- The meaning of DEX is Decentralized Exchange (DEX), a peer-to-peer marketplace where transactions occur directly between crypto traders.
- DEXes fulfill one of the original tenets laid out by Satoshi Nakomoto in the Bitcoin whitepaper: helping to foster financial transactions that aren’t officiated by banks, brokers, payment processors, or any other kind of intermediary. Unlike centralized exchanges they operate without the need for an intermediary.
- Decentralized exchanges are a foundational part of the decentralized finance ecosystem, which some suggest didn’t really get established until one of the most popular DEX exchanges, Uniswap, helped spotlight the sector in what became known as “DeFi Summer” during the summer of 2020.
What is a DEX (Decentralized exchange)
The meaning of DEX is Decentralized Exchange (DEX), a peer-to-peer marketplace where transactions occur directly between crypto traders. Unlike traditional centralized exchanges that rely on intermediaries to facilitate transactions and store user funds, decentralized exchanges operate on blockchain technology and smart contracts.
DEXs eliminate the need for a central authority, giving users full control over their funds and reducing the risk of hacks, fraud, or censorship. By removing the middleman, DEXs promote transparency, security, and privacy, as users retain ownership of their private keys and conduct transactions directly from their wallets.
DEXs also foster financial inclusivity, as anyone with an internet connection and a compatible wallet can participate in trading on a DEX.
How a DEX Works
If you’re wondering what a DEX is and how a DEX works, you’ve come to the right place. In this article, we've broken down this topic into key questions and provided bitesize answers to help you familiarize yourself with DEXs and how they operate.
In a few words, DEX exchanges (DEXs) are completely crypto-native, meaning that they only trade in digital assets and don’t allow for exchanges between fiat (government-issued currencies) and cryptocurrencies. For this reason, some form of digital assets or cryptocurrencies are required to interact with DEXs, which means that for the time being, centralized exchanges (CEXs) are still a vital part of getting new funds into the cryptocurrency ecosystem.
As opposed to managed “order books” that are run by brokers, decentralized exchanges utilize a set of smart contracts to establish the prices of various cryptocurrencies against each other algorithmically.
Liquidity pools (pools of digital assets that are locked in a smart contract on the blockchain for trading) that are funded by users of the platform and other market makers are harnessed to facilitate trades, with portions of the trading fees being redirected to the liquidity providers as a reward for the risks involved with providing liquidity.
DEX exchanges or transactions are recorded directly on the underlying blockchain that they operate on, meaning anyone can view and verify any trade that takes place. What is a DEX built on? Typically they’re built with open-source code, meaning developers can adapt existing code to create new competing projects. This is the mechanism by which multiple spin-offs of the Uniswap interface have appeared on DEXs across the crypto ecosystem, including SushiSwap, QuickSwap, and PancakeSwap.
Benefits and Downsides of DEXs
- Maintain anonymity: No KYC/AML required. Although many DEXs are choosing to change this to provide additional security.
- No counter-party risk: Users maintain control of their funds the entire time. This is because funds are stored in a digital wallet.
- First Mover Advantage: Access to unlisted tokens before they are added to centralized exchanges, which often results in a notable price increase.
- Better Utility: Utility in the developing world often lacks good banking and financial services.
- Lower fees: Decentralized exchanges typically charge lower fees than centralized exchanges since there is no need for intermediaries to facilitate trades.
- Faster Trades: Depending on the type of blockchain. Removing intermediaries also makes trading faster.
- DEX exchanges can be difficult to use and are not as user-friendly as CEXs.
- Less fail-safes in place, which increases the potential for lost funds.
- Lower trading volumes and token liquidity than on CEXs – can lead to a greater difference in the bid and ask prices.
- Can be difficult to find the trading pairs desired due to low supply and/or demand.
- Smart contract vulnerabilities that can lead to protocol hacks/loss of funds.
- Riskier/Unvetted coins that could be scams or “rug pulls”
How SOMA.finance Is Addressing DEX Limitations
To address the common downsides of DEX exchanges, SOMA.finance has focused its development on several crucial areas to improve the overall user experience.
The first is a focus on conducting KYC/AML verification procedures to remain in compliance with local regulations. While a major selling point in the early days of DeFi was anonymity and the ability to forgo KYC, such anonymity is not consistent with the legal and regulated exchange of crypto assets, which are financial instruments and therefore require KYC/AML. This requirement not only protects against financial fraud and other crimes but it makes the marketplace safer for all involved.
The second area of focus on the development side of SOMA.finance is improvements in UX/UI that provide users with a simplified experience that is easy to navigate and understand.
A major DEX turn-off for many has been complicated user interfaces with clunky navigation features that made it hard for users to locate what they were looking for. With SOMA.finance, accessing your favorite features will be as easy as finding someone on Crypto Twitter to pitch you their favorite project.
How to Interact With a DEX
Now that you know what a DEX is, this is how they work. Most decentralized exchanges in operation today require users to connect with them using a cryptocurrency wallet like the software wallet Metamask or a hardware wallet like Trezor.
Typically, DEX exchanges can be accessed on their official website through a computer’s web browser, where users can click a button that says “Connect to a wallet” to get started.
Once a wallet is connected and has a sufficient amount of the underlying cryptocurrency that is required to pay for transaction fees (known as gas), swaps can be conducted through the protocol swap interface using any funds already held in the wallet.
What is the fee for using a DEX?
Fees vary from DEX to DEX but generally run in the 0.3% to 0.5% range. The proceeds from fees are split, with a portion going to liquidity providers while the remainder is a protocol fee that is often deposited in the protocols Treasury.
The other main fee involved in a decentralized exchange is the gas fee, which in the case of the Ethereum network, can often dwarf the swap fees charged by the DEX. Luckily, there has been a concerted effort to create cross-chain bridges between different blockchain networks with many popular DEXs offering multi-chain support, which gives traders several different options when it comes to which network to conduct trades on. This includes separate layer-one networks like Avalanche and BNB Smart chain, as well as Ethereum layer-two solutions like Polygon and Arbitrum.