What is a DEX?

A decentralised exchange (‘DEX’, a decentralised exchange) is a platform for exchanging cryptocurrencies that operates without a central authority, using blockchain technology to enable direct trading between users. Unlike traditional exchanges, DEXs are powered by smart contracts, self-executing computer programmes on the blockchain that define the rules for buying, selling and exchanging tokens and operate automatically when certain conditions are met. As a result, DEXs offer a higher level of security, as users retain control over their cryptocurrencies and do not have to trust them to an exchange. The DEX is one of the most important innovations within Decentralised Finance (DeFi), or blockchain-based economy.

History of the DEX

The development of DEXs began as a reaction to the limitations and risks of centralised exchanges. The first DEXs emerged shortly after the introduction of Bitcoin, with platforms such as Bitshares in 2013 pioneering the idea of a decentralised financial infrastructure. The blockchain Ethereum, launched in 2015, played a crucial role in the evolution of DEXs by introducing smart contracts, enabling more complex forms of exchange on the blockchain. Uniswap, launched in 2018, revolutionised the space by introducing liquidity pools and the automatic market maker model, leading to a significant increase in the adoption and functionality of DEXs. An automated market maker (‘AMM’, also called automated market maker) is a smart contract that regulates some crucial functions of the DEX as a decentralised exchange, such as prices on the DEX and the liquidity available, which is stored in liquidity pools. A liquidity pool is also a smart contract, which is programmed to hold cryptocurrencies placed in the liquidity pool by market participants. The liquidity pools enable actual trading on DEXs by allowing market participants within DeFi to place money (liquidity) in the liquidity pools and make it available as trading liquidity on the DEX for a fee.

Benefits and challenges of DEXs

While DEXs are attractive because of their ability to give users full control over their cryptocurrencies and the fact that anyone, worldwide, can use them 24 hours a day, there are also challenges such as lower liquidity and slower transaction speeds, which can lead to difficulties in executing large orders. Moreover, these platforms can be difficult for beginners to use as their comprehensiveness can lead to complexity. However, the advantages of DEXs are significant, including increased privacy, as users often do not have to provide personal information (except for the information published on the blockchain, such as the wallet address), and improved security as money does not have to be stored in a centralised exchange's database. Indeed, a user of a DEX benefits from all the advantages the blockchain offers as a decentralised technology! In addition, users of DEXs can count on the fact that the latest applications of blockchain technology are usually the first to be rolled out on a DEX, which brings risks but also opportunities. The final advantage, of course, is that earning can also be done in various ways on a DEX, for instance by participating in liquidity pools.

What is a CEX?

Centralised exchanges (‘CEX’, a centralised exchange), such as Binance and Coinbase, operate more like traditional brokers. Users deposit their money into the exchange's accounts, after which all trading is facilitated internally. This ensures fast transactions and high liquidity. The advantages of CEXs include their user-friendly interfaces and customer service. However, centralising funds on one platform increases the risk of hacks and exposes users to potential privacy issues due to mandatory KYC and AML procedures.

Key differences between DEXs and CEXs

The main differences between DEXs and CEXs lie in the degree of control users have over their money, speed of transactions, available liquidity and level of customer service. While DEXs emphasise decentralisation and privacy, CEXs offer speed and ease of use. With a DEX, users always retain control over their cryptocurrencies, reducing the risk of theft through a hack. With a CEX, users entrust their money to the exchange, which must ensure security. CEXs can offer faster transactions as they do not rely on blockchain verification for every transaction, unlike DEXs where every transaction has to be processed and verified on the blockchain.

Examples of DEXs and CEXs

Well-known DEXs include Uniswap, famous for its automatic market maker system that sets prices based on the ratio of tokens in the pool, SushiSwap, a ‘fork’ (a kind of elaborate copy) of Uniswap with additional features and a distinctive community, and PancakeSwap on the Binance Smart Chain, known for its low transaction costs and fast transactions. Among the CEXs, we find Binance, the world's largest cryptocurrency exchange in terms of trading volume, Coinbase, known for its user-friendliness and accessibility for beginners, and Kraken, which offers extensive trading capabilities, including futures and margin trading.

Trading volumes and impact

Despite the growing popularity of DEXs, CEXs continue to dominate in terms of trading volume. These trading volumes are an important indicator of market liquidity; higher volumes typically mean smaller price differentials (‘spreads’) and more easily executable orders. The higher liquidity of CEXs makes them more attractive to institutional investors and large traders who need to be able to trade large positions without causing significant price movements.

Technological and economic factors

The technology behind DEXs is based on blockchain and smart contracts, meaning that every transaction is transparent and verifiable on the blockchain. This contributes to the security and integrity of the DEX, but can also lead to higher transaction costs and processing time during peak hours on the blockchain. CEXs, on the other hand, use internal databases to process transactions, resulting in faster and cheaper transactions, but these are less transparent and dependent on the security of the exchange itself. In addition, CEXs have also gone dark during peak hours in the past, and then users cannot access their money.

Future of DEXs and CEXs

The future of both DEXs and CEXs is promising, but they are likely to follow different paths. DEXs will continue to evolve with improved user interfaces, faster transactions and lower costs thanks to scaling solutions such as layer-2 protocols (these are basically faster blockchains built ‘on top of’ larger blockchains). They will continue to appeal to users who value decentralisation and privacy and want to be in control of their own money, in addition to remaining at the forefront of innovation in blockchain technology. CEXs will likely continue to innovate with new products and services to attract a wider range of users, from retail investors to large institutional parties.