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Decentralised Exchanges; The Complete Mega Guide

What is a Decentralised Exchange (DEX)?

A decentralised exchange (DEX) is a peer-to-peer (P2P) platform that connects crypto buyers and sellers. Where a DEX differs from a centralised exchange (CEXs) (e.g. Binance or Kucoin etc) is in the ability of users to retain custody of their private keys and therefore, their tokens (Remember; not your keys, not your coins!).

Decentralised Exchanges (DEX) vs. Centralised Exchanges (CEX)



Rather than having a central platform (a CEX) to deposit your assets on which can lead to security issues, DEXs run on smart contracts, which then self execute under the set parameters of the transaction and record the transaction on the blockchain.



This non-custodial setup is the essence of decentralisation. No middlemen, just one person direct with another person. Put simply, DEXs replace central platforms with smart contracts, giving the user the benefit of easier access, lower fees and increased security.

How do DEXs Work?



A DEX is built on a smart contract supporting blockchain. As mentioned earlier they are non-custodial (users retain custody of their assets). When a transaction is executed by the smart contract, users are charged a transaction fee and a trading fee.



A Short Word on Liquidity.



It is important that at this stage we take a short pause to explain the concept of liquidity as this will help you understand the nuances of the different types of DEXs.



In short, liquidity refers to having enough of each cryptocurrency on an exchange to meet demand. If an exchange has low liquidity, it could be difficult to complete your buy or sell transaction.

 

Decentralised exchanges run on one or more of three models. However, Cardax takes one of them and improves it. More on this later.



All three of these models allow users to interact in a peer-to-peer fashion through the smart contract.



  • Automated Market Maker (AMM) DEXs

  • Order Book DEXs

  • DEX Aggregators



Different types of decentralised exchanges

Automated Market Makers (AMMs)



Automated market maker (AMM) DEXs have been around since Uniswap was launched in 2018 and are designed to solve the liquidity problem. To prevent low liquidity on AMM DEXs by using liquidity pools instead of matching buy orders with sell orders (see Order book DEXs below).



What are Liquidity Pools?



Liquidity pools are crowdsourced “baskets” of (usually) a trading pair of cryptocurrencies that are locked in a smart contract. Liquidity providers allocate some of their holdings to a pool and are rewarded for doing so by receiving trading fees. 



A liquidity pool with a high number of locked tokens is much more stable, meaning the crypto price is also more stable and traders experience less slippage. 



So, What’s Slippage?



Slippage describes the change in price from when the user initiated the trade until its completion (this can be positive or negative). The larger the transaction the greater the possible slippage.



If one asset is more volatile than the other in a trading pair, liquidity providers can also suffer from impermanent loss. 



A trading pair is always kept at a specific ratio between the two cryptocurrencies.

If the price rises considerably in the more volatile asset, a liquidity provider’s total hold (the number of tokens locked) may go down (because it is held in a set ratio). It is considered impermanent because as the price of the token comes back down, their holding will go back up again (to rebalance the ratio).

Order Book DEXs

Order book DEXs compile all open buy and sell orders for specific asset pairs. A buy order indicates a user wants to buy an asset for a specific price and a sell order shows the opposite. The range between the buy and sell orders and the volume of orders determines the market price on the exchange.



There are two types of order book DEXs:

  • On-chain order books

  • Off-chain order books



On-chain order books hold open orders on the blockchain while allowing users to keep their funds in their own wallets. Whilst this is the more fundamentally decentralised option, recording orders on-chain could result in slower transaction time and increased fees



In contrast, off-chain order book DEXs generally have increased transaction speed and lower costs but because the buy and sell orders must be recorded somewhere else, usually on a third-party platform, this reduces the decentralisation of the DEX.



It is worth noting that both types of order book DEXs can suffer from liquidity issues as in essence, they are competing with the large centralised exchanges (which all use the order book methodology).

DEX Aggregators



In short, a DEX aggregator uses many other DEXs to find the best (cheapest and fastest) trade for the user.



Think of it like this. 



When booking a flight, you can go straight to the airline and book a return ticket between your chosen destinations or you can use one of the many websites and apps that aggregate data from all the airlines to find you the cheapest option, you may have a different airline on your return journey from your outbound journey but you’ll pay less as the service you use will match the cheapest options for you.



DEX aggregators do the same, they are fed data from many DEXs and execute the user's trade depending on what the cheapest route is at any given time.



DEX aggregators aim to provide minimal slippage and fees while giving the user the best price in the shortest possible time.



So what one is Cardax using?



Extended Automated Market Maker (EAMM) Protocol 



Cardax aims to utilise a best of both worlds approach. As we have seen order book DEXs work better with training pairs with high liquidity but not so well with low liquidity. Whereas AMM DEXs serve illiquid (low liquidity) pairs as long as there is enough locked in the liquidity pool.

The EAMM protocol aims to:

  • Allow anyone to be a market maker by starting their own liquidity pool or joining an existing one.

  • Minimise slippage.

  • Minimise the risk of impermanent loss.

  • Provide more price transparency.

  • Allow token issuers to create a new trading pair without having to provide a large amount of collateral.

What can you do on a DEX?

Apart from trading your crypto tokens, there are several other ways of making a passive income on decentralised exchanges.



