It is important to note that liquidity pools don’t have to be limited to just two assets. However, the more assets in a pool, the more volatile the pools are, and the more exposed liquidity providers are to impermanent loss. Although order books are efficient and mechanistically intuitive, automated market makers are a more popular way to facilitate asset exchange in DEXes. Wallet extensions allow users to explore dApps, trade on DEXs, and more. Users can link their blockchain account to a wallet extension to use their funds without giving the application custody of their assets. MetaMask is a popular chrome extension for managing assets on the Ethereum blockchain and signing application transactions, and HashPack is a popular browser extension powered by Hedera.

How does a Decentralized Exchange work

Liquidity risk—While DEXs are becoming increasingly popular, some DEX markets have poor liquidity conditions, leading to large amounts of slippage and a suboptimal user experience. Due to how the network effects of liquidity works , significant portions of trading activity is still conducted on centralized exchanges, which often leads to less liquidity on DEX trading pairs. Smart contract risk—Blockchains are considered highly secure for executing financial transactions.

Speed of Transactions

DeFi has been compared to the initial coin offering craze of 2017, part of a cryptocurrency bubble. Inexperienced investors are at particular risk of losing money because of the sophistication required to interact with DeFi platforms and the lack of any intermediary with customer support. In addition, DeFi platforms might inadvertently provide incentives for cryptocurrency miners to destabilize the system.

How does a Decentralized Exchange work

A smart contract is a piece of code that automates the execution of a contract. You can think of liquidity pools as the massive cash reserves which banks use for offering financial services to their customers. The liquidity pools can give crypto traders adequate crypto assets for purchasing, selling, or borrowing. Therefore, they don’t have to wait for another party to match their transaction request for completing the transaction. Fully on-chain order book DEXs have been historically less common in DeFi, as they require every interaction within the order book to be posted on the blockchain.

What are decentralized exchanges?

This requires either far higher throughput than most current blockchains can handle or significant compromises in network security and decentralization. As such, early examples of order book DEXs on Ethereum had low liquidity and suboptimal user experience. Even so, these exchanges were a compelling proof of concept for how a DEX could facilitate trading what exactly Is a decentralized cryptocurrency exchange using smart contracts. A decentralized exchange enables users to trade crypto assets through blockchain transactions without the need for a custodian or centralized intermediary. With sophisticated technology, potentially fewer blockchain security risks, and the ability to self-custody funds, further adoption of decentralized exchanges seems likely.

How does a Decentralized Exchange work

Decentralized Exchanges work on peer-to-peer transactions in the marketplace, where transactions occur directly between crypto traders. DEX facilitates financial transactions that aren’t officiated by banks, brokers, payment processors, or any other kind of third-party intermediary. Decentralized Exchanges are known to trade exclusively upon cryptocurrency tokens in exchange for other cryptocurrency tokens, unlike CEX where you are able to trade fiat for crypto and vice versa.

What Is an Oracle in Blockchain?

Another DeFi protocol is Uniswap, which is a decentralized exchange set up to trade tokens issued on Ethereum. Because no centralized party runs Uniswap , and any development team can use the open-source software, there is no entity to check the identities of the people using the platform and meet KYC/AML regulations. It is not clear what position regulators will take on the legality of such platforms. Some 99% of crypto transactions are facilitated by centralized exchanges, which suggests that they are accountable for the majority of the trading volume. Due to the lack of volume, decentralized exchanges often lack liquidity, and it can be difficult to find buyers and sellers when trading volumes are low.

  • At BCB, we work with businesses across the blockchain and Fintech sectors that offer both centralised and decentralised services and products.
  • One of the unique selling points of Kine Protocol is its liquidity sharing mechanism, which allows users to earn a share of the trading fees by providing liquidity to the exchange.
  • This is in contrast to how centralized exchanges work by using intermediaries to connect the different exchange users.
  • Another important aspect of an order book decentralized exchange or DEX platform is the risk of liquidity issues.
  • These large financial institutions nject liquidity into the market in exchange for a small cut out of each trade.

The rate of return on investments can vary widely over time, especially for long term investments. Investment losses are possible, including the potential loss of all amounts invested, including principal. Brokerage services are provided to Titan Clients by Titan Global Technologies LLC and Apex Clearing Corporation, both registered broker-dealers and members of FINRA/SIPC. You may check the background of these firms by visiting FINRA’s BrokerCheck.


