What is a decentralized exchange (DEX)?

A decentralized exchange (DEX) is a peer-to-peer marketplace where users can trade cryptocurrencies directly without a traditional intermediary. In order to understand the role of decentralized exchanges in crypto, it is easiest to consider it in the context of a more familiar financial establishment: the stock market. If you want to sell a share of stock, there must be another party to buy it from you. The marketplace for such transactions is called an exchange. Traditional stock exchanges allow individuals to swap between assets in an easy, seamless way.

A number of analogous institutions exist in the cryptocurrency space, acting as intermediaries to pair traders who want to swap cash and cryptocurrencies, or even one cryptocurrency for another. These are known as centralized exchanges (CEXs).

The strengths of centralized and decentralized exchanges differ considerably, and both have a role in the cryptocurrency ecosystem. First and foremost, centralized exchanges benefit users as a fiat onramp. This means they provide simple ways to buy crypto with traditional, government-issued currencies and to sell crypto to receive the same currency in return. Additionally, centralized exchanges are historically able to provide access to assets on multiple blockchains, whereas many DEXs operate only on one chain.

Decentralized exchanges use a different model that removes intermediaries and lets users transact in a more direct, peer-to-peer fashion. Because they operate in parallel to the traditional financial system, DEXs allow users to transact pseudonymously. Because there is no one institution dictating the rules of exchange, DEXs are open to anyone with a compatible crypto wallet. Furthermore, because DEXs don't hold your cryptocurrency in their own wallets, you are the sole person who holds the private keys to your digital assets.

Decentralized exchanges are meant to enable users to swap easily between cryptocurrencies on a blockchain. The decentralized aspect implies that no single company controls how this is done or takes possession of the user's assets. Instead, users send crypto from their own wallets through an automated, smart contract-based platform and receive their desired crypto in return. The code itself facilitates the exchange, helping reduce the need for traditional intermediaries.

Traditional finance exchanges use the order book model to match buyers and sellers. Essentially, order books are lists of buy and sell orders submitted by traders, organized by the prices at which they want to transact. This list is kept by institutions who are entrusted by market participants to connect matching orders.

Decentralized order book models exist as well. Some DEXs use a decentralized order book to allow users to trade assets without the need for an intermediary on the blockchain. One benefit of these order books is that traders can set limit orders that execute only at the prices they desire.

Although order books are mechanically intuitive, automated market makers (AMMs) are a popular way to facilitate asset exchange in DEXs.

In traditional finance, market makers provide liquidity for trading and benefit from small differences in the bid-ask spread. AMMs automate this process, removing the market's reliance on third parties for the provision of liquidity. DEXs that use AMMs host pools of funds, called liquidity pools, where users (called liquidity providers) deposit their crypto.

Imagine a large pool of different cryptocurrencies. Liquidity providers put their crypto into this pool. When you want to trade, you can deposit one type of crypto into the pool and withdraw another type. You pay a small fee for this, which goes to the liquidity providers.

The most common risk for using an AMM DEX is impermanent loss, which occurs when depositing into a pool causes a loss in asset values as compared to simply holding tokens in a crypto wallet due to price fluctuations. Additionally, unlike order book DEXs, AMM traders typically cannot set limit orders for their buys. Lastly, all DEXs rely on smart contract code, which can be vulnerable to exploits or hacks if poorly designed.

As decentralized finance expanded into newer platforms, various chain-specific and cross-chain DEXs were developed.

Disclosures:

Content provided for educational purposes only. Not investment advice or a recommendation. Trading and owning digital assets involves significant risk, including the risk of substantial loss. Cryptocurrency services are offered through an account with Robinhood Crypto, LLC (NMLS ID 1702840). Robinhood Crypto is licensed to engage in virtual currency business activity by the New York State Department of Financial Services. Cryptocurrency held through Robinhood Crypto is not FDIC insured or SIPC protected.