What are Decentralized Exchanges? Beginner’s Guide on DEXs
Decentralized exchanges – or simply DEXs, allow you to buy and sell cryptocurrencies without going through a centralized platform.
DEXs offer a number of core benefits over their centralized counterparts, such as being able to trade without providing any personal information, lower fees, and avoiding the need to go through an intermediary.
In this beginner’s guide, we explain everything there is to know about decentralized exchanges – and why you might consider using one over a centralized provider.
- 1 What is a Decentralized Exchange? Overview
- 2 Pros and Cons of Decentralized Exchanges
- 3 How do Decentralized Exchanges Work?
- 4 Benefits of Using a Decentralized Exchange
- 5 What Products and Services do DEXs Offer?
- 6 How to Use a Decentralized Exchange
- 7 Conclusion
- 8 FAQs
What is a Decentralized Exchange? Overview
As the name implies, a decentralized exchange is a cryptocurrency platform that allows users to buy and sell digital assets without requiring a third party.
This is in stark contrast to a centralized exchange like Binance, which requires you to register some personal details and deposit funds into your account. Then, when it comes to trading, centralized exchanges use traditional order books. This means that in order to buy a cryptocurrency, there needs to be a seller on the other end of the trade.
In comparison, decentralized exchanges operate without an intermediary. There is no requirement for users to open an account nor provide any personal information. Instead of depositing funds into the platform itself, decentralized exchanges simply require users to connect their private wallet – which is both secure and convenient.
Moreover, decentralized exchanges do not use order books to facilitate buy and sell orders. On the contrary, DEXs use a relatively new and innovative system known as an automated market maker – or AMM. In a nutshell, the AMM utilizes liquidity pools. This means that when a user swaps Ethereum for DAI, the required tokens are taken from the liquidity pool in real-time.
Decentralized exchanges typically offer much lower fees than centralized platforms. After all, DEXs operate autonomously via smart contract technology, which means that the costs of running the exchange are minute. Many DEXs in this space – including DeFi Swap, offer a variety of other tools in addition to exchange services – such as staking and yield farming.
Pros and Cons of Decentralized Exchanges
Here’s a quick overview of the pros and cons of using a decentralized exchange:
Pros of Decentralized Exchanges
Cons of Decentralized Exchanges
There is no guarantee that you will make money when investing in this or any DeFi product or service. Proceed at your own risk.
How do Decentralized Exchanges Work?
The overarching pillar of Bitcoin – the world’s first and still de-facto cryptocurrency of choice, is decentralization. This means that people from all over the world should be able to send and receive funds without going through a third party.
And as such, there is no reason why over a decade after Bitcoin was created we should be buying and selling digital currencies via a centralized operator.
Instead, decentralized exchanges offer all of the tools and features as found on a centralized platform – but without requiring an intermediate or custodian.
If you’re completely new to decentralized exchanges and require some comprehensive information about how they work – the following sections will explain everything you need to know.
The entire framework of a decentralized exchange is backed by smart contract technology. This enables the exchange to operate and subsequently facilitate buy and sell orders without requiring a third party.
The underlying smart contract essentially sits between traders and the blockchain network. For instance, if a trader wishes to swap BNB for BUSD, the smart contract will communicate with the blockchain autonomously and complete the exchange.
Most importantly, smart contracts that govern decentralized exchanges are both transparent and immutable. The former means that each and every transaction is publicly viewable on the respective blockchain.
The latter ensures that no person or authority can amend the smart contract for their own gain.
Automated Market Makers (AMMs)
Perhaps the most innovative part of decentralized exchanges is the automated market maker system. In its most basic form, AMMs are linked to a liquidity pool for a specific trading pair – such as Ethereum and Tether (ETH/USDT).
The AMM will determine what price ETH/USDT should be offered to trades on the respective exchange. This is based on a highly complex algorithmic model, albeit, the main drivers that determine prices include:
- Buying and selling pressure
- Market capitalization
For instance, if the pair has a huge market capitalization alongside significant trading volume, buy and sell orders will not have as much of an impact on the AMM’s pricing model.
On the other hand, pairs with a small market capitalization that attract large trading orders will have a much greater effect on pricing.
Nonetheless, automated market makers completely alleviate the need to use a traditional order book system – which is implemented by centralized exchanges.
Automated market makers enable buyers and sellers to trade cryptocurrencies without a third party or a traditional order book. This does, however, mean that the trading pair will need to have sufficient levels of liquidity available.
After all, if somebody wants to swap $1,000 worth of BNB for GALA, there needs to be $1,000 worth of GALA in the respective pool. If there isn’t, there is no way for the underlying smart contract to execute the swap.
