You know a financial topic is trending when it lands in Fortune or the Wall Street Journal. Both publications have begun covering decentralized cryptocurrency exchanges, or DEXs, the attention-getting services that promise to give users and investors more control over their crypto funds.
It’s not just the media. Researchers at Messari report that DEXs handled $122 billion in transactions during crypto’s record-breaking April 2021 bull market – compared to just $1 billion in April 2020.
Analysts at DEX Metrics report that as of July 2021, decentralized exchanges like Uniswap, PancakeSwap, and Binance DEX are handling about $15 billion in transactions each week. That’s less than 10% of overall crypto transaction volume, but the technology’s rapid growth and market acceptance are impressive. It’s no wonder people are talking.
Why All the Fuss?
Decentralization is one of the core values of the crypto movement. Crypto transactions are conducted freely without the approval, regulatory oversight, or high fees of banks and other financial institutions. That’s one of the benefits of using and investing in cryptocurrencies. DEXs are intended to bring the benefits of decentralization to crypto buying, selling, and portfolio management.
DEX enthusiasts argue that centralized exchanges like Coinbase, Binance, and Kriptomat bring many of the features of traditional banks into the crypto world. They envision a future in which users rely on smart contracts to conduct business with each other on the blockchain, with no centralized exchange to compromise user anonymity, impose fees, hold funds, regulate transactions, decide which coins and tokens to support, or attract hackers.
Others worry that those who leave traditional exchanges behind are throwing out the baby with the bathwater. Centralized exchanges provide essential services: user education, customer support, trading-partner validation, lower fees, security, managed liquidity pools, coin background info, price histories, and much more. Reputable exchanges comply with consumer safeguards, including laws, financial regulations, and licensing requirements in the countries where they do business. These features are not part of the DEX world.
As Wall Street Journal financial reporter Alexander Osipovich wrote in May 2021, decentralized exchanges “look less like the New York Stock Exchange and more like Napster, the defunct music-sharing service.”
How Do DEXs Work?
At a conventional cryptocurrency exchange, you start by creating an account and satisfying the site’s Know Your Customer conditions. After you have deposited funds or connected your existing crypto wallet, you can buy, sell, and trade cryptocurrencies, making a quick transaction or building a long-term portfolio.
At a decentralized crypto exchange, you connect your cryptocurrency wallet to software running on the DEX website. If you wish to purchase or swap crypto assets, you simply specify what you are looking for. The app tells you the price, and if you approve, you okay the transaction. You never log in, provide a name or email address, or create an account.
DEX crypto exchanges don’t match you up with an individual seller. Instead, they employ automated market makers, or AMMs, to offer you coins and tokens from a liquidity pool: a quantity of cryptocurrency that other users have made available for a specified period. When you buy crypto at a decentralized exchange, you buy from a liquidity pool.
The AMM approach means you can join liquidity pools by lending funds to them. You can make your crypto funds available for a week, a month, or another specified period. At the end of the period, you get your funds back plus a portion of the transaction fees generated by the liquidity pool. It’s like buying a government bond.
Sophisticated DEXs give you lots of control over how you participate in a liquidity pool. For example, you might make tokens available only within a specific price range. Sophisticated traders tweak these options to boost their profits.
That’s DEXs in a nutshell. They are essentially matchmaking services that link crypto buyers with pools of crypto funds that are available for purchase.
Do You Need a DEX?
DEXs are a step in the evolution of a worldwide digital economy. In the long run, their weaknesses will be addressed and their benefits will be matched by traditional exchanges. Hybrid exchanges are already emerging, platforms that aim to offer the best of both worlds.