When crypto investors exchange one digital asset for another, they generally go through centralized exchanges (CEX) like Binance, Coinbase Exchange or KuCoin. These platforms are similar to “TradFi” exchanges – ie regulated financial marketplaces that charge fees for trades executed by investors.
In the world of decentralized finance, an alternative has emerged: the decentralized exchange, or DEX. Unlike CEXes, which hold client assets and record transactions in their own internal databases, DEXes are managed by cooperatives of token holders and use self-executing, open-source code strings tied to the blockchain — known as “smart contracts” — to facilitate peer-to-peer trading between investors.
DEXes are in many ways more secure and “crypto-native” than the cumbersome top-down corporations that control CEXes. They also come with their own unique — and, being DeFi, often quite eccentric — risks.
Core function of DEX: The liquidity pool
Decentralized exchanges really started to make their mark in 2020 with the rise of Uniswap, founded by Hayden Adams in 2018. Uniswap, now the fourth-largest cryptocurrency exchange by trading volume, was one of the first DEXs to deploy “pools of liquidity,” blockchain-based reserves held in smart contracts and used to automatically fulfill users’ buy and sell orders.
Let’s say you are a trader and you want to sell 100 Reputation (REP) tokens. REP is a rand token, rarely traded, and there may not be much organic demand for it. Centralized exchanges typically route these types of trades to professional market makers, large funds that specialize in acting as counterparties for users of the exchange.
But market makers can’t prop up every low-cap market. In contrast, a liquidity pool purports to decentralize this process by allowing everyone to deposit their funds into a common, interest-generating “pool” whose reserves can be used to fulfill users’ orders. It’s an algorithmic approach that uses “automated market makers” that cleverly shift the balance of assets in each pool to maintain balance after each order. This means that even the most obscure tokens can (theoretically) find a market.
Whose Custody?
DEXes also purport to eliminate the risks associated with exchanging assets through third parties. When trading on a CEX, investors are often – though not always – required to transfer their funds to a digital wallet managed by the platform. Some argue that this goes against Crypto’s founding ethos of “not your keys, not your coins.”
There is no custodian at DEX. Instead, investors keep their keys in their own wallets. Because of this, unless they provide liquidity to the DEX, a user’s capital is never at risk. You will not lose if the exchange is robbed, hacked, declared bankrupt, subjected to a run on its reserves, or found to be fraudulent. That the companies running CEX often have billions of dollars worth of bitcoin reserves makes them obvious targets. Counterparty risk – where one of the parties to a trade defaults on their contractual obligation to buy or sell – is also eliminated as there is no way to exit a smart contract.
Fraud, hacks, manipulations
However, this is crypto: all is not quiet.
One problem with DEX’s main selling point – that they host unverified assets – is that the lack of regulation increases the likelihood of fraud. Since anyone can mint a new Ethereum-based token and offer it for sale on a DEX, it is easier for criminals to trick investors into buying junk assets when the marketplace is decentralized.
During the 2021-2022 bull market, on estimated 10,000 such “scam” tokens have been minted and circulated on Uniswap alone. A number of DEXes have been behind scams themselves, including industry leader SushiSwap, which eventually rehabilitated its image after its pseudonymous founder attempted to sell the exchange’s native token, SUSHI, at the top of the market. (SushiSwap, which started out as a clone or “fork” of Uniswap, is also a good example of the “open-source” approach that DEXes embody.)
It also doesn’t help that DEXs have a rather limited market share: Even in the post-FTX era, around 95-99% of digital asset trading still takes place via CEXs. Liquidity pools are struggling to underpin the high trading volumes of the really big tokens, meaning more reputable assets are traded on CEX. Meanwhile, the low supply of lesser-known tokens hosted on DEXes makes them easy to manipulate.
This has led to a kind of cottage industry of innovative scams and hacks. In early 2023, the dealer was Avraham Eisenberg sued for exploiting a token’s low liquidity to increase its price by 2,200%.
Other pioneers who took advantage of unregulated anarchy developed algorithmic traders that buy and sell at exceptionally high frequency. This allows them to buy assets microseconds before human traders have signaled their intent to buy, pumping assets up and selling them back to traders at a premium. This practice, known as “front running,” was immortalized in the essay Ethereum is a dark forest.
user inexperience
To top it off, DEXes’ interfaces are rarely intuitive to use, and the average investor needs to acquire expertise to ensure they don’t make costly or silly mistakes. Unfortunately, some of the most common of these are also the least reversible.
For example, if a user forgets the keys and passwords associated with their private wallet, they can never recover their assets. Without the help of an intermediary, investors are largely left to their own devices.
DEXs are also generally uninsured and legally unclear, making it difficult to track down hackers and recoup user losses.
The eternal question, as always, is whether it is worth trusting third parties or risking losing your money for security reasons.
The five largest DEXs by trading volume
- Uniswap: The decentralized OG exchange built on top of Ethereum
- PancakeSwap: Uniswap, but for Binance’s native chain
- Curve: A DEX specializing in trading stablecoins
- DODO: A DEX that uses a different, supposedly more fluid, market-making model called “proactive market-making.”
- SushiSwap: A smaller, leaner Uniswap with a more loyal fan base and a complex rewards system
The future of DEX
Despite strong headwinds in the crypto world, the failure of centralized exchanges like FTX in the final months of 2022 has led to one renewed interest in DEXes by users and investors, including venture capitalists.
They may not be perfect, but DEXs show that centralized intermediaries are not necessarily inevitable in crypto.
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