Decentralized Exchange: Trade Crypto While Keeping Control of Your Funds

Long before the introduction of centralized platforms and banks, barter allowed people to exchange goods with one another. While the way individuals and entities deal has changed significantly since then, the core need remains the same for a number of people.

Cryptocurrency has introduced numerous ways for individuals to participate in this time-honored system of exchange. Decentralized exchanges represent one of these solutions that allow individuals to trade crypto while keeping full control over their funds.

Decentralized Exchange Trading Basics

A decentralized exchange (DEX) is a blockchain-based platform that allows users to trade cryptocurrency without the assets having to go through a third party (i.e. an exchange). Unlike a centralized exchange (CEX), which holds deposits from users in its own wallet and executes trades from these funds, a DEX allows individuals to keep their assets in their own wallet.

A decentralized exchange lets users swap crypto directly from their own wallets.

When a trade order is submitted, the smart contract on the DEX will rely on the rules programmed into its protocols to determine how to execute the trade. The manner in which a DEX determines the price and execution of a trade will depend on what type of DEX it is. This is also what we will explore in the next section.

Types of Decentralized Exchanges

While the basic process is broadly the same across DEXs, the way each DEX handles a trade, as mentioned before, can differ depending on its underlying model. 

AMM DEX and Liquidity Pools

At the very moment, AMMs represent the model that makes up the majority of spot DEXs, including Uniswap. An AMM (Automated Market Maker) is a program that executes trades against liquidity pools. There are liquidity providers (LPs) who supply crypto to this pool, and the exchange rate will be determined by an algorithm based on the ratio of tokens in the pool.

Most spot DEXs use an automated market maker model (AMM).

While several variations of this design are beginning to appear on the blockchain landscape, most AMMs rely on either a constant product market or a concentrated liquidity design to dictate the algorithm that determines the exchange rate and how liquidity is provided to the pool. The fundamental difference between these two is the former has a fixed ratio while the latter allows LPs to provide liquidity within a certain range for a specific price.

The benefit of this structure is that users do not have to wait for another person to provide the counterparty to their trade, as is the case with order-book DEXs (see below). As long as there is sufficient liquidity in the pool for the asset the user wishes to trade, they can make the trade instantly. At the same time, slippage (the difference between the expected price of a trade and the price the trade is executed for) can be an issue if the size of the trade significantly impacts the pool.

Order-Book DEXs

Order-book DEXs, like Hyperliquid, differ considerably from AMMs. While AMMs execute trades against liquidity pools, order-book DEXs allow traders to bid against each other. Buyers set the price they are willing to pay for an asset, while sellers set the price they are willing to accept. When the two prices match, the trade is executed. Liquidity on these DEXs come in the form of orders placed by other traders and market makers.

Order-book DEXs match buyers and sellers directly.

This design is similar to how many CEXs function, with the critical difference being that order-book DEXs’ infrastructure is not run by a central entity. On an order-book DEX, the blockchain performs some (or all) of the functions of a CEX by processing and settling transactions.

The benefit of this model is that it allows traders to use a similar interface and features, like limit orders (orders that allow traders to set a price for a trade), that CEXs offer. However, just like with AMMs, trade execution depends on the presence of liquidity within the desired price range.

DEX Aggregator

A DEX aggregator does not represent a design type, but rather a method of aggregating liquidity from different DEXs and liquidity pools in order to execute a trade.

A DEX aggregator will look for the best available price for a trade across liquidity sources and execute the trade using one or more of them. For instance, 1inch can route a trade through multiple liquidity pools in order to execute it. Additionally, it can perform a token swap via a third token (e.g. ETH to USDT to USDC) if this is more efficient than a direct swap (e.g. ETH to USDC).

A DEX aggregator routes trades across multiple DEXs and liquidity pools to find better execution.

While a DEX aggregator can provide the most efficient price for a trade, the execution of a trade may require additional transactions and gas fees. In some cases, a trade that appears to have a better exchange rate may not be efficient when all transaction costs are taken into account, especially for large trades. As a result, it is important for users to analyze the actual amount of tokens they will receive when considering a trade, rather than just the exchange rate.

What Makes Up the Cost of a DEX Trade?

A DEX swap can involve several types of costs, and the fee shown by the interface is rarely ever the full picture.

Direct Fees Associated with a DEX Trade

The direct fees associated with a DEX trade include the trading fee charged by the DEX and the network fee (gas fee) charged by the blockchain.

The trading fee, for one, is charged on the amount being swapped according to the DEX's fee structure. For instance, on Uniswap v3, the trading fee varies depending on the liquidity pool, with 0.05% being the rate for most stablecoin pairs and 0.3% representing the rate for standard pairs.

DEX trades typically involve a protocol trading fee and a blockchain gas fee.

On the other hand, the network fee is charged by the blockchain in order to process and record the transaction on the blockchain ledger. The rate of this fee depends on the blockchain and its demand: higher traffic results in higher fees as miners prioritize transactions with higher gas prices. It is also important to note that failed transactions still incur gas fees, as the blockchain already processed the transaction attempt.

These fees, however, do not form the complete picture of the cost of a DEX trade, as execution costs can also play a significant role in determining the final fee a trader will pay.

Indirect Costs Associated with a DEX Trade

A trader will see a price for their trade based on the information available at the time they submit their transaction, but the liquidity conditions at the moment their transaction is processed by the blockchain will determine the execution price.

For instance, when a trader submits a large trade, the size of the trade can impact the pool, thus changing the price. This difference between the expected price and the execution price is commonly referred to as price impact. The final execution price can also differ from the expected price, resulting in slippage. On an order-book DEX, the gap between the best available buy and sell prices, known as the spread, can similarly affect the trade's outcome.

