Decentralized Exchange (DEX) Meaning
What is a Decentralized Exchange (DEX)?
A decentralized exchange (DEX) defines an exchange where crypto transactions are conducted in a non-custodial manner. This means that it has no intermediary or custodian that facilitates custody and exchange of funds. Instead, users have complete control over their digital assets and can trade directly from their wallets.
Instead of relying on order books to execute trades, decentralized exchanges typically rely on smart contracts – pieces of self-executing code – to facilitate these transactions. However, trading volumes in DEXs tend to be lower than they are in centralized exchanges (CEX). Hence, the platforms offer incentives for users to provide liquidity to liquidity pools.
The liquidity providers (LPs) – users supplying the liquidity pool with their digital assets – deposit an equal value of trading pairs (two tokens) to generate interest from their cryptocurrencies. Every transaction made incurs a transaction or trading fee, which is then rewarded to the LPs.
CEX vs DEX
A centralized exchange is a type of crypto exchange where the marketplace is created and owned by a single entity with its own motives and priorities. The entity acts as an intermediary that matches buy and sell orders using an order book system, which is the same system traditional banks still use. In contrast, DEXs are not controlled by any entity. Instead, they use automated market makers (AMMs) to crowdsource funds in liquidity pools and automate transactions. Thus, while CEXs rely on market participants to decide the price for exchanging two assets, the pricing is automatically adjusted in AMM DEXs.
CEXs are characterized by their custodial nature, where the exchange holds the assets being traded. DEXs, on the other hand, carry out non-custodial transactions, meaning that the asset never passes through an intermediary. The users maintain complete custody of their digital assets during the entire transaction process, reducing counterparty risks. Traders typically interact with a smart contract rather than a counterparty in a DEX.
While CEXs vet digital assets before they can be listed, DEXs list any token minted on the protocol they are built on. This creates token availability for early adopters in DEXs before they can be found on centralized exchanges, but also exposes them to potential rug pulls. DEXs are also prone to a myriad of risks, including liquidity risks, smart contract risks, frontrunning risks, network risks, and volatility risks.