The main use case for smart contracts and blockchain technology is decentralized exchanges, or DEXs. Instead of taking the conventional route of serving as a financial intermediary between buyers and sellers, they accomplish this entirely through automated algorithms. Let’s explore one of the most important tools in crypto in more detail.
What Exactly is a DEX?
DEXs, or decentralized exchanges, are peer-to-peer markets where cryptocurrency traders can conduct transactions without entrusting the management of their funds to a middleman or custodian. Smart contracts, which are self-executing contracts written in computer code, are used to facilitate these transactions.
DEXs were developed to do away with the need for any authority to monitor and approve trades executed within a particular exchange. Cryptocurrency trading can be done peer-to-peer (P2P) on decentralized exchanges. Since they are frequently non-custodial, users retain ownership of their wallet’s private keys. An advanced encryption method that gives users access to their cryptocurrencies is known as a private key. After entering their private key to access the DEX, users can immediately access their cryptocurrency balances. For those who value their privacy, they won’t be required to submit any personal information like names and addresses.
How do they work?
Every trade involves a trading fee in addition to a transaction fee because decentralized exchanges are constructed on top of blockchain networks that support smart contracts and allow users to maintain custody of their funds. To use DEXs, traders essentially communicate with smart contracts on the blockchain.
By interacting with the smart contracts that power the trading platform, it enables users to conduct transactions directly from their wallets. Traders are in charge of protecting their funds and are accountable for their loss if they commit errors like misplacing their private keys or sending money to the wrong addresses.
Main Types of DEXs:
Decentralized exchanges can be of three different types. Through their smart contracts, all of them enable users to transact directly with one another.
- Order Book DEXs
- DEX Aggregators
Automated market makers (AMMs)
To address the liquidity issue, a smart contract-based automated market maker (AMM) system was developed. These exchanges were partly inspired by a paper on decentralized exchanges written by Vitalik Buterin, a co-founder of Ethereum, which explained how to carry out trades on the blockchain using contracts holding tokens.
Order book DEXs
Order books keep track of all open buy and sell orders for particular asset pairs. Sell orders show that a trader is prepared to ask for a specific price to sell an asset, whereas buy orders show that a trader is willing to buy or bid for an asset at that price. The size of the order book and the market price on the exchange are determined by the difference between these prices.
DEX aggregators use a variety of protocols and mechanisms to address liquidity-related issues. To minimize slippage on large orders, optimize swap fees and token prices, and provide traders with the best price in the shortest amount of time, these platforms essentially aggregate liquidity from various DEXs.
How to Use Decentralized Exchanges
A decentralized exchange does not require registration because you can interact with these platforms without even providing your email address. Instead, traders will require a wallet that is compatible with the network’s smart contracts. The financial services provided by DEXs are accessible to anyone with a smartphone and an internet connection.
A user must first choose which network they want to use before using DEXs because there is a transaction fee associated with every trade. The following step entails selecting a wallet that works with the chosen network and funding it with that wallet’s native token. In a particular network, transaction fees are paid with a native token.
Interacting with decentralized applications (DApps), such as DEXs, is made simple by wallet extensions that let users access their money directly in their browsers. These must be created by the user or imported into an existing wallet using a seed phrase or private key, just like any other extension. Password protection further tightens the security.
DEXs Will Keep Evolving
These platforms’ reliance on self-executing smart contracts may lead to the development of more use cases in the future. Flash loans are an example of how innovation in the decentralized finance sector can produce goods and services that were previously impossible. Flash loans are defined as loans taken and repaid in a single transaction.