This is the final chapter in the series on how exchanges work. You can read part 1, an intro to crypto exchanges here, and part 2, on exchange aggregators, here.
5 key takeaways
- Peer-to-Peer Trading: DEXs use blockchain technology for direct, peer-to-peer trading, bypassing traditional intermediaries for increased transparency and cost-efficiency.
- Role of Smart Contracts: Transactions on DEXs are managed by smart contracts, self-executing code lines acting as automated market makers for direct asset exchange.
- Using a DEX: Users need a compatible digital wallet to interact with a DEX, which allows them to place and track orders. DEXs often use liquidity pools and mathematical formulas for price calculations.
- Risk Factors: Risks in DEXs include smart contract vulnerabilities, visible on-chain transactions leading to front-running risks, liquidity risks causing price slippage, and scalability issues causing transaction delays.
- DEX Evolution: Despite challenges, DEXs continue to evolve, offering an alternative to traditional financial systems with ongoing improvements in security, efficiency, and user experience.
Decentralised crypto exchanges (DEX) are a revolutionary trading paradigm that emerged from the evolution of blockchain technology. As the name suggests, they are platforms that facilitate peer-to-peer trading directly on the blockchain without intermediaries. Their unique architecture has prompted significant interest in the blockchain community, but understanding their operations, usage, and inherent risks is crucial before making an informed dive into this new ecosystem.
How does a DEX work?
Traditional financial systems require middlemen like banks and brokers to facilitate transactions. These intermediaries often impose fees and restrictions, creating an opaque and costly trading environment. Blockchain technology, however, enables users to bypass these intermediaries through a DEX. The peer-to-peer structure of a DEX means that trades are conducted directly between users, ensuring transparency, speed, and cost efficiency. It ultimately removes your need to place your trust in a counterparty.
A DEX operates through smart contracts, which are self-executing agreements with the terms of the contract directly written into lines of code. These smart contracts allow users to exchange digital assets instantly. When two parties agree to a trade, the smart contract automatically executes it, transferring the assets between their digital wallets.
How to use a DEX
To use a decentralised crypto exchange, users typically require a compatible digital wallet, like MetaMask or WalletConnect, to interface with the platform. Once connected, users can place orders, execute trades, and track transactions directly from their wallets, maintaining complete control over their assets at all times.
There are three types of DEX: automated market makers (AMM), order books, and DEX aggregators.
Predominantly, DEXs offer “swaps” as the main mechanism for exchanges where the market making is automated (hence AMM). Instead of using a traditional order book, swaps utilise liquidity pools to facilitate trades. Liquidity providers (LPs) stake their crypto assets into these pools, and a formula, such as the "constant product formula," calculates the post-swap price based on the size of the trade and the current liquidity. This structure allows DEXs to ensure trade execution even in lower liquidity scenarios.
Some DEXs offer conventional limit order books similar to those on a centralised exchange. Users can input the amount and type of asset they wish to trade and the price they are willing to accept. Once the conditions of the order are met, the smart contract automatically executes the trade. These types of exchanges are less transparent as a market maker is required to facilitate the trade, meaning some trust is still needed to be placed in the counterparty.
DEX aggregators are comparable to a decentralised exchange search engine, as they aggregate decentralised exchanges, eliminating the need to find the best token price manually. These platforms use various protocols to aggregate liquidity from multiple DEXs, enabling them to minimise slippage on large orders, lower trading fees, and offer optimal token prices.
DEX risks
While decentralised crypto exchanges offer significant benefits, they are not without risks. One major concern is the vulnerability of smart contracts. Even though these contracts are often audited, potential exploits can occur, particularly affecting LPs. However, the risk for regular users is relatively small.
Front-running risks also exist in the DEX environment. In traditional markets, front-running refers to the practice of a broker executing orders on a security for its account while taking advantage of advanced knowledge of pending orders from its customers. In a DEX, a similar attack, known as a "sandwich attack," can occur, where a malicious actor sees a pending transaction on the blockchain and quickly places a trade before and after it, potentially manipulating the price.
Liquidity risk, or slippage, is another concern. As DEXs typically have smaller trading volumes than CEXs, an asset's price can change significantly between when a trade is placed and when it is executed, particularly for large transactions.
Finally, DEXs face scalability challenges. Because all trades are processed on-chain, network congestion can cause delays in transaction confirmation or even failed transactions. In periods of high demand, these scalability issues can become particularly pronounced, leading to a subpar user experience.
Conclusion
DEXs offer a decentralised and transparent trading environment, providing an excellent alternative to traditional financial systems and CEXs. Their reliance on smart contracts and blockchain technology facilitates direct asset exchange, making peer-to-peer trading a reality. However, as with any financial system, DEXs have their risks. It's essential for potential users to understand these risks, including smart contract vulnerabilities, front-running attacks, liquidity risks, and scalability concerns. As the blockchain space evolves, improvements in these areas are being developed to create a more secure, efficient, and user-friendly DEX environment.
The SwissBorg solution
Much like a DEX aggregator, at SwissBorg we run a more centralised version, which we call the Smart Engine. The Smart Engine is a powerful exchange aggregator which aims to find you the best rates and liquidity across multiple big exchanges. We value the transparency of decentralisation above all, and whilst we cannot yet offer a DEX, we put transparency at the forefront of our operations, empowering our users with information about where and at what price their orders were executed. This level of transparency ensures that we don't add hidden spreads, nor do we engage in trading against our users.
