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A to Z on a Decentralized Exchange & the Mechanism of It


The most recent thing in the blockchain universe might be DeFi (decentralized finance), widely known as apps on digital finance developed on decentralized blockchain networks. In accordance with a reliable source, the cryptocurrency value kept in DeFi apps today is approximately USD 89.23 billion. Nonetheless, besides a DeFi, one should also know about a decentralized exchange (DEX). 

To begin everything with, a DEX is a part of developing DeFi tools that allow a large variety of financial services to be connected with a suitable crypto wallet. Let's focus more on the DEX instead and find all about it below. 


What is a Decentralized Exchange?

Abbreviated as DEX, a decentralized exchange is a P2P (peer-to-peer) exchange that plays a role as a connecting bridge between traders and buyers of crypto assets. Different from its counterpart, CEX or centralized exchange, a DEX is 'noncustodial', meaning users remain in control of their private key when having a transaction via a DEX platform. 

Due to the central authority's absence towards DEX, users optimize smart contracts that run themselves under defined circumstances and record every single transaction made in the blockchain. Who can resist such a highly-secure transaction without any central authority? This may contribute to the increasing segment of the crypto asset market. 

The Role of Automated Market Makers (AMMs) in Creating a DEX

So, what is the correlation between AMMs and a DEX? Well, to start it with, an AMM (automated market maker) is the key protocol that drives the entire DEXs, which will then assist users in exchanging cryptocurrencies with a direct connection to the other users—with no mediator at all. 

In other words, AMMs are mechanisms in autonomous commerce that write off the requirement for CEXs (centralized exchanges) and other relevant techniques that involve market making. 


How a DEX Works

Speaking of mechanism, there are three ways in which a DEX works in the cryptocurrency universe, as follows. 

Order Book

This way is the 'first generation' to use in DEX and is more or less similar to the CEX. It collects the record of the whole orders of any trading and purchasing activities for a particular asset. The difference between the order book way and the conventional CEX is that the price really determines the depth of the effective market price and the order book itself. 

On an order book way of a decentralized exchange, the information is usually stored in an on-chain transaction while the user's fund is kept in their wallet, which is off-chain. 


After the order book, the next generation in DEX is swapped to support any commercial activities related to crypto-assets or to determine prices. Nevertheless, the swap platform optimizes a liquidity pool to set the asset prices. 

On a P2P network, the transactional process will directly trade between the users' wallets, known as a swap. A DEX works this way by rating the asset value stored in smart contracts or TVL (total value locked). 

DEX Aggregator

DEXs commonly use some varieties of protocols or methods. Even though DEX's dynamic ways of working often result in a much better autonomy and security, the impact is usually low-grade liquidity throughout any platform. 

That poor level of liquidity may be an obstacle for traders or investors looking forward to purchasing some particular cryptocurrency assets in more enormous volumes. The good news is that DEX aggregators exist to overcome the issue by developing tools to add depth to the pools of asset liquidity across any DEXs.


The Benefits of Using a DEX

Trading with a DEX is relatively expensive, specifically when the transaction fee is pretty high. Fortunately, there are actually many benefits you can consider, and some of the major ones are as follows.

Reducing Security Risks

One of the numerous advantages of using a DEX is how high it is the security level of the assets. As DEX is noncustodial, users do not have to lose control over their private key in any transactions. In addition to that, an external (off-chain) wallet can be directly bridged with the DEX, making the trading activities automatically run via a smart contract. 

Keeping the Users' Anonymity

As mentioned above, a trader who uses a DEX does not have to reveal their own private keys as their wallet is stored off-chain and the DEX is not in charge of the trader's funds. This means, as a user, you get to keep anonymous during the transactions, which is excellent for your own safety and convenience.  

Making Token always Available

DEXs include any printed token in the blockchain, meaning new projects may be listed on the exchanges before they even become available on the CEX. Even though this means users can get ready early on the projects, all types of scams will also be listed on the DEX. 

One of the scams that often happens is 'rug pulls.' This common scam occurs when the team throws away the tokens used in order to make liquidity available on the pools of exchanges—especially once the price is high. This will create a barrier for other users to trade. 


The Downsides of Using a DEX

Despite the many benefits the DEX offers, the platform still has several drawbacks that users must focus on. They include:

Still Under a Development Phase

Right now, the DEX remains in the early development stages, so users must understand if there are any flaws with the platform. This is specifically for those unfamiliar with DeFi (decentralized finance) in blockchain technology. Furthermore, users also have to top up the balance of their wallets with a transfer of some cryptocurrency assets or fiat currency. 

As if that is not enough, users need to link their wallets first to the DEX interface to make a transaction. The process of fund depositing in making a sale is somehow more straightforward to do via centralized exchange methods. 

Poor Liquidity Level

As a relatively new product of DeFi, DEX facilitates numerous trading pairs, making the market segregation negatively affect the market liquidity. 

Lastly, despite some drawbacks of decentralized exchange platforms, the DEX asset liquidity has been increasing along with the DeFi itself. Therefore, there will be a better change in the near future. 

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