When crypto investors trade one digital asset for another, they generally go through centralized exchanges (CEX) such as Binance, Coinbase Exchange or KuCoin. These platforms are similar to “TradFi” stock exchanges—that is, regulated financial marketplaces that charge fees on trades executed by investors.
In the world of decentralized finance, an alternative has sprung up: the decentralized exchange, or DEX. Unlike CEXes, which hold customers’ assets and record transactions on their own internal databases, DEXes are governed by cooperatives of token holders and use open-source, self-executing strings of code tied to the blockchain—known as “smart contracts”—to facilitate peer-to-peer trading between investors.
DEXes are, in many ways, safer and more “crypto native” than the lumbering, top-down corporations that control CEXes. They also bring their own unique—and, because it’s DeFi, often fairly eccentric—set of risks.
DEXes’ Core Feature: The Liquidity Pool
Decentralized exchanges began to really make their mark in 2020 with the rise of Uniswap, which was founded in 2018 by Hayden Adams. Uniswap, now the fourth-largest cryptocurrency exchange by trading volume, was one of the first DEXes to deploy “liquidity pools,” blockchain-based reserves that are held in smart contracts and used to automatically fulfill buy and sell orders placed by users.
Say you’re a trader and you want to sell 100 Reputation (REP) tokens. REP is a fringe, thinly traded token, and there might not be much organic demand for it. Centralized exchanges typically forward these kinds of trades to professional market makers, large funds that specialize in serving as counterparties to the exchange’s users.
But market makers can’t prop up every low-cap market. A liquidity pool, by contrast, purports to decentralize this process by allowing anybody to deposit their funds into a common, interest-generating “pool” whose reserves can be deployed to meet users’ orders. It’s an algorithmic approach, one that makes use of “automated market makers” that cleverly shift the balance of assets in each pool to maintain an equilibrium following each order. That means even the most obscure tokens can (theoretically) find a market.
DEXes also purport to eliminate the risks associated with exchanging assets via third parties. When trading through a CEX, investors are often—though not always—obliged to transfer their funds to a digital wallet managed by the platform. Some argue that this goes against crypto’s founding ethos of “Not your keys, not your coins.”
With DEXes, there is no custodian. Instead, investors safeguard their keys in their own wallets. For this reason—unless they are providing the DEX with liquidity—a user’s capital is never at risk. They will not lose out if the exchange is robbed, hacked, declared bankrupt, exposed to a run on its reserves, or found fraudulent. That the companies running CEXes often have billions of dollars’ worth of bitcoin reserves makes them obvious targets. Counterparty risk—in which one of the parties to a trade defaults on its contractual obligation to purchase or sell—is also eliminated, because there is no way to back out of a smart contract.
Scams, Hacks, Manipulations
This is crypto, however: All is not serene.
One issue with DEXes’ main selling point—that they host unvetted assets—is that the lack of regulation increases the likelihood of scams. Since anybody can mint a new Ethereum-based token and list it for sale on a DEX, it is easier for criminals to hoodwink investors into purchasing junk assets when the marketplace is decentralized.
Over the course of the 2021-2022 bull market, an estimated 10,000 such “scam” tokens were minted and circulated on Uniswap alone. A number of DEXes themselves were behind scams, including industry leader SushiSwap, which eventually rehabilitated its image after its pseudonymous founder tried to sell off the exchange’s native token, SUSHI, at the top of the market. (SushiSwap, which began as a clone, or “fork,” of Uniswap, is also a good example of the “open source” approach DEXes embody.)
Neither does it help that DEXes have a rather limited market share: even in the post-FTX era, some 95-99% of trades in digital assets still take place through CEXes. Liquidity pools struggle to underpin the high trading volumes of the really big tokens, meaning more reputable assets are traded on CEXes. Meanwhile, the low supply of the lesser-known tokens hosted on DEXes leaves them easy to manipulate.
This has resulted in something of a cottage industry of innovative scams and hacks. In early 2023, the trader Avraham Eisenberg was sued for exploiting a token’s low liquidity to pump its price by 2,200%.
Other pioneers, taking advantage of the unregulated anarchy, have developed algorithmic traders that buy and sell at extraordinarily high frequencies. This allows them to buy up assets microseconds before human traders have signaled their intention to buy, pumping the assets sky-high and selling them back to the traders at a premium. That practice, known as “frontrunning,” was immortalized in the essay Ethereum is a Dark Forest.
To top it all off, DEXes’ interfaces are rarely intuitive to use, and the average investor will need to acquire specialist knowledge to ensure they do not make expensive or foolish mistakes. Unfortunately, some of the most common of these are also the least reversible.
For instance, if a user forgets the keys and passwords associated with their private wallet, they will never be able to recover their assets. Without the help of an intermediary third party, investors are left largely to fend for themselves.
DEXes are also generally uninsured and legally murky, making it difficult to pursue hackers and recoup users’ losses.
The eternal question, as always, is whether it is worth putting faith in a third party or risk losing one’s funds for the sake of security.
Five Biggest DEXes by Trading Volume
- Uniswap: The OG decentralized exchange, built on Ethereum
- PancakeSwap: Uniswap, but for Binance’s native chain
- Curve: A DEX that specializes in stablecoin trading
- DODO: A DEX that uses a different, supposedly more fluid market-making model called “proactive market making”
- SushiSwap: A smaller, leaner Uniswap with a more loyal following and a complex rewards system
The Future of DEXes
Despite strong headwinds in the crypto world, the failure of centralized exchanges like FTX over the last few months of 2022 has led to a renewed interest in DEXes from users and investors, including venture capitalists.
They may not be perfect, but DEXes show that centralized intermediaries aren’t necessarily inevitable in crypto.