How to Use and Evaluate a DEX

Using a DEX is not just a matter of connecting a wallet and confirming a swap. Each step you take is an opportunity to check whether the platform, market, and trade are the right fit for what you want to do.

Step-by-step on how to use and evaluate a DEX.

Step 1: Selecting the Right DEX for Your Trade

When selecting a DEX for a trade, users should first consider which blockchain and trading pair they are interested in. While a DEX might provide the blockchain and pair a user wants, it does not necessarily mean it is the best option available, especially regarding liquidity. For instance, when initiating a trade, the amount of liquidity available for the trading pair should be sufficiently high to complete the trade, especially for large trades.

With the trading pair evaluation out of the way, the user should review the reputation and track record of the protocol. Like any blockchain-based service, a DEX has a certain level of risk associated with it, dictated by its security practices. A secure DEX will have undergone regular independent third-party audits and have a strong overall security track record.

Step 2: Access the Official Website of a DEX and Connect Your Wallet

Before initiating a trade, a user should ensure they are on the official website of the DEX. Fake websites that appear identical to the official one can lure unwary users into connecting their wallet and signing a malicious transaction. As such, it is best to avoid dubious links, especially those that appear in ad banners, social media posts or messages.

After accessing the official application, the user should connect their self-custody wallet. Connecting the wallet is necessary to allow the DEX to interact with it, but it does not grant the DEX custody of the assets in the wallet. In fact, any DEX that asks for a user’s private key or seed phrase should raise an immediate alarm.

Step 3: Setting Up the Trade

During this step, the user selects the token they want to sell and the token they want to buy. 

It is particularly important to review the contract address of a token if the user is unfamiliar with it, as anyone can launch a token with any name or symbol (yes, including existing ones). The contract address, on the other hand, represents the unique address of the token on the blockchain, which means it is pretty much the only reliable manner of identifying a token.

The DEX will then provide a quote (an estimated trade price), which can differ considerably from the actual price (as we explained earlier). As such, it is crucial to review the fee breakdown, price impact, slippage, and the final amount of tokens received before proceeding to the next step.

Step 4: Approve and Sign the Transaction

Before the DEX can process a trade, it will most likely require a token approval from the user first, which provides the DEX’s smart contract with permission to spend the tokens the user wishes to trade. Some DEXs, however, do not require this step, which is why it is important to review the details of the transaction before signing it.

After the transaction is signed, it will be sent to the blockchain where it will be processed and recorded. Whether the swap actually succeeded can be checked after submission.

What Are the Advantages of Using a DEX?

A DEX gives users direct control over their assets and access to blockchain-based markets without relying on a centralized custodian.

Advantages of using a DEX.

Self-Custody and Direct Access

Keeping control of their assets gives users more direct control over how they interact with the market. At the protocol level, users generally do not need to create an account or obtain approval for each trade; a compatible wallet and sufficient funds are enough to interact with the DEX.

The benefit of self-custody is obvious: a user is in full control of their assets at all times and bears no custody risk.

Access to On-Chain Assets

A DEX can provide access to assets that are not available elsewhere. New assets will likely appear on DEX liquidity pools before they become available on CEXs, allowing users to invest in projects earlier.

Composability With DeFi

A DEX exists within the larger DeFi space, which allows it to interact with other DeFi platforms. As a result, a user can move assets between protocols within the DeFi space without having to use an intermediary. This composability is a defining characteristic of DeFi.

What Are the Risks of Using a DEX?

The same features that give DEX users greater control also place more responsibility on them.

Risks of using a DEX.

Smart Contract and Protocol Risk

A DEX relies on smart contracts to facilitate trading, which means vulnerabilities in the contracts can lead to losses for the users.

Exploits can target different aspects of a DEX, including its front-end interface, smart contracts or the liquidity in the pools. Attackers can take advantage of these weaknesses to manipulate the price of an asset or withdraw liquidity from a pool, impacting trades.

Transaction and Wallet Risk

A DEX operates in a permissionless environment, which means the responsibility of making sure a trade is successful falls on the user. Unlike a CEX, a DEX cannot cancel or reverse a transaction, so mistakes are costly (same case with any other transactions that happen on-chain).

A user has to ensure they are interacting with the correct blockchain, address and network. If a transaction is sent to the wrong network or address, the funds are typically lost. A similar risk is involved with interacting with malicious smart contracts or fake tokens.

MEV and Sandwich Attacks

A DEX processes transactions on a blockchain, which means users are subject to MEV (Miner Extractable Value) risk. This risk is particularly pertinent to users who trade on DEXs that operate on blockchains that allow MEV extraction (e.g. Ethereum).

On CEXs, MEV is typically mitigated by the exchange itself, but a DEX cannot protect its users from it. A sandwich attack is a common form of MEV. It involves a bot that detects a user transaction that will impact the price of an asset and front-run it in order to make a profit from the price change. The greater the slippage tolerance (the degree to which the execution price can differ from the expected price), the more vulnerable a user is to a sandwich attack.

A Final Word About Decentralized Exchange

The reason why Coinminutes published this guide about decentralized exchange was not to dictate which DEX a user should select. Instead, it was intended to inform readers about the inner workings of a DEX, its potential benefits and risks, as well as factors that influence the costs of a trade.

Now that you understand the fundamentals behind a DEX, you may want to learn more about the DEXs themselves and how they differ from one another. Alternatively, you might be interested in learning about other ways to interact with crypto apart from trading.

If you were interested in either of these options, consider browsing our blog for additional guides.