Before we learn how a decentralized exchange works, first, we need to understand how it compares to its traditional, centralized counterpart. Think of it as a pool of water, with the water representing the various components of the pool. A liquidity pool cannot be made up of just one asset; in fact, a majority contains two tokens, but some have experimented with up to eight assets. A decentralized exchange can still have centralized components, whereby some control of the exchange is still in the hands of a central authority. The Ethereum blockchain popularized smart contracts, which are the basis of DeFi, in 2017.

How does a Decentralized Exchange work

In addition, DEX aggregators could also ensure optimization of token prices and swap fees alongside offering quick price estimates for traders. Furthermore, aggregators also safeguard users from the detriments of the pricing effect alongside reducing the risks of failed transactions. Uniswap is one of the most popular decentralized exchanges, it uses an Automated Market Maker algorithm to set the price of assets and match buyers and sellers.

DeFi: The Foundation of Decentralized Exchanges

A decentralized cryptocurrency exchange is a platform that allows users to buy and sell cryptocurrencies without the need for a third-party intermediary. Instead of using a central server to match buyers and sellers and hold their funds, decentralized exchanges use blockchain technology to enable peer-to-peer trading. This means that users can trade directly with each other, without the need for a trusted third party to oversee the transactions. DEX, which functions as a third party, makes it possible to establish a blockchain, which is a distributed ledger.

CoinDesk is an independent operating subsidiary of Digital Currency Group, which invests in cryptocurrencies and blockchain startups. As part of their compensation, certain CoinDesk employees, including editorial employees, may receive exposure to DCG equity in the form of stock appreciation rights, which vest over a multi-year period. In addition to the above, some users may find having full custody of their private keys a daunting prospect.

CEXes may support more advanced order types, such as stop-limit orders, which can help an investor limit risk. Additionally,Liquidoffers high-performance API, deep liquidity, and low fees. However, users can get answers to general questions within the DEXs’ community pages from other users.

Gas fees could also be low on certain blockchains, and some DEXes are coming up with ways to offer gas-free trades. DEXes automate peer-to-peer trading while centralized exchanges may act as intermediaries. For example, Uniswap was built on the Ethereum blockchain and it allows investors to trade Ether and other Ethereum-based tokens. But someone who wants to trade cryptos on a different blockchain, such as the Binance Smart Chain, would need to use a compatible DEX, like PancakeSwap. Next, connect it to your cryptocurrency wallet, which has some tokens in it to swap.

How Do Decentralized Exchanges (DEXs) Make Money?

Additionally, hybrid order book designs have become more popular, where the order book management and matching processes take place off-chain while the settlement of trades occurs on-chain. Decentralized exchanges tend to focus on executing simple buy and sell orders. As such, users may find advanced trading functions such as stop losses, margin trading, and lending are unavailable on most DEXs. Decentralization is a fundamental philosophy of blockchain technology and the crypto space. It redistributes authority from a central power, and places it in the hands of users. And the concept of decentralization is reengineering how many conventional financial services operate.

One thing all decentralized exchanges have in common is that they execute orders on chains with smart contracts, and at no point do they take custody of users’ funds. Kyber Network is a hybrid decentralized exchange that combines features of both AMM and order book DEXs. It uses an order book to match buyers and sellers, but also uses an AMM algorithm to set the price of assets.

Account holdings and other information provided are for illustrative purposes only and are not to be considered investment recommendations. The content on this website is for informational purposes only and does not constitute a comprehensive description of Titan’s investment advisory services. While DEXes don’t store private keys, hacks and bugs in the code could still put investors’ crypto at risk. DEXes never take control of private keys and investors don’t need to trust a CEX to protect their funds.

Unvetted Token Listings

There are many benefits of DEX, including higher transparency, safety, ease of use, reliability and provide opportunities for investors. Any data, text, or other content on this page is provided as general market information and not as investment advice. Georgia Weston is one of the most prolific thinkers in the blockchain space.

What are Cryptocurrency Exchanges?

Additionally, because there is no one institution dictating the rules of exchange, DEXes are truly open to anyone. The largest DEX is Uniswap, which was created on the Ethereum blockchain in 2018 by a former mechanical engineer who had learned to code only after getting laid off by Siemens the previous year. By late 2021, it was processing transactions worth more than $1 billion each day. In the long run, their weaknesses will be addressed and their benefits will be matched by traditional exchanges.