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What is a decentralized exchange (DEX) And how does it work? | Algorand

Written by Algorand Foundation | Jun 1, 2023 4:09:00 PM

Decentralized exchanges (DEXs) challenge the traditional financial system and redefine the way we trade and transact assets.  

What is a decentralized exchange (DEX)?

A decentralized exchange, or DEX for short, is an innovative platform that allows users to trade cryptocurrencies directly with each other. Unlike traditional centralized exchanges, which rely on intermediaries to facilitate transactions, DEXs enable peer-to-peer trading without the need for an intermediary, allowing you to fully control your digital assets.

How does a decentralized exchange work?

Instead of relying on a central authority to hold and manage user funds, DEXs utilize smart contracts, which are self-executing programs running on a blockchain. These smart contracts act as the backbone of the exchange, enabling secure and transparent transactions. When you want to trade on a DEX, you typically connect your digital wallet to the platform. By linking your wallet to the DEX, you retain full control over your assets until you execute a trade. This differs from centralized exchanges, where the exchange has custody of your assets while you use the platform. 

Differences between centralized and decentralized exchanges

Centralized exchanges Decentralized exchanges
Controlled by a central authority Operate on a decentralized network
User funds held by the exchange User funds of those trading currencies remain in their wallets until a trade takes place
Depend on intermediaries for transactions Direct peer-to-peer trading
Identity verification often required Anonymity and privacy options are available

What are the types of decentralized exchanges?

Order book DEXs

An order book DEX is similar to a traditional exchange where buyers and sellers place orders that are matched by an order book. They rely on an order-matching mechanism to determine the price and execute trades. The benefit of an order book DEX is that users can place limit orders, allowing them to have better control over the buy and sell price of an asset. Anyone can view a DEX order book. 

Algodex and Ultrade are order book DEXs whose order books live on the Algorand blockchain.   

Automated market maker (AMM)

An AMM operates differently from an order book DEX. Instead of relying on an order book, they use liquidity pools. These pools contain funds contributed by users, and trades are executed based on a mathematical formula. An AMM enables permissionless and trustless trading. 

AMMs on Algorand are Pact, Tinyman, and Humble.

DEX aggregator

A DEX aggregator is a platform or tool that allows users to access multiple decentralized exchanges in one place. Instead of manually checking each individual DEX, aggregators consolidate liquidity from various exchanges, providing users with a unified view and the ability to compare prices and execute trades across different DEXs.

Alammex, Vestige, and Althena are DEX aggregators on Algorand. Defly is a wallet with a DEX aggregator.  

What are the benefits of decentralized exchanges?

Control over your funds: DEX users have full control of their funds as they remain in their wallets until a trade is executed. This eliminates the need to trust a centralized exchange with the custody of assets.

Privacy and anonymity: DEXs often provide options for users to trade anonymously or with enhanced privacy. This can be beneficial for those who value financial privacy.

Security: By leveraging blockchain technology and smart contracts, DEXs enhance security. There is no central point of failure, making them less vulnerable to hacking and data breaches compared to centralized exchanges.

Global accessibility: DEXs operate on a decentralized network, allowing anyone with an internet connection to access and trade on the platform. This global accessibility opens up opportunities for users around the world. 

Tokens available: Centralized exchanges must review and verify tokens before listing them, while decentralized exchanges can include any token created on the blockchain they operate on. DEXs are often the first to list new projects because of this. 

What are the challenges faced by decentralized exchanges?

Smart contract risks: While smart contracts provide the backbone of DEXs, they are not immune to vulnerabilities like bugs and security flaws. It's important for users to exercise caution and conduct due diligence before engaging with any DEX.

Liquidity: DEXs, especially newer ones, may have lower liquidity compared to centralized exchanges. This can impact their feasibility and usage.

User experience: Some decentralized exchanges may have a steeper learning curve and a less intuitive user interface compared to centralized exchanges. This can make it more challenging for beginners to navigate the platform.

How to use a decentralized exchange

Using a decentralized exchange is straightforward, as no sign-up or user details are required. Just connect your compatible wallet to the DEX. 

Don’t have a wallet? Start by downloading and setting up a crypto wallet. Load it up with the crypto you want to use on the DEX. Some wallets let you buy crypto directly, while others require you to go through a centralized exchange to purchase your desired cryptocurrency. 

Once you have crypto in your wallet, you can access the DEX directly from the wallet's browser or go to your desktop and connect your wallet there.

Keep in mind that each DEX can be different, so make sure you read the instructions before connecting your wallet and making any transactions.

Further reading 

DeFi on Algorand

What Is a Web3 Wallet and How Does It Work?

Web2 vs Web3: What's the Difference?

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