What Is a DEX and How Do Decentralized Exchanges Work?

The popularity of decentralized exchanges (DEX) is expected to continue growing. In 2023, an average of about $2 billion in daily trading volume was transacted on DEXs. As of January 2024, the total yearly trading volume on DEXs had reached $900 billion.

Well, what is DEX, and what makes it an interest to crypto traders and investors? In this article, we will discuss what DEX is, how it works, and the top DEX examples.

Let’s dive in.

What is DEX?

A DEX refers to a peer-to-peer exchange or marketplace within which transactions happen directly between crypto buyers and sellers without an intermediary. 

One of the core inspirations behind cryptocurrencies is the ability to access financial services without the intervention of brokers, banks, payment processes, or any form of intermediation. DEX has made this possible, leading to decentralized finance (DeFi). 

Currently, there are hundreds of DEXs; the most popular being Uniswap, which leverages the Ethereum blockchain and available DeFi tools to make it possible for users to access a wide range of financial services through compatible crypto wallets. 

In contrast, Centralized exchanges (CEX) enable transactions through an intermediary. Examples of centralized crypto exchanges include Binance, Coinbase, and Kraken.

In the second quarter (Q2) of 2024, DEXs' spot trading volume had increased by over 15% from Q1 2024; reaching a total of $370 billion. On the other hand, CEX trading volume decreased by over 12% in the same period; recording a total of $3.4 trillion trading volume.

As investors move from CEXs to DEXs, it is important to understand how DEXs work.

How Do Decentralized Exchanges Work?

Decentralized exchanges use smart contracts and blockchain technology to facilitate transactions in the absence of an intermediary. 

Smart contracts use the concept of self-execution, where certain conditions are set to be met. For instance, the use of smart contracts in insurance; where in the event that an insured condition happens, a payoff is automatically delivered. 

A blockchain can be described as an immutable public ledger verified by diverse and anonymous users. Blockchains such as Ethereum that enable transactions executed through smart contracts and recorded on the blockchain are creating a massively growing DeFi market

With cryptocurrency, P2P transactions happen between pre-existing crypto wallets; from the seller's wallet to the buyer's wallet. 

Investors and traders can securely store their crypto assets on these wallets and transfer or receive assets through DEXs, for instance.

The participants involved in Decentralized Exchanges 

DEX users primarily include crypto investors, crypto traders, blockchain developers, and DeFi governance participants.

However, the influence of DEXs has expanded to businesses in diverse industries exploring DeFi services and models. Several regulatory bodies are also exploring blockchain technology and DEXs, as a way to improve regulatory compliance within the legal frameworks. 

Lastly, DEX users earn money in a variety of ways. Apart from trading, anyone can participate by providing liquidity on a specific DEX, earning a portion of the transaction fees. Also, most DEXs have a bonus reward program, where governance participants are paid a particular token.

How do you interact with a DEX?

A crypto wallet allows you to connect to a particular DEX such as Uniswap. A crypto wallet can be accessed both from your smartphone and web browser. If you’re just getting started with crypto investment, you can explore Sophie Crypto Index, a crypto investment solution for beginners, the UNI token is included in SOPHIE basket, when you buy $SOPHIE token you buy also UNI tokens.

Additionally, you'll need ethereum coins to start transacting or participating in DEXs; which you can buy from popular CEXs such as Binance. Ethereum (ETH) is needed because they are required for payment of transaction fees (gas fees) for transactions that occur on the ethereum blockchain. 

The Revenue model of DEXs

Decentralized exchanges have created a unique economic model that generates revenue, leveraging the unique advantage they have over CEXs; that is true decentralization. There are several ways in which DEXs generate revenue:

Transaction Fees

Similar to CEXs, Decentralized exchanges charge transaction fees. However, with DEXs the transaction fees are lower because there are no intermediary costs. As such DEXs attract a massive user base. The fees are used to facilitate the continuous development and operational needs of a DEX.

Token Issuance

Most decentralized exchanges issue a native token, which is used as the utility token within the ecosystem. Users holding these coins get access to certain functionalities and have certain rights within the DEX's ecosystem. The initial sale of these tokens provides the first capital for the development of the DEX, marketing, Value-Added services, and promotion.

