Pros and Cons of Decentralized Exchange (DEX)
Marcel Deeron April 5, 2022.
A DEX, or decentralized exchange, is a peer-to-peer marketplace where crypto traders can make transactions directly. For example, a decentralized platform fosters financial transactions unmanaged by brokers, banks, or any other form of intermediary. Most popular DEXs run on Ethereum, such as SushiSwap and Uniswap.
If you’ve ever heard the term DEX blockchain thrown around, it essentially refers to decentralized crypto exchanges being blockchain-based apps. These apps facilitate the large-scale trading of crypto assets between users worldwide.
Types of Decentralized Exchanges
The DEX field is incredibly vast. However, you should be aware of three primary forms of DEXs:
1. The Automated Market Maker DEX
Many more popular DEXs fall into the category of automated market maker (AMM). AMMs are focused on pricing assets using a simple mathematical formula and organizing them into liquidity pools.
Automated market makers typically don’t support more complicated orders. However, they serve the purpose of allowing users to add their assets to liquidity pools and earn a share of the fees that trades have generated.
Uniswap is an excellent example of an AMM and was one of the first exchanges in the market to deploy an automated market maker protocol.
2. The Order Book-Based DEX
Order book-based DEXs can fulfill more complex order types that are not typically possible with AMMs. For example, functions not available with AMMs include limit, take profit, and stop-loss orders.
Older order book-based DEXs were slow and inefficient compared to today. As a result, they offered limited and low liquidity, and still do to a degree. In addition, they required traders to deposit tokens into a smart contract-controlled address, ensuring orders would automatically execute. This action made them somewhat centralized.
Today, many decentralized order book-based exchanges operate, including dYdX, IDEX, Serum, and Dexalot.
Remember that you have to pay and wait three times when purchasing a token from a DEX with an off-chain order books system. However, it’s a single transaction when using an on-chain order books system, which is much quicker.
3. The Hybrid/Alternative Platform DEX
While most DEXs classify as either order book-based or AMM platforms, there is an uptick in platforms attempting something entirely different.
Platforms such as Polkadex or Serum offer both AMM and order book-based trading features, and the new IDEX v3 platform blends the best of both worlds to create something called “Hybrid Liquidity.” This unique platform aims to address some of the underlying issues with AMM.
Advantages of Decentralized Exchanges
Decentralized currency, also known as peer-to-peer money or digital currency, refers to banking-free methods of transferring assets or ownership of a commodity without needing a third party to officiate it. Since those intermediaries aren’t necessary, it allows for more transparency between the parties and lowers the transaction costs. DEXs are desirable for enhanced privacy, better security practices, and greater user control.
Users also don’t have to worry about counterparty risk since they don't have to transfer their assets to an exchange. As a result, DEXs are famous for reducing the risk of loss and theft of funds due to hackers. They’re also able to prevent price manipulation and fake trading volume, and they can maintain anonymity among users due to a lack of Know Your Customer (KYC) crypto rules and regulations.
Disadvantages of Decentralized Exchanges
One of the main disadvantages of DEXs is the exact thing that makes them so unique: the lack of central authority. Many believe this can result in regulatory concerns.
Here are a few examples of negatives that may come with DEXs:
No Recovery Ability
The lack of a KYC process or the ability to cancel a transaction complicates things. If an account is compromised or the private key is lost, users are typically unable to recover any lost data or assets. Refunds are not possible.
Traders typically prefer centralized services with larger liquidity pools, currency pairs, and order types. DEX liquidity is inferior compared to centralized exchanges. Since they are relatively new and have low liquidity, they’ll need to attract new users to generate more in the future.
Limited Trading Functionality
Since DEXs have recently become operable, things are still in the early stages. This means functionality is pretty simple. More advanced features tend to be unavailable on most DEXs.
It takes more time to perform transactions as they need to be checked and validated on a blockchain network, and processing speeds depend on the network’s miners.
Many investors aren’t aware of the advantages that DEXs have to offer. They may be wary of security risks, and it may not be user-friendly enough; a handful may not even give them a chance because of low liquidity. Either way, it seems that the adoption of decentralized exchange has been a bit slow.
Are Decentralized Exchanges the Future of DeFi?
DEXs are a true innovation, allowing users anywhere to trade tokenized assets immediately without a third party. A blockchain or distributed ledger replaces these entities.
Decentralized exchange volume surpassed $1 trillion in 2021, and it’s not showing many signs of slowing down either.
However, since DEXs are somewhat new, some snags still need to be addressed. However, as time goes on, they have the potential to adopt more complex trading functionalities, become more secure, and grow their liquidity, leading to more users placing their faith in the system.