How Does a Dex Work?

Decentralized exchanges (in structure and function) are diametrically opposite to centralized exchanges. To evaluate the modus operandi of how a decentralized exchange works, we need to establish what a decentralized exchange is.

The name decentralized gives off the meaning that no central authority controls the activity of the exchange. In decentralized exchanges, there is a peer-to-peer exchange of crypto assets between users in the marketplace. There is no need for a financial intermediary, referred to as a middleman, to facilitate transactions between the participants.

A smart contract is a piece of computer code or computer programs (software) that algorithmically executes a step of logical actions. So, blockchain exchanges and protocols are mechanically driven by smart contracts.

The performance of decentralized exchanges is predicated on smart contracts. With smart contracts, agreements or transactions among disparate or anonymous parties are enforced through its internal mechanism.

Integral SIZE

Most decentralized exchanges are built on the Ethereum blockchain. Integral SIZE is a popular Ethereum DEX, originally designed and built as a decentralized exchange for executing large orders on several blockchains like Ethereum and Arbitrum. Its highly promoted feature, the time-weighted average price (TWAP), protects whale funds (large orders) from price impact, improving overall price efficiency.

To trade on DEXs, we must first outline the three different operational types of decentralized exchanges. It is a given that decentralized exchanges have evolved. Some of the earlier DEX operated like centralized exchanges. These decentralized exchanges had order books similar to centralized exchanges and faced the same challenges of slippage, price mismatch from delivery algorithm error, and shallow liquidity pools.

The improvement in order books came with automated market makers (AMMs). With AMMs came the increased challenge of slippage and front-running the AMMs and they also provided a superior user experience and protocol composability.

Another type of DEX is the DEX aggregator. DEX aggregators are super efficient and possess the classical functionality of a DEX. With aggregators, a large pool of liquidity is available to traders for vast amounts of swappable crypto assets. In addition to its robust infrastructure and anonymity features, it offers users competitive pricing for the exchange of tokens.

There are several working components of a DEX that are highly technical but for the most part, decentralized exchanges rely on features added to the smart contract like the price oracles and other beneficial protocols. With these features, the price of tradable assets is set.

Liquidity Pools

A DEX is as valid as its liquidity pools. The highly liquid DEXs like Uniswap record high trading volume. The liquidity pools serve as a replacement for conventional buy and sell orders in centralized exchanges. With liquidity pools, not only do participants find a plethora of options, but they also earn a percentage of the transaction fee. These all occur at a reduced counterparty risk to the lenders and broader access for capital to the borrowers.

DEXs come with improved interfaces. While some are wallet extensions on a web browser, others are decentralized applications (DApps), all built for the users to buy, sell, stake, and swap tokens. To trade on a DEX, the user must be sure of the consistent effort of the DEX to regularly monitor risk through safe risk management practices and customer/consumer protection. With that set, the user connects their wallet to the DEX to perform any activity like trading where the user’s asset in his wallet reflects and can be swapped for any asset for a minimal transaction fee. In the case of Ethereum, the transaction cost is denominated in gas fees.

Challenges of a DEX

The process of trading on a DEX is not entirely without its downsides. Liquidity providers could face impermanent loss. Impermanent loss is a token’s price change due to the movement from one pool to another. The value of the deposit could reduce as a result of this movement. It is called impermanent because this momentary price drop can be reversed if the token or crypto asset returns to the initial price.

Another challenge that can result from interacting on a DEX is slippage error and front-running as we discussed earlier. In front-running, some users use some form of technology or market advantage to make economic gains to the detriment of the trade initiators. So, Mr. A gets an inside knowledge of a particular buy or sell order, he then goes ahead to stack up or offset his orders in the market to make gains.

To checkmate market irregularity and price error introduced by frontrunners, most DEX have resorted to splitting the transactions into smaller transactions, creating what is referred to as batched auction matching, and adjusting for the almost resultant low slippage.

Conclusion

Several improvements have been made during the evolution of decentralized exchanges but more importantly, in the context of the loss of confidence in centralized exchanges especially with the arbitrary transfer of customers’ funds in custodial wallets, the adoption of DEXs will increase more. In most cases and primarily, the security of assets and user anonymity is the knockout punch that has engineered the growing preference for DEX. With the winding down of the FTX fiasco, centralized exchanges are living on borrowed time.

Editorial Note: This is a sponsored article. Opinions expressed are those of the sponsor and readers should conduct their own due diligence before taking any action based on information presented in this article.