Token Pair Revenue

Apart from trading, decentralized exchanges provide additional services that generate revenue. One such service is liquidity mining, which rewards users in token payments, encouraging user participation. This in turn increases trading volume, thereby boosting the DEXs' competitive advantage.

DEXs collaborate with diverse crypto projects to launch new trading pairs. This way, liquidity, and trading volume is increased, indirectly increasing revenue from transaction fees.

Partnerships and Ecosystem Building

Decentralized exchanges can partner with other platforms that receive fees to share revenue. Brand promotion and community building also end up attracting more users to a DEX, generating more revenue. 

Such innovative and creative revenue streams enable DEXs to function and thrive without intermediaries like in CEXs. With this unique advantage and diverse revenue streams, DEXs are set to disrupt the CEXs landscape and the traditional finance landscape by providing value in the DeFi industry.

The most Popular Decentralized Exchanges (DEXs)

We conducted intensive research and found the best DEXs for investors depending on your goals. This discussion will help you understand what each DEX offers and its features that attract crypto investors like you.

Uniswap (the Most Popular DEX)

Currently, Uniswap is considered the largest DEX globally. You can trade, buy, and sell all ERC-20 through Uniswap on the Ethereum blockchain. 

To use Uniswap, you need to connect your wallet. After connecting a wallet, you can start trading crypto or adding the cryptocurrencies you’re holding to provide liquidity and earn rewards.

Due to its popularity, Uniswap offers sufficient liquidity for traders to transact successfully. Additionally, the DEX has been reviewed as user-friendly.

Features that make Uniswap great for Crypto Investment:

• Most secure DEX

• Extremely low transaction fees

• User-friendly interface

• Supports Ethereum, Binance Smart Chain (BSC), Optimism, Polygon, Avalanche and other EVM-compatible networks

  
  

Curve (the Best DEX for Stablecoins)

Curve was originally designed for the exchange of stablecoins between users. The design was meant to prevent impermanent loss and protect the DEX’s liquidity providers.

Experts refer to Curve as the most secure and trusted DEX in the crypto space. As such many crypto investors place their stablecoins in the DEX to earn staking rewards at the lowest risk.

What makes Curve great:

• Highest level of trust in the DeFi space

• Very low transaction fee (0.04%)

• APYs up to about 10% on some crypto such as sETH!

  
  

PancakeSwap 

PanckaSwap is a DEX built on BSC. It was developed and launched in 2020, when Ethereum-based DEXs such as Uniswap, were experiencing slow transactions due to the high gas fees.

Today, the DEX boasts billions of USD in liquidity.  The platform’s success is partly attributed to its straightforward user interface (UI) that facilitates buying and selling BSC-based digital assets. 

What makes PancakeSwap great:

• Low transaction fees (0.25% for spot trading)

• High security as confirmed by Slowmist’s audits.

• Offers some of the highest APYs in the market.

  
  

1inch 

1inch is a DEX aggregator. This means 1inch searches through various DEX platforms on the ethereum blockchain for the DEX with the best crypto prices and lowest fees for your trades.

Users can buy, sell, and exchange ERC-20 tokens on 1inch. Additionally, the DEX allows for crypto purchases through debit and credit cards even it is really not native because it needs a centralized platform.

What makes 1inch great:

• Supports a huge range of crypto assets because it is an aggregator pulling prices from various exchanges.

• 1inch doesn’t charge additional transaction fees. But you’ll pay fees for the transactions that happen in the exchanges the DEX aggregates from.

• It supports a huge number of blockchain networks

• It can be accessed on your smartphone through an App on Google Play or App Store.

Conclusion

Although CEXs still command the largest share of the crypto market, serving the daily needs of crypto investors and traders, DEXs are gaining traction, increasing daily trading volumes.

Through smart contracts on blockchains such as the Ethereum blockchain, decentralized exchanges are successfully providing a trustless way of connecting crypto sellers and buyers. 

Additionally, DEXs have provided new methods of profiting from crypto investment for instance governance rewards for stakeholders and bonus rewards for liquidity providers. 

However, most of these decentralized exchanges are still in the early stages of development and need further enhancement to refine functionality, user experience, scaling mechanisms, and infrastructure to increase connection to Centralized crypto exchanges and legacy financial industry players to further increase future adoption.

In connection to DeFi, decentralized exchanges might be a major driver of the future of crypto investment, innovation, and fintech.