For people no familiar with the crypto industry, noticing that decentralized exchanges exist might spark a couple of questions right off the bat, like:

• Why do crypto people don’t use just a centralized exchange, are they trying to hide something?
• What even is different about a decentralized exchange, when compared to a centralized exchange?

A decentralized exchange is, in simple terms, a decentralized app (DAPP) that facilitates the exchange of cryptocurrencies within certain limits.

This transaction is done without any intermediary, like a bank or company, which allows the whole operation to be more secure & convenient in certain aspects.

See? simple, but now let’s break down each portion of this explanation.

Decentralization

DEXes are decentralized since they operate within the bounds of a decentralized blockchain, at their core, they are smart contracts that facilitate transactions in a trustless manner.

The limits of a DEX

A decentralized exchange has the following limitations:

• It can only function inside of the blockchain the smart contract is deployed, which means that it cannot do cross chain transactions.
• It depends on liquidity providers who need to inject assets at a ratio of 50/50 so that users of the DEX can transact cryptocurrencies.

No middle man 

Due to the fact that blockchains are usually decentralized entities, and that smart contracts can handle simple transactions between pairs, no human oversight is necessary to fill orders or conduct trade between two parties, which is one of the biggest benefits that a DEX offers.

And with this revolutionary technology, we get many benefits.

How does a DEX work?

A DEX functions by setting up the price of a crypto asset algorithmically, this is done via liquidity pools, in which the different purchases move the price a certain percentage depending of the amount of liquidity available.

This has the benefit that a DEX would never reject a transaction if it has the liquidity to execute it, while it can also provide a negative experience for its users, since sometimes the price moves too quickly, causing a user to receive a price execution different than what was intended.

Why DEXes are important

Benefits of a Decentralized Exchange

Haydenz Adams, the inventor of the uniswap protocol, put it best:

“By this point I was fully captivated by Ethereum’s unbounded potential. These were the properties I cared about:

It was censorship resistant. No one could stop it.

It was decentralized. No one controlled it.

It was permissionless. Anyone could use it.

It was secure. Anyone could verify execution”

Expanded, we could go with these succinct summary of benefits:

Decentralization: No one with more power over any participant. Freedom.

Censorship-resistant: Gone are the days of suppressing basic activities due to ideological reasons, at last a neutral platform!

Permissionless: No more red tape, no more bureaucracy, no more discrimination for any reason whatsoever. Freedom. Justice.

More secure: No more proprietary code and hidden transactions, everyone has access to the same data, and can protect themselves by verifying every aspect of each transaction. 

Value accrues to the users: In a centralized exchange, most of the value of the transaction fees ends up flowing to the centralized exchange, while on a decentralized exchange it goes to liquidity providers and sometimes also to any regular user of the protocol, like when there is airdrops targeted at the users of a DEX.

More private: Wallets are pseudonymous, which grants a higher level of privacy than using a centralized exchange. DEXes also don’t require government Identification, which is not the case with centralized exchanges.

Reduced counterparty risk: Since the users don’t need to deposit their funds with any third party, the possibilities of losing funds while doing transactions is reduced.

Can help against price manipulation & wash trading: The outstanding openness of the Blockchain technology allows to identify bad actors operating on a DEX, this mitigates the ability of such bad actors to manipulate the price of a pair without being noticed, as well as to operate nefarious actions to manipulate the market, such as wash trading.

Recap

A decentralized exchange is usually a smart contract that functions inside of a Blockchain, with certain limits, such as the inability to transact assets between different blockchains.

It offers certain notable benefits, such as more freedom for its users, more access to critical information, and more security in certain areas.

Conclusion

Decentralized exchanges were one of the first big killer dapps in the crypto industry, it opened an astounding amount of possibilities to traders and investors, and the value and capital inflows to these dapps quickly reflected that, although they are far from being perfect, they do provide massive benefits to their users, and can also help you in your cryptocurrency journey.