Earlier, I shared two posts that dealt with cryptocurrency wallets.
Understanding what they are, how they work, the features they support, and the best options out there was essential for us to move to the next step.
That next step is trading cryptocurrencies through decentralized exchanges (DEXs).
Having already covered advanced topics like Yield Farming, staking & NFTs, this post will round up our discussion on the subject for the time being. Later on, we shall pick up on DAOs and new-age technologies.
So let’s put on our learning hat and get busy!
1. What is a DEX?
A DEX, short for decentralized exchange, is a DeFi protocol without any functioning central authority.
In other words, it is just like a fruit market, where buyers and sellers engage in trading a particular fruit at an agreed-upon price.
Your question should be, how is this different from a centralized exchange, and the answer is as follows:
- To buy fruit from your local fruit market, you don’t have to open an account at the entrance to the market. You just breeze through. The same is true for a DEX. No need to open an account.
- Similarly, to buy fruit from your local fruit market, you don’t have to prove to the fruit market who you are. The seller or the fruit market organizer is not concerned with KYC. The same is true for a DEX.
- Interestingly, to buy fruit from your local fruit market, you don’t have to deposit cash at the entrance and are not provided a cash voucher to make your purchase. You carry your cash with you in your wallet & make payment directly to a seller. The same is true for a DEX that has a P2P (Person to Person) layer (More on this later).
In other words, a DEX is a decentralized market. No central authority. Just buyers & sellers.
2. DEX Types
The earliest DEXs were based on a P2P layer. They envisioned markets where buyers & sellers could interact at mutually agreed upon prices for the coinage they wanted to exchange.
However, the industry realized that this created the issue of barter, that is:
I should be willing to sell something that someone else needs I exchange for something that I need. In economics, this problem is called the double coincidence of wants.
DeFi enthusiasts had an innovative solution called liquidity pools to solve this problem.
2.2 Liquidity Pool Backed DEX
In a nutshell:
- I own $ETH & want to earn passive income on my holding;
- You own $WBTC ($BTC on the Ethereum blockchain) & want to earn passive income on your holding;
- We both contribute our holdings to a liquidity pool which will sell $ETH to people moving out of their $WBTC positions & sell $WBTC to people looking for a $BTC position;
- In return for locking up our holdings in a liquidity pool, we will get commissions from the protocol in terms of trading fees;
- That is not all; the protocol, in return for locking up our holdings, will also issue LP tokens representing our stake in the pool. These LP tokens could be collateralized to raise more funds for the acquisition of further coinage or staked to earn an additional passive income.
Thus, liquidity pools ensure that there is no double coincidence of wants. Trading is thus facilitated instantly without any central authority.
In truth though, most DEXs operate as a hybrid. You can wait for someone to come along and trade with you through the P2P layer or trade instantly by tapping into the liquidity pool.
3. Does a DEX Really Not Require KYC?
Yes. A DEX will not ask you for your KYC information. It is a simple plug-and-play with your wallet. Recall, it is, after all, a fruit market.
However, that does not mean that you begin your career in crime here (anywhere for that matter!). You would benefit from reading this post on KYC, and I will touch upon the matter further below.
What many people fail to understand is that a blockchain is public. This means that the record of your transactions on an Ethereum-based DEX, for example, will be posted on Etherscan with your wallet address.
In fact, this public nature of the blockchain ensures that a money trail is available & all you need then is the identity. Blacklisting your wallet will be enough to make you cower out of your den.
This public nature of the blockchain has been very effective for law enforcement, and the best part is that the industry as a whole continues to collaborate on this matter. No wonder illicit trade in cryptocurrencies is estimated to be just 0.15%.
4. What Are Some of The Popular DEX Protocols?
Thousands of DEX protocols exist on every blockchain. All of them boast the same basic utility and are hence homogeneous.
You may check out the complete list that is updated daily on the CoinGecko website.
Despite the popularity of centralized exchanges (CEXs) and the dominant CeFi experience, there is a steady shift happening towards DeFi.
Volume growth in DEXs is giving heated competition to CEX volume. There are plenty of reasons for this, including but not limited to the fact that many new offerings & new assets are exclusively available in the decentralized space.
I hope this post was informative & if you have any questions that need answering, hit me up on the FinChamps channel.