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What Is A Decentralized Exchange? How Does Dex Work? 

Decentralized Exchange, also known as DEX, is a peer-to-peer market where crypto traders trade directly without handing over control of their funds to intermediaries or managers. These transactions are facilitated by using self-contained contracts written in code called smart contracts. 

DEX was created to remove the requirement for the authority to monitor and approve transactions made on specific exchanges. Decentralized exchange enables peer-to-peer (P2P) transactions in cryptocurrency

These are usually not managed. This means that users can still manage the wallet’s private key. Private keys are a type of high encryption that allows users to access their cryptocurrencies. Users can access their cryptocurrency balances immediately after logging in to DEX with their private key. You do not need to provide personal information such as your name or address. This is great for people who value privacy. 

Innovations that solve liquidity-related issues such as automated market makers helped attract users to decentralized finance (DeFi) spaces and contributed to their growth. DEX aggregators and wallet extensions have helped drive the growth of decentralized platforms by optimizing token prices, swap rates, and slippage while offering better rates to users. 

What Is A Decentralized Exchange? 

Decentralized exchanges rely on smart contracts that allow traders to process orders without intervention. Centralized exchanges, on the other hand,  are managed by centralized organizations such as banks. Banks are engaged in the financial services sector to generate profits. 

Centralized exchanges are regulated entity that holds user funds and provides a user-friendly platform for new entrants, so they account for the majority of the trading volume of the cryptocurrency market. Some central exchanges provide insurance for deposit assets. 

The services provided by the Central Exchange can be compared to the services of banks. Banks keep customers’ funds safe and provide security and monitoring services that individuals cannot provide on their own, making it easier to transfer funds. 

In contrast, decentralized exchanges allow users to trade directly from their wallets by interacting with the smart contracts behind the trading platform. Traders are responsible for protecting their funds and losing their funds if they make the following mistakes: B. You lose your private key or send money to the wrong address. 

Funds or assets deposited by customers are provided on “I owe you” (IOU) via a decentralized exchange portal that can be freely traded on the network.  IOU is basically a blockchain-based token with the same value as the underlying asset. 

The popular decentralized exchange is built on the major blockchains that support smart contracts. These are built on the Layer 1 protocol. That is, it is built directly on top of the blockchain. The most popular DEX is based on the Ethereum blockchain.

How does DEX work?

Decentralized exchanges support smart contracts and are built on a blockchain network where users hold funds, so each transaction has a transaction fee in addition to the transaction fee. Basically, traders use DEX to interact with smart contracts on the blockchain. There are three main types of decentralized exchanges: automated market makers, order book DEX, and DEX aggregators. All users can trade directly with each other through smart contracts. The first decentralized exchange, like the centralized exchange, used the same type of purchase order. 

Automatic Market Maker (AMM) 

Based on smart contracts, the Automatic Market Maker (AMM) system was developed to solve liquidity problems. The creation of these exchanges is inspired by an article on the decentralized exchange of Ethereum co-founder Vitalik Buterin, which explains how transactions are carried out on the blockchain using contracts containing tokens. Partially born from the ration. 

These AMMs rely on blockchain-based services that provide information from exchanges and other platforms to price trading assets called blockchain oracles. Instead of matching buy and sell orders, these decentralized exchange smart contracts use a pool of pre-funded assets called a liquidity pool. 

 

Orderbook DEX

Orderbook edits the record of all open orders in order to buy or sell the assets of a particular asset pair. A buy order means that the trader is willing to buy or bid on an asset at a specific price, and a sell order indicates that the trader is willing to sell or request a specific price on the asset in question. The spread between these prices determines the depth of the purchase order and the market price of the exchange. 

There are two types of DEX, on-chain order book and off-chain order book. DEXs that use order books often keep open order information on the chain while the user’s funds remain in the wallet. These exchanges allow traders to leverage their positions with funds borrowed from lenders on the platform. 

Leveraged trading increases the profitability of the transaction, but it also increases the risk of liquidation by increasing the size of the position of the borrowed funds that need to be repaid even if the trader loses the bet. 

However, the DEX platform, which removes purchase orders from the blockchain, only closes transactions on the blockchain to provide traders with the benefits of a centralized exchange. With off-chain order books, exchanges reduce costs, speed up, and ensure that transactions are executed at the prices users want.

DEX aggregator 

DEX aggregators use a variety of protocols and mechanisms to solve liquidity problems. These platforms basically aggregate liquidity from multiple DEXs, minimize slippage for bulk orders, optimize swap fees and token prices, and give traders the best possible price in the shortest possible time. 

Protecting users from price impacts and reducing the chances of a transaction failing are two other important goals of the DEX Aggregator. Some DEX aggregators use the liquidity of centralized platforms to leverage integration with specific centralized exchanges to provide users with a better experience while remaining unmanaged. increase. 

 Use of decentralized exchange 

If you use a decentralized exchange, you don’t even need an email address to interact with these platforms, so you don’t need a sign-up process. Instead, traders will need a wallet compatible with the smart contracts on the exchange`s network. Anyone with a smartphone and an internet connection can benefit from the financial services offered by DEXs. 

To use DEXs, the first step is to decide which network a user wants to use, as each trade will incur a transaction fee. The next one is to choose a wallet compatible with the selected network and fund it with its native token. A native token is a token used to pay for transaction fees in a specific network. 

Decentralized exchanges keep evolving 

 The first decentralized exchanges appeared in 2014, but these platforms only became popular as decentralized financial services built on blockchain gained traction and AMM technology helped solve the liquidity problems previously faced by DEXs. 

It is hard for these platforms to enforce Know Your Customer and Anti-Money Laundering checks, as there is no central entity verifying the type of information traditionally submitted to centralized platforms. Regulators can continue to attempt to carry out these reviews on decentralized platforms. 

Regulations that apply to custodians do not apply to these platforms either. This is because regulations that accept deposits from users require users to sign messages on the blockchain in order to move funds from the platform. 

On today’s decentralized exchanges, users can borrow money to take advantage of their position, lend money to passively earn interest, or provide liquidity to collect transaction fees. 

 These platforms are built on top of self-executing smart contracts, so more use cases may be created in the future. 

Flash  loans are loans that are borrowed and repaid in a single transaction, and are an example of how  decentralized finance innovation can create products and services that were previously impossible.

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