Everything There Is to Know About Decentralized Stock Exchanges

Josiah Makori
By Josiah Makori
Siphokazi Mdidimba
Edited by Siphokazi Mdidimba

Published June 6, 2022.

Graphs on computer screen with city buildings in the background

What Is a Decentralized Stock Exchange?

A decentralized stock exchange or decentralized exchange (DEX) is a peer-to-peer (P2P) marketplace that facilitates direct trades between market participants. They accomplish one of crypto's primary missions: enabling financial transactions without intermediaries.

Uniswap and Sushiswap are the biggest decentralized stock exchanges by transaction volume built on the Ethereum blockchain. They are part of the budding collection of decentralized finance (DeFi) tools, consisting of a wide range of financial services and products accessible with a digital wallet.

Trading comes with its fair share of risks, but traders should not encounter additional risks other than those they are willing to handle. Typically, decentralized stock exchanges don't provide custody of users' funds. Instead, traders directly keep their digital assets in their digital wallets all the time.

The legality of decentralized stock exchanges is uncertain as digital assets themselves. For example, some DEXs are illegal in the State of New York in the U.S. Besides, popular DEXs are increasingly under scrutiny by regulators for compliance, transparency, and other customer relations issues.

In some instances, decentralized stock exchanges are the only avenues of obtaining digital currencies that are not listed on government-regulated marketplaces, like Monero and Dash. Furthermore, DEXs allow investors to stake their assets in liquidity pools to generate rewards.

However, there is a risk of using decentralized stock exchanges—users don't enjoy the same protections offered by centralized exchanges (CEXs). This is why most stock traders still prefer CEXs over DEXs.

How Does a Decentralized Stock Exchange Work?

DEXs differ from CEXs by leveraging the full functionalities of blockchain technology, especially smart contracts and decentralized governance models. In a DEX, users enjoy custody of their assets in the protocols or blockchain networks.

You need to consider the various types of DEXs to understand better how decentralized stock exchanges work. Let's briefly have a look at each of them:

Automated Market Maker DEXs

The first noteworthy type of DEXs is the one that applies the automated market maker (AMM) model. The approach uses smart contracts to resolve the liquidity issue plaguing cryptocurrency exchanges. AMM relies on blockchain oracles to access data from other marketplaces and establish the fair prices of assets.

When you take a closer look, AMMs present a significant deviation from how DEXs work with matching buy and sale orders. Contrary, DEX protocols rely on pre-funded asset pools, known as liquidity pools.

Two examples of DEXs from this category include the following:

  1. 1inch Exchange It aggregates liquidity from various DEXs to reduce slippage on big orders. In the stock market, slippage is a product of inadequate liquidity in one marketplace, making a buyer incur more on an asset than was expected. 1inch minimizes slippage and allows traders to discover the best market prices for assets.
  2. DiversiFi It aggregates liquidity from DEXs and CEXs to offer the best liquidity. Besides, it applies StarkWare's batching technique to enable almost 10,000 trades per second.

Liquidity Pool DEXs

Liquidity pools in AMM-based DEXs comprise two digital assets in a trading pair. Liquidity providers (LPs) deposit assets in a 1:1 ratio into a DEX's liquidity pool. They receive a certain percentage of transaction fees for every trade performed on the pair. In addition, LPs lock an equal amount of the assets in a trading pair to earn interest via liquidity mining.

Liquidity pools play a major role in how DEXs work as they allow users to perform trades and earn interest in a permissionless, trustless and transparent way. You can compare them to the vast cash reserves banks use to provide financial services to customers. With liquidity pools, traders don't have to wait for an imaginary buyer or seller to match their transaction requests.

Two examples of DEXs from this category include the following:

  1. Uniswap It allows traders to swap a pair of listed assets through liquidity pools. The pools ensure Uniswap remains permissionless and trustless, further democratizing financial products and services.
  2. Curve Like Uniswap, Curve is a liquidity pool decentralized stock exchange, but Curve categorically deals with stablecoin trading, facilitating trades with minimal slippage and fees.

The other examples of liquidity pool DEXs include SushiSwap, DODO, Balancer, Bancor, and Gnosis.

Order Book DEXs

Still, on waiting for an imaginary buyer or seller, order book decentralized stock exchanges present another approach to how DEXs work. Order books enable document compilations of all open buy and sell orders.

In order book DEXs, the difference between the buy and sell orders is essential in finding the order book depth. Consequently, the order book depth helps establish the market price of assets in a marketplace.

  1. dYdX It enables users to use derivative products in a decentralized way. The platform also offers P2P borrowing, meaning users can generate passive income by holding assets on the dYdX protocol.
  2. DDEX It enables decentralized margin trading. In other words, it allows users to borrow assets and increase their potential yields.

Other order book DEXs include Binance DEX, Looprint Exchange, ViteX, Tomo DEX, and Nash Exchange.

Advantages of Decentralized Stock Exchanges

  • A broad basket of assets If you are looking for newly listed tokens with high potential, DEXs have you sorted. They have a nearly endless basket of assets—from popular to little-known tokens.
  • Heightened security They are tentatively impossible to hack since DEX users self-custody their assets.
  • Anonymity Users do not need to sign up or submit personal information to use DEXs.
  • Unlimited access Unlike CEXs that are restricted by local laws, DEXs are borderless. Anyone from any part of the world can access them by connecting their digital wallets.

Disadvantages of DEXs

  • Complex user interfaces DEX users require extensive knowledge as the interfaces are complex. To make matters worse, DEXs lack customer support to guide users accordingly.
  • Smart contract vulnerability DEX platforms are as secure as their underlying smart contracts. They may contain bugs that hackers can exploit to access user wallets.
  • Riskier tokens Since DEXs list coins without vetting them, most of the listed tokens are riskier than those listed in CEXs.

Decentralized Stock Exchanges–Bottom Line

While CEXs are more popular than DEXs, some market participants dislike their bells and whistles. Satoshi Nakamoto's original vision was to decentralize traditional finance completely, and decentralized stock exchanges align well with this vision as they eliminate third parties and significantly minimize fees. As DEXs are built on smart contracts, expect more revolutionary use cases in the future.