This is where liquidity pools and yield farming come into play. In a nutshell, decentralized exchanges allow users to earn a passive income on their idle tokens by adding liquidity to a pool. In return, the user will be paid a share of any trading fees that the pool collects.
This is a win-win situation for both the decentralized exchange and the user. While the exchange gets the liquidity that it requires, the user can generate interest on their tokens.
We mentioned earlier that when trading cryptocurrencies on a decentralized exchange, there is no requirement to register or even deposit funds. Instead, DEXs support non-custodial trading.
In its most basic form, this means that the DEX does not at any point hold the tokens that you wish to trade. On the contrary, you can access your desired trading market simply by connecting your wallet.
For instance, if you use the MetaMask browser extension, you can securely connect it to the DeFi Swap exchange at the click of a button.
The underlying DeFi Swap smart contract would then be able to transfer the tokens from your MetaMask wallet and exchange them for the cryptocurrency you wish to buy.
Then, the smart contract would deposit the new cryptocurrency back into your MetaMask.
Here’s a simple example to expand on the above point:
- You connect your wallet to a DEX
- You fill out a simple order box
- You state that you want to swap 1,000 BUSD for BNB
- The smart contract would deduct 1,000 BUSD from your wallet
- It would then swap 1,000 BUSD for BNB at the current exchange rate as determined by the AMM
- Finally, the smart contract would transfer the BNB into the wallet that is connected to the DEX
Best of all, the above example would be completed by the smart contract in a matter of seconds.
Decentralized exchanges have the ability to connect to a specific blockchain network. For instance, let’s suppose that your chosen DEX is compatible with the Binance Smart Chain (BSc). This means that in theory, the DEX should allow you to swap any two tokens listed on this blockchain network.
With that being said, DeFi Swap – which currently supports the BSc, is currently working on cross-chain functionality. This means that it will eventually allow users to swap tokens from two completely different networks. For instance – Ethereum for BNB or Bitcoin for XRP.
Achieving this goal at a centralized exchange is simple, as the platform will have an allocation of all of the tokens that it supports. However, as decentralized exchanges connect directly to the blockchain network via smart contracts, it needs to have the required framework in place to achieve this.
Nonetheless, the development team at DeFi Swap is in the final stages of adding additional networks to its DEX, so there will no longer be a need to use a centralized operator.
Benefits of Using a Decentralized Exchange
If you’re completely new to the decentralized exchanges and wondering whether or not they are a better alternative for you than centralized platforms – below we explore the key benefits that DEX offer.
First and foremost, the major difference between centralized and decentralized exchanges is the information required from users. That is to say when using a centralized platform, you are required to go through a registration process.
- For instance, let’s suppose that you were to open an account with Coinbase.
- You would first need to provide a full range of personal information – such as your first and last name, residential status, home address, date of birth, and contact details.
- Next, Coinbase would then ask you to go through a KYC process.
- Not only does this require you to upload a copy of your passport or driver’s license, but a selfie of you holding the document.
- A proof of address is typically required too – such as a bank statement or utility bill.
In comparison, decentralized exchanges require none of the above. No personal information, no contact details, and not even an email address.
Furthermore, there is no requirement to upload any documents. This allows you to access core DeFi services anonymously – such as token swaps, yield farming, and staking.
Access DEX Services Instantly
Not only do decentralized exchanges allow you to trade digital currencies anonymously, but the setup process is significantly faster than using a centralized platform.
For instance, once you have gone through the KYC process, centralized platforms then require you to add funds to your account. This can again delay the process – oftentimes by several days if opting for a bank wire.
In comparison, it takes just seconds to start using a DEX. For example, when using DeFi Swap, all you need to do is connect your preferred wallet to the platform and you are good to go.
DEXs Never Touch Your Funds Directly
As noted earlier, the main premise of decentralized exchanges is that the underlying framework is backed and governed by smart contracts. What this means for you is that your chosen DEX will never touch your funds directly.
Instead, after you have connected your wallet and chosen your desired DeFi service – such as a simple token swap, it is the smart contract that will execute the trade.
In order to do this, the smart contract will deduct the token that you wish to swap from your wallet. It will then obtain your preferred token from the AMM and subsequently deposit the funds into the wallet you have connected to the DEX.
To add to this point, the fact that tokens are not held by a decentralized means that the risk of being a victim of a hacking attempt is near-enough alleviated. Your tokens are not kept in the DEX, rather, they are instantly transferred to your wallet.
After you disconnect your wallet from the exchange, nothing else can happen. In comparison, centralized exchanges are fraught with risk.
Time and time again we hear about platforms being hacked and users subsequently losing the tokens that they have stored on the respective exchange.
