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Decentralized Exchanges: What Is DEX & How To Use One? | SOMA.finance

The SOMA.finance guide to getting started with a DEX.

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Key Takeaways

  • The meaning of DEX is Decentralized Exchange (DEX), a peer-to-peer marketplace where transactions take place 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.
  • 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 DEXes, Uniswap, helped put a spotlight on the sector in what became known as “DeFi Summer” during the summer of 2020.

How a DEX works

If you’re wondering what is a DEX? You’ve come to the right place. In a few words, DEXs are completely crypto native, meaning that they only trade in crypto assets and don’t allow for exchanges between fiat and cryptocurrencies. Because of this, cryptocurrencies are required in order 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 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. Most DEXs are built with open source code, meaning developers can adapt existing code to create new competing projects. This is the mechanism by which multiple spinoffs of the Uniswap interface have appeared on DEXs across the crypto ecosystem, including SushiSwap, QuickSwap, and PancakeSwap. 

Benefits and downsides of DEXs 

Benefits: 
  • Maintain anonymity – No KYC/AML required
  • No counterparty risk – Users maintain control of their funds the entire time
  • Access to unlisted tokens before they are added to centralized exchanges, which often results in a notable price increase. 
  • Utility in the developing world often lacks good banking and financial services
Downsides: 
  • 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 to interact with a DEX

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 a Trezor. 

Typically, DEXs 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 protocols 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.

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