Liquidity Mining

Also known as yield farming, liquidity mining allows automated market maker DEXs to function. Given that AMM DEXs need to have liquidity, platforms allow you to earn a passive income from providing liquidity to the liquidity pools.



Liquidity providers are paid some of the transaction fees for transactions using the liquidity pool. These rewards are generally paid in the form of the DEX’s own utility token.



These utility tokens can then either be traded for any other token (or stablecoin) or, on some DEXs utility tokens can then be staked to earn further rewards.

What are the Advantages and Disadvantages of using a DEX?

As with any financial solution, there are advantages and disadvantages; decentralised exchanges are no different, especially as they are still in their infancy. 



It is important to take both the pros and the cons into account before diving headfirst into DEXs. As long as you’re comfortable with the potential downsides, go for it!



Advantages of Using a DEX

  • Custody. Not your keys, not your coins” is the phrase that echoes around the crypto world. DEXs are non-custodial; they don't require users to give up control of their private keys in order to trade. DEXs interact with a user's private wallet (such as Daedelus or Yoroi on Cardano) via smart contracts. Centralised exchanges all require you to give up custody of your assets…erm…no thanks!!

  • Trustless Transactions. Smart contracts record every transaction directly onto the blockchain, so buyers and sellers don’t need to rely on a third party (like a CEX) to ensure their transactions are secure; as DEXs don’t hold your funds, they are less likely to be targetted by hackers.

  • Diversity of Market. As of November 2021, coinmarketcap.com lists over 8200 different cryptocurrencies, most of which are only accessible on decentralised exchanges because P2P transactions can occur without having high trading volumes. Centralised exchanges control which tokens they will list and, as we said earlier, CEXs work better with higher trading volumes, so they generally only list tokens with a high enough volume of transactions. 

  • Privacy. DEX users are not usually required to complete KYC (know your customer) and AML (anti-money laundering) protocols. This is a result of the DEXs not being liable for your assets because you retain custody of them.

  • Lower Fees. As we mentioned earlier, DEXs run on self-executing smart contracts, eliminating the need for a penny-pinching middleman (e.g. a centralised exchange). While fees on DEXs do fluctuate, they remain far lower than the fees on CEXs.

  • NFT and DeFi products. With the launch of smart contracts, DEXs can do more than just swap tokens. Financial services like lending and borrowing can be bolted onto a DEX, as can NFT art and gaming products.

 

Ok, so that all sounds groovy, I’m going to dive in” We hear you cry! 



Hold your horses' soldier!



Successfully navigating any part of the crypto world relies on being sensible and using your common sense. 



That said, let's look at the potential disadvantages.



Disadvantages of Using a DEX

While the following can be considered disadvantages, most, if not all, are a result of the infancy of the DEX industry and will become less and less of a problem as the arena matures. Depending on the blockchain the DEX is built upon (Cardano especially), some of the following disadvantages have already been fixed!



  • Scalability. A DEX is only as good as the blockchain it is built upon, therefore it is bound by the same scalability issues as the host blockchain. As adoption rises, so does the volume of transactions. If the host blockchain struggles to handle the volume, transaction times and fees go up. We have seen this recently with skyrocketing congestion and gas fees on the Ethereum network. Third-generation blockchains like Cardano, are able to handle a much higher volume of transactions and with upgrades like Hydra, Cardano will be able to scale even more while still retaining decentralisation and security.

  • User Experience. Early DEXs were often clunky and difficult to navigate, however, today’s DEXs are much more user friendly. DEXs like Cardax aim to make the user experience much more fluid and logical. 

  • User Learning Curve. The number of novel concepts that a new DEX user must get to grips with is a barrier to entry. Whether it’s the jargon or the ability to transfer funds from wallet to wallet etc, many DEXs and blockchains are pumping out academy style learning material (exactly like this article in Cardax’s academy!) to help new crypto investors make the leap without issue.

  • Liquidity. As we mentioned earlier, liquidity is always an issue, especially with newer DEXs or trading pairs, however, the uptake of the entire DeFi space over the last few years has been nothing short of remarkable. Currently, there is around US$100 billion locked in DeFi. This will only increase over the next few years, so the liquidity problem is a beaten dragon.

  • Currency on and off-ramps. In order to invest in crypto and start using decentralised exchanges, you need to be able to get your fiat currency (USD, GBP and Euro etc.) onto the system somehow. Currently, support for fiat on and offramps is limited and difficult for new users to manage. However, like the other “disadvantages”, time will fix it. This may be by using new stablecoin technology (like Djed) or the ability to buy crypto directly from the token issuers. Either way, if DEXs continue to progress at the same incredible rate as they have been, it won’t be a problem for long.



Final Thoughts

At present, centralised exchanges still dominate the majority of crypto trading, decentralised exchanges like Cardax are launching left, right and centre (especially on Cardano) and they all share a similar idea; “How can we make it easier for new crypto investors to join the party”.



With this kind of mentality, adoption will increase exponentially and the usage gap between CEXs and DEXs will dramatically reduce.



Given the advantages of DeFi in general, the growth of the sector over the coming years is going to be very exciting. Will it change the global financial industry as a whole? We certainly hope and think it will. People deserve better than the greedy banking fat cats we have at present.



Welcome, stick with it, future generations will thank you!

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