*obligatory not financial advice*

Hi,

In this series I want to explain some terms that are relevant to the amazing world of cryptocurrencies to help newcomers understand it better. Today I want to talk about decentralized trading.

Previous Parts:

Crypto Basics #1: What even is a Blockchain?

Crypto Basics #2: What are Smart Contracts?

Crypto Basics #3: What is a Cryptocurrency Wallet?

Crypto Basics #4: What is Mining and Proof of Work?

Crypto Basics #5: What is Staking and Proof of Stake?

What is a Decentralized Exchange?

The main purpose of cryptocurrencies is to remove the need for a centralized middle man for the trustworthy exchange of money. The initial goal of Bitcoin was to allow global p2p payments without any bank, government or other centralized actor having control of the transaction. Because of that, cryptocurrencies also need a way to be traded without centralized middleman that could control the trades.

This is why decentralized exchanges were invented. They are dApps on smart contract blockchains that allow their users to swap their tokens or supply them for trading fees. They allow developers of other dApps to distribute their new tokens and raise funds and they allow the creation of dApps that need a place to make automated trades while staying decentralized, for example a lending protocol could use a DEX to automatically sell the collateral of loans that are at risk. Usually, the first application that launches on a new smart contract blockchain is a DEX.

Uniswap was the first DEX and it allowed the creation of many more tokens and dApps which kick-started the DeFi boom in the last bull run. Each smart contract chain has its own DEXes that all have their own perks and special features but most are strongly based on how Uniswap works.

Most traditional centralized exchanges for cryptocurrencies, and also stocks and the like, work with an order book, where people and institutions make buy or sell orders for the price they want and the exchange matches the trades of its users and uses them to calculate the current price of each asset. There are some decentralized exchanges that work like that, like Loopring, but that depends on many individual transactions that’s why most DEXes work with liquidity pools and Automated Market Makers (AMM).

Uniswap and co work by letting users supply their tokens to liquidity pools for trading pairs that are then offered to traders in exchange for a fee. The prices are set automatically based on the ratio of their supply in the pool. The total supply of both tokens in the pool is valued the same, so if you have a pool with 10,000 USDC and 10 ETH it will trade 1 ETH for 1,000 USDC, and once there are 11,000 USDC and 9 ETH in the pool it will trade 1 ETH for 1,222 USDC. This example is a bit of extreme but that’s how Uniswap and most other decentralized exchanges set their prices and the price change, or slippage, depends on how much liquidity is provided and on how much money you are trading with.

Every swap has a trading fee of usually 0.3% which is directly added to the pool as a reward for liquidity providers to encourage people to provide the much needed liquidity. Most DEXes are also having their own governance token that is largely being distributed to the liquidity providers.

Most exchanges have their own features that make them special. For example, Curve Finance uses a slightly different AMM that is specialized for the exchange of stablecoins, SushiSwap is using some of its collected trading fees to buy back its SUSHI token and SpookySwap is offering limit orders. There are countless different DEXes and they are all a little bit different.

I hope that short explanation was helpful for some newcomers. I will keep writing more such short articles about various crypto terms. Feel free to follow me if you are interested.

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