Ask the Orb: Decentralized Exchanges (DEX) for dummies!
The market has been flooded with decentralized exchanges or DEX, and many have asked what they are, their pros and cons, and how they work. Luckily, the Orb is here to answer their queries!
Decentralized Exchange or DEX is a peer-to-peer marketplace where crypto traders conduct transactions directly with one another. DEXs fulfill one of crypto’s primary functions: they facilitate financial transactions that aren’t mediated by banks, brokers, payment processors, or any other type of middleman.
As an analogy, when you visit an arcade, you will be required to purchase a specific arcade token that will be used as a kind of cash in any arcade game. DEXs eliminate the need for a mediator to purchase such tokens. You don’t have to go to the cashier to exchange your pennies for these unique arcade tokens; instead, you may do it yourself.
You may trade one token for another in cryptocurrency without using an intermediary as long as the tokens are on the same blockchain.
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How DEXs work
Instead of having a middleman, Decentralized Exchanges have smart contracts that allow you to trade your crypto coins in a decentralized way. These smart contracts are pieces of code that will enable two or more people to enter into an agreement. Basically, these smart contracts are responsible for one to swap their tokens into another directly.
DEXs are nothing more than a collection of smart contracts. They employ “liquidity pools,” in which investors lock assets in exchange for interest-like returns to ease trades and set the prices of multiple cryptocurrencies against each other algorithmically.
What are the advantages of using a DEX?
- DEXs have an almost infinite number of tokens, ranging from the well-known to the bizarre and completely random. Because anyone may build an Ethereum-based token and a liquidity pool for it, there will be a broader range of projects to choose from, both verified and unvetted.
- Because all of the funds in a DEX trade are stored on the traders’ own wallets, the chance of a hack is theoretically reduced. (In a non-DeFi transaction, DEXs also lower what’s known as “counterparty risk,” which is the possibility that one of the parties involved — even the central authority — may default.)
- Anonymity: In using DEXs, no personal information is required.
- DEXs have been increasingly popular in developing economies, where reliable banking infrastructure may not be accessible due to peer-to-peer lending, quick transactions, and anonymity. A DEX allows anyone with a smartphone and an internet connection to trade.
What are some of the potential drawbacks?
- Some DEX has User Interfaces that are more difficult to navigate. Also, when you commit an unfixable error, such as you transferred into the wrong wallet, it can no longer be recovered. Another prevalent problem is “permanent loss,” which occurs when a more volatile coin is combined with a less volatile one in a liquidity pool.
- Any DeFi protocol is only as safe as the smart contracts that power it, and code can have exploitable defects that can result in the loss of your tokens (despite extensive testing). While a smart contract may function as planned in normal conditions, developers cannot predict all uncommon situations, human factors, or hacks.
- Because most DEXs offer an unvetted, large assortment of tokens, there are also more scams and schemes to be aware of. A hot token could be “rug pulled” if its creator mints a large number of additional tokens, overloading the liquidity pool and causing the coin’s value to plummet.
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