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Trevor
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DEX 101: What is a Decentralized Exchange?

February 9, 2022

gm. If you have floated into the world of web3, you have undoubtedly come across these 3 letters: D-E-X. But W-T-F is a D-E-X? Is it an acronym? Is it a meme coin? Can it get me to the moon? This introduction to DEXs explains what they are, how they work, and when you might want to use one. 

Decentralized vs. Centralized Exchanges

A DEX, or Decentralized Exchange, is a peer-to-peer cryptocurrency marketplace that allows users to trade cryptocurrencies for other cryptocurrencies with relatively low fees. That meme coin you asked about? You will probably need to get it via a DEX. 

If you are new to web3, keep in mind that while the number of crypto tokens seem almost endless, fiat money (government-sanctioned currencies) will not be accepted on DEXs. In order to use a decentralized exchange, you will have to procure some cryptocurrency from a CEX, or centralized exchange (Coinbase is an example of a well-known CEX).

Besides the fact that you cannot trade fiat for crypto tokens on a DEX, the main thing that differentiates a DEX from a CEX has to do with privacy and accessibility concerns. Centralized exchanges follow Know-Your-Customer (KYC) policies, meaning users are required to verify their identities and sometimes home addresses by providing the CEX with identity documents like a driver’s license, passport, or something else. This is problematic for users who do not have a home address, or access to traditional ID documents, or who would simply prefer to keep personal information private.

To use a DEX, you just need a wallet with crypto tokens in it. One you do, you can start diving into DeFi and web3.

How do DEXs work?

DEXs are run by smart contracts and assets are provided via liquidity pools. Smart contracts facilitate the trades between wallets and stabilize the prices of cryptocurrency on the exchange. For a basic understanding of DEXs, we don’t need to get into the weeds about how smart contracts work. The important thing to understand is that they are programs of self-executing code that run when predetermined conditions are met, and they record transactions directly onto a blockchain.

Liquidity pools (LP) are crowdfunded pools of cryptocurrency that are locked into a DEX’s smart contract. Individuals who decide to deposit assets into liquidity pools are rewarded with LP tokens that you can then swap on a DEX for other cryptos. LPs are how DEXs provide liquidity for its user’s trades, and thus liquidity pools are the key to a thriving DeFi ecosystem and a smooth-operating DEX.  

DEXs Remove “The Middleman”

The use of smart contracts gives users full autonomy over their funds. Coins are moved directly from wallet to wallet through a DEX, without a stop in between. This is different from CEXs, which facilitate the movement of coins from one wallet to the exchange’s account and then to another wallet. All assets that are exchanged through a CEX are stored with the exchange, creating a single point of failure in the system. If something goes wrong with a centralized exchange users lose access to all of their funds.

DEXs put the power of facilitating trades and maintaining control of assets back into the hands of the individual user. But be aware, because with great power comes great responsibility. Transactions on a DEX can not be reversed; there are no customer support lines to call if you accidentally add a 0 to your trade. It is wise to send a small test amount through a DEX if you are using it for the first time, just to get the feel of it. In addition, make sure you triple-check the accuracy of the transactions you submit, and familiarize yourself with the steps of token approval.

DEX Advantages 

Smart contracts have cut out the middleman in a decentralized exchange, and because of this two things have happened. Trading fees have been lowered and security has been enhanced.

When trading on a DEX you will still need to pay gas fees, but trading fees are roughly 1-3% lower when compared to centralized exchanges. While that might not seem like a lot, it can easily add up over time if you are trading between cryptocurrencies regularly. 

Decentralization makes DEXs more secure than CEXs because there is no single point of failure in the system. This makes DEXs less prone to hacks and price manipulation. DEXs cannot stop you from trading and they cannot freeze your accounts. Still, make sure to do your own research (DYOR) before trading. DEXs are open-source, meaning anyone can add a cryptocurrency to them; sometimes a bad actor will create a new token purely for the purpose of trying to trick or scam users. 

Ready to Get Started?

We’ve covered a fair amount in DEX 101. We discovered what a DEX really is, dipped our toes in a liquidity pool, and talked about the advantages of using a DEX. If you are ready to start your DeFi journey, Uniswap, 1Inch, and Sushiswap are some popular DEXs to try. Connect your wallet and swap away, my fren.

Using a DEX opens up the entire web3 universe to your wallet. DEXs are where you might find the next big token, enter into DeFi, and they are a pillar of the web3 economy.

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