scalability of blockchain depends on the number of transactions a network may process. For instance, Ethereum processes 15 TPS while Bitcoin processes 4.6 TPS. Therefore, since DEX functions using smart contracts, DEX has limits on its underlying network infrastructure.
The other limitation is that the current technology of DEX does not enhance digital assets purchased with fiat currency. Besides, with it, you cannot make any withdrawals into your bank account. Although stable technology is coming up to play this role, the lack of on and off stamp is a limitation of entry for novice traders.
Exit scams might affect DEX. The Exit scams do take place when developers, large stakeholders, or founders in crypto decide to pull the rug. It means that they will leave the coins held with the other investors worthless. Even though exit scams also take place in central exchanges, there are lower chances.
The last limitation is the lack of user experience. Since DEX is in its early development stages, it is challenging for a trader who is not familiar with the way decentralized blockchain technology works. Therefore, as a user, you should understand external wallet platforms to interact with DEX.
The first use is in crypto-to-crypto exchange. Any trader using P2P trading on DEX may only trade with cryptos. They are different from the CEX, which allows for the exchange of fiat and cryptos. Besides, stablecoins have made DeFi less volatile.
The other use is DeFi access. DEX provides access to the DeFi world. This allows users to get funds in the DeFi protocols. For instance, they may use them in staking instead of going through a centralized exchange.
Furthermore, DEX is used in transaction storage. Institutions like CEX keep transaction data for about six months for tax and security implications. However, in DEX, transactions are visible on the blockchain. This strategy makes every transaction transparent. Even though the wallet addresses are anonymous, the blockchain allows traders to access all the transactions. Besides, DEX is developed on open-source code. This allows any person to see the way they work.