Crypto Swapping: Exploring Decentralised Exchanges

What is a crypto swap?

Crypto swapping is a fancy way of describing trading or barter with one key difference - it allows one to instantly exchange their crypto token for a different one, for instance, swapping 1 ETH for 5500 MATIC tokens.

Crypto traders usually convert their tokens into fiat money first and then use it to buy other crypto tokens. In other words, crypto trading involves the use of fiat currencies. However, in crypto swapping, there is an instant exchange of tokens based on the equalisation of the value of both tokens.

A crypto swap could be more efficient than regular trades, as it is generally cheaper and much faster than the latter. Since the crypto market is volatile, crypto swaps can be more effective with the real-time exchange of tokens.

But why is crypto swapping so important? To get access to new blockchain projects as a stakeholder, one usually has to buy native tokens of that project. These projects often then give rewards to stakeholders. But it is not as easy as it seems. For instance, these tokens are usually not available on central exchanges, at least initially. To own them, we need to use a decentralised exchange and swap them with their base layer tokens. For example, a new token running on the Ethereum blockchain can be owned by swapping some ETH. Thus, a crypto swap is the most useful way of getting hold of different tokens without the usual way of buying them with fiat money.

Types of crypto swapping

A crypto swap can be largely categorised into two categories:

• Swapping on the same network: As the name suggests, this kind of crypto swapping happens on the same blockchain.  
• Cross-chain swapping: A cross-chain swap is a crypto swap between different blockchains. These crypto swaps, also known as atomic swaps, leverage smart contracts to facilitate swapping between blockchains.

Crypto swapping can be done through both centralised and decentralised exchanges.

Crypto swapping on decentralised exchanges

Since centralised exchanges hold the risk of loss of crypto holdings and also require a lot of time to list a new upcoming token, decentralised exchanges have become very popular for crypto swaps. A decentralised crypto exchange is also non-custodial, which means the exchange will not hold its users’ crypto holdings. Crypto swapping on decentralised exchanges is done in a peer-to-peer mode.

In the next section, we will learn more about decentralised exchanges.

Decentralised exchanges

Decentralised exchanges allow crypto traders to control their private keys since users connect their own web3 wallets to the exchanges, thereby giving them exclusive access to their crypto holdings. Meanwhile, in a DEX, trades are executed through smart contracts with no presence of any intermediary. Hence, several decentralised exchanges are built on blockchains like Ethereum and Solana, providing smart contract functionalities.

While choosing a decentralised exchange, these factors should be noted:

Liquidity: This factor is one of the most important attributes of a decentralised crypto exchange. Since no fiat money is involved, sufficient liquidity is required in these exchanges to ensure seamless trading. Low liquidity in a DEX might result in very high slippage or the trade not getting executed.

Security: A secured decentralised exchange usually performs regular smart contract audits and maintains the required security and privacy protocols.

Fees: One should determine the cost-effectiveness before going for a decentralised exchange. Depending on the blockchain, fees may vary a lot.

Further, decentralised exchanges are classified into the three categories below:

• Automated Market Makers (AMM): Automated market makers use smart contracts to implement trades and update prices of crypto trades. However, they rely on liquidity pools for trades, which means users do not trade in a peer-to-peer mode. The algorithms within the smart contracts determine the supply and demand within the liquidity pools. An example of an AMM is Balancer.
• DEX Aggregators: A DEX aggregator can be described as a search engine for decentralised exchanges. It scouts multiple DEXs for the best price for its users’ required swap. Users are then able to execute the most efficient trades or swaps across multiple DEXs. LI.FI is a prominent DEX aggregator.
• Order Book DEXs: Order book decentralised exchanges maintain records of all open buy and sell orders, similar to a centralised exchange. When both the buy and sell order criteria are met, the exchange implements a trade or a swap. Uniswap is a popular order book DEX.

How do decentralised exchanges earn revenue?

A decentralised crypto exchange could earn revenue by these three main avenues:

Transaction fees: Similar to other exchanges, DEXs could also charge a fee for each trade on their platform. Since DEXs do not have intermediaries, this fee could be lower than the other exchanges.

Issuing tokens: A host of DEXs have issued their own native tokens for their stakeholders. These tokens could be either used as utility tokens or governance tokens for the DEX ecosystem, and the sale of these tokens also generates revenue for the DEX.

Other exclusive services: A DEX may offer exclusive services to create a revenue stream. It could include services like liquidity mining schemes and others.

How to provide liquidity in DEXs

A decentralised crypto exchange maintains its liquidity levels, essential for trades, through a liquidity pool. These liquidity pools are managed by smart contracts. A DEX may offer incentives like token rewards to encourage users to deposit their tokens in the liquidity pool. Every DEX trading pair could have its own liquidity pool as well. A sufficient liquidity pool in a DEX ensures smooth trades without any obstruction.

How are DEXs regulated by KYC and AML rules?

Owing to their decentralised nature and high levels of privacy offered to users, bringing DEXs under the ambit of KYC and AML rules is often difficult. It is an evolving subject, though, and it could undergo further deliberations in the future. In recent months, the Securities and Exchange Commission of the US has sued Uniswap for not implementing KYCs. On the other hand, 1inch Network has started implementing KYC verification checks for its users. 

Examples of DEXs

As we conclude this blog, let's explore a few prominent decentralised exchanges active today:

Uniswap: Uniswap is the largest DEX on the Ethereum blockchain.

SushiSwap: The SushiSwap DEX, also built on Ethereum, uses its automated market maker (AMM) for swaps.

Jupiter: Built on Solana, Jupiter is a swap aggregator DEX.

Curve Finance: Curve Finance, running on the Ethereum blockchain, is a liquidity pool for stablecoin trading. It also relies on an AMM model.

PancakeSwap: PancakeSwap is a popular multi-chain DEX platform.

Summing it up

Decentralised exchanges derive considerable trading volume from relatively new tokens that are not on centralised exchanges yet, such as memecoins. Since compliance teams do not review these tokens, it’s important to be careful when trading tokens on DEXs. Meanwhile, choosing DEXs with higher liquidity is equally essential to avoid slippage. In CEXs, one does not own the tokens in their wallet until withdrawals. Here, DEXs have a clear advantage over CEXs since you directly own the tokens in your DEX wallet.

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