Decentralized Exchange (DEX) is a peer-to-peer marketplace where buyers and sellers are met directly without the intervention of the Central Authority. Decentralized Exchange is currently used only for the trading of cryptocurrency. DEX gained popularity with the growth of Decentralized Finance (DeFi). DEX being decentralized uses blockchain technology and smart contracts in place of a central authority.
Understanding Components of Decentralized Exchanges (DEX)
Smart contracts are basically self-executable programs dependent on predetermined conditions which means that contracts get executed themselves if the specified conditions are met. Blockchain is a ledger where transactions are recorded. Transactions executed by smart contracts are recorded in the blockchain ledger and it facilitates faster execution and with effective record-keeping ability.
In the world of crypto-currencies, buyers and sellers exchange their assets between two pre-existing wallets for digital Assets through DEX and can safely store their digital assets on these wallets to transact in the future as well.
To match buyers and sellers without the intervention of central authority it uses a new and advanced type of order management technique called Automated Market Makers (AMM). These AMMs facilitate the trading of digital assets by using the Liquidity Pool without the need for any permission.
The above figure explains the functioning of DEX by taking the example of Tesla Shares. Though these are generally done in the pair of crypto-currencies, Tesla shares are used for the simplicity of understanding.
Let us now understand more about Liquidity Pools. Liquidity Pools are composed of pairs of Assets that are traded and can be instantaneously executed in any trade and essentially transaction is executed similarly to a market order.
How do Liquidity Pools facilitate transactions and create Arbitrage Opportunities?
The funds are provided by the users known as Liquidity Providers and they earn fees as a percentage of the amount that is added as Liquidity to the pool. The liquidity of the asset pair is determined by the number of liquidity providers for the particular pair. There is a simple math involved in the functioning of this Liquidity Pool. It is a constant formula x*y=C where x, y are the amount of each asset submitted in the pool. This formula helps maintain the value of the pool at a constant whenever any trade occurs.
Whenever any transaction occurs, the pair price of assets is changed and this gives opportunity to arbitrageur. If the trade is larger than the price, the slippage is also larger. In the world of crypto-currencies, arbitrageurs are mostly automated bots who also take advantage of price discrepancies in the different crypto-currency exchanges.
Advantages of DEX
- It does not require any manual intervention and control to operate. DEX is operational on a 24*7 basis.
- Trading halts are not possible which is possible in the case of Stock Exchanges.
- Trading time is reduced to minutes or seconds where traditional exchanges follow T+2 settlement.
- Investors have direct control over their assets and thus reduce counterparty risks.
- A degree of anonymity can be maintained by investors as there is no need for KYC.
Disadvantages of DEX
- As of now, it is not possible to place limit orders, stop-loss orders, or margin trades.
- Trading for other asset pairs is not possible except for crypto-currencies.
- If there is less liquidity in the pool, then there will be a greater price impact on the two assets in the pool.
- These DEX are prone to regulations with the gaining popularity.
- There are congestion issues when the trading is at peak leading to higher transaction costs and settlement time.
Scope of Evolution
With the advancements in technology and growing popularity, it is possible to include other financial instruments and resolve the current issue of liquidity. In the future, some regulations in the DEX space can be announced to safeguard the interests of liquidity providers and investors but it is still very unpredictable how these regulations will affect the transactions. Uniswap is the biggest DEX as of now with an average daily trading volume of more than 1 Billion. With the increase in popularity, it is possible to have other CEX players establish themselves as DEX.
Nancy J. Allen is a crypto enthusiast and believes that cryptocurrencies inspire people to be their own banks and step aside from traditional monetary exchange systems. She is also intrigued by blockchain technology and its functioning.
Source: https://www.thecoinrepublic.com/2023/10/20/decentralized-exchange-gaining-popularity-with-increase-in-volume/