No Restrictions on Location or Products
National regulators are becoming more and more focused on centralized exchanges.
By this, we mean that conventional crypto exchanges are required to comply with a wide range of draconian regulations that ultimately restrict an individual’s freedom to invest and trade.
For example, a number of popular centralized exchanges do not accept account applications from certain regions of the world. Moreover, some nationalities are prohibited from accessing certain crypto products – such as leveraged tokens or derivatives.
Decentralized exchanges, however, do not discriminate against people based on where they are from. Instead, DEXs offer their products and services to all.
No Single Point of Control
Decentralized exchanges have no single point of control. This means that no single person or authority – such as a government, can take control of the platform.
This is in stark contrast to how centralized exchanges work. After all, governments can at any time decide to shut the respective exchange down if it operates within its jurisdiction.
What Products and Services do DEXs Offer?
Decentralized exchanges offer a vast range of products and services, such as those discussed below:
Perhaps the main service offered by decentralized exchanges like DeFi Swap is the ability to swap one token for another without needing to go through a third party.
As we explained earlier, DEXs use liquidity pools. This means that users can exchange ETH for DAI at the click of a button without requiring a traditional order book system. Instead, decentralized exchanges use an AMM model.
DeFi Swap and several other DEXs in this marketplace also offer staking products. This allows you to earn a fixed rate of interest on your crypto tokens.
At DeFi Swap, there are four terms to choose from – 30, 90, 180, and 365 days. The term that you choose will determine how long the tokens are locked away and thus – cannot be withdrawn.
Here’s a quick example of how staking works:
- You own 1,000 BUSD tokens
- You opt for a 365-day term at an APY of 11%
- After 365 days have passed, you receive your 1,000 BUSD tokens back into your wallet
- You also receive your 11% staking rewards, which amount to 110 BUSD
You can read our full beginner’s guide on crypto staking here.
DeFi Swap also offers yield farming services on its decentralized exchange.
Here’s a quick example of how yield farming works:
- You want to provide liquidity for the trading pair BNB/BUSD
- You provide equal amounts of BNB and BUSD (in dollar terms)
- For instance, suppose that 1 BNB is worth $310 BUSD. Therefore, you deposit 2 BNB and $620 BUSD.
- You will then earn a share of any trading fees collected on DeFi Swap for the BNB/BUSD pair
Yield farming deposits can be withdrawn at any time. When you do make a withdrawal, you will receive your initial deposit plus any rewards that have been earned.
You can read our full beginner’s guide on DeFi yield farming here.
How to Use a Decentralized Exchange
For an overview of how to use a decentralized exchange, we will now show you how to trade tokens on the DeFi Swap platform.
Step 1: Connect to DeFi Swap
DeFi Swap currently supports tokens on the Binance Smart Chain (BSc). Therefore, in order to use the DeFi Swap DEX, you will need a wallet that connects to the BSC network.
The best two wallets for this purpose are MetaMask and Trust. Either way, you can click on the ‘Connect to a Wallet’ button on the DeFi Swap platform and choose your preferred provider.
Your chosen wallet will ask you to provide authorization before it allows you to connect to DeFi Swap.
Step 2: Choose Input Token
Now that your wallet is connected to DeFi Swap, you can choose the token that you want to exchange. By default, this is set to BNB. By clicking on the small arrow next to BNB, you can choose your input token.
Step 3: Choose Output Token
Next, you will need to choose the token that you want to receive.
As you can see from the image above, we are looking to swap BTCB for BNB.
Step 4: Enter Number of Tokens
Now that you know which tokens you wish to exchange, DeFi Swap needs to know the quantity.
You can enter this into the relevant field next to the token you are looking to offload. In doing so, DeFi Swap will give you an estimation as to how many tokens you will receive in return.
Step 5: Finalize Swap
After confirming the exchange via DeFi Swap – there is one more step to take. A notification will appear within the wallet that is connected to DeFi Swap asking you to authorize the transaction.
When you do, the DeFi Swap smart contract will perform the swap instantly and within a few seconds, your new token should appear in your connected wallet.
And that’s it – you’ve just learned how to swap tokens on a decentralized exchange without proving so much as an email address — let alone any personal information or ID documents.
This beginner’s guide has introduced you to decentralized exchanges. As we have covered, DEXs allow users to trade tokens and access other DeFi investment services without requiring a central provider.
This means that you can get started with a DEX like DeFi Swap right now without needing to open an account or provide any sensitive personal data.
DeFi Swap also allows you to earn interest on crypto tokens via yield farming and staking.
There is no guarantee that you will make money when investing in this or any DeFi product or service. Proceed at your own risk.