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A Decentralised Exchange (DEX) is a blockchain-based platform that allows users to buy, sell, and swap cryptocurrencies directly from their own crypto wallets without relying on a centralised intermediary. Instead of a company holding user funds and managing trades, DEXs use smart contracts, liquidity pools, and blockchain technology to facilitate transactions.
DEXs are a key part of the DeFi ecosystem, giving users greater control over their assets and enabling permissionless access to crypto trading. However, using a DEX also comes with risks, including smart contract vulnerabilities, price slippage, and impermanent loss.
A DEX allows users to trade crypto assets without depositing their funds into a centralised exchange account. Users connect a self-custody crypto wallet, select the assets they want to swap, and approve the transaction.
The transaction is then processed by a smart contract and recorded on the blockchain. Since users generally retain control of their private keys and assets until a transaction is executed, DEXs offer a different trading model from centralised exchanges.
Many DEXs use Automated Market Makers (AMMs) and liquidity pools to facilitate trades instead of relying on a traditional order book.
An Automated Market Maker (AMM) is a system that uses smart contracts and predefined mathematical formulas to determine the price of crypto assets. Instead of matching buyers and sellers directly, AMMs allow users to trade against liquidity pools.
Liquidity pools contain crypto assets deposited by liquidity providers. For example, a pool may contain two different tokens that traders can swap between. Liquidity providers may earn a portion of the trading fees generated by the pool in exchange for supplying liquidity.
The amount of liquidity available can affect the price and execution of a trade. Lower liquidity can lead to higher slippage, while liquidity providers may also face impermanent loss when the relative prices of deposited assets change.
DEXs can use different mechanisms to facilitate crypto trading. The three common types include:
Together, these different models make DEXs an important part of decentralised trading and the broader DeFi ecosystem, allowing users to access crypto markets directly through blockchain-based applications.
A DEX (Decentralised Exchange) allows users to trade crypto directly from their own wallets using smart contracts, while a CEX (Centralised Exchange) is operated by a company that manages the trading platform and typically holds user funds in custodial wallets. DEXs generally offer greater control over assets and on-chain transparency, whereas CEXs often provide features such as account recovery, order books, and customer support. Both models have different risks, fees, and user experiences.
An Automated Market Maker (AMM) uses a mathematical formula and the assets available in a liquidity pool to determine the price of a token. When a user buys or sells an asset, the pool's token ratio changes, which affects the next available price. In many AMM models, larger trades relative to the pool's liquidity can result in greater price impact and slippage.
A liquidity pool is a collection of crypto assets locked in a smart contract and used to facilitate trading on a DEX. Users, known as liquidity providers (LPs), deposit the required assets into a pool and may receive a share of the trading fees generated by it.
To provide liquidity, a user typically connects a compatible crypto wallet, selects a liquidity pool, deposits the required assets, and confirms the transaction. The exact process, fees, and rewards vary between DeFi protocols.
Impermanent loss is the potential loss a liquidity provider experiences when the price of assets in a liquidity pool changes compared with simply holding those assets outside the pool. It occurs because AMMs automatically rebalance the proportion of assets in a pool as traders buy and sell.
The loss is called "impermanent" because it can decrease if asset prices return to their previous relationship. However, it can become permanent when liquidity is withdrawn while the price difference remains. Trading fees and other rewards may offset some or all of this loss, but they do not eliminate the risk.
