Imagine a world in which you are free to apply for a loan or mortgage without the hassles that your bank puts in your path. There are forms to fill, KYC requirements to meet, and of course, the many third-party charges that the process would incur. This is a major drawback of centralized financial institutions worldwide and can test even the most patient of customers!
However, blockchain technology has made the distant dream of decentralized banking a reality with decentralized exchanges, commonly called DEXs. They are the next step in evolving financial instruments that use blockchain technology. They provide users with the scope and freedom to transact safely, securely, and, most importantly, conveniently.
DEXs come with a host of advantages such as accessibility, increased security, and a measure of flexibility in the manner they are used and the services that can be availed through them. Yet, there are challenges that must be managed suitably to make the most out of them.
Understanding DEXs can be difficult if certain aspects of the technology aren’t fully examined. For one, the use of Smart Contracts can be quite the challenge for new users to wrap their head around. Yet, they are the bread and butter of DEXs, allowing them to offer security and flexibility to their users.
A Smart Contract is simply a series of instructions stored on the blockchain in the form of – if/when program. These instructions are set to automatically execute when a set of conditions are met. The trigger for this code could be a predetermined condition, such as – when funds are received by a wallet. Once the code is executed, the blockchain is updated, and the parties involved in the contract are notified.
Consider a typical situation between a borrower and lender. Once they agree to a set of terms and conditions, they enter into a contract on a DEX. The code automatically executes these terms based on the agreement between two parties and how they take the transaction forward. Their contract is automatically executed and is also private and accessible only by those involved.
Another important part of DEXs that merits a closer look is the concept of IOUs. An IOU (or an “I owe you”) is simply a token or digital asset that matches the monetary value of a user’s funds. A decentralized exchange issues it to enable seamless trading and easy identification of an asset’s value on the platform of choice for both borrowers and lenders.
While Smart Contracts and IOUs add to the utility of decentralized exchanges, their real value lies in how these tools operate.
DEXs solve a number of these issues by virtue of the fact that they are non-custodial.
The advantages of DEX’s make associating with them an obvious move. How about the less discussed disadvantages?
While there are certainly advantages to using decentralized exchanges for crypto trading, not all of the news is as good as enthusiasts of the technology would likely claim.
As far as security is concerned, another key issue is that DEXs are all non-custodial. This means that investors are responsible for securing their wallets and portfolios on their own. It could be seen as an inconvenience at best or a serious risk at worst, depending on the investor and their own personal capacity to manage their assets effectively.
Weighing the pros and cons, how should you go about this?
Based on your needs as an investor or an individual, there is a variety of DEXs to choose from.
For example, Automated Market Makers are decentralized exchanges in which liquidity is rarely an issue. It is because these exchanges use blockchain technology to aggregate information from other platforms and exchanges to fix a price for an asset.
Aggregator programs called blockchain oracles allow users to fund a liquidity pool and trade instead of using buy-and-sell orders. While this does come with its own set of challenges, they are an effective and quick way to set up trading profiles that can be very lucrative in the long term!
Order books DEXs track all open purchases and sell orders for particular asset pairs. Buy orders represent a trader’s willingness to buy or bid for an asset at a specific price, and sell orders indicate a trader’s desire to sell or ask for the asset in question at a specific price.
The depth of the order book, as well as the market price on the exchange, are governed by the difference between these values. These can be either on-chain or off-chain and can be used in a variety of ways.
Finally, DEX aggregators aim to address liquidity issues through optimizing and fine-tuning the concept of a decentralized exchange. They essentially accrue liquidity across exchanges, allowing them to streamline the fee on transactions such as swap fees and token costs. They also ensure minimal slippage costs and cut down on time it takes for a trader to get the best possible price on their assets.
As a minimum, a stable internet connection and a capable device are needed to use DEXs. Aside from these obvious considerations, there are measures that you, as a user, can take to ensure the best possible experience with this innovative new technology.
First things first, choose a wallet and exchange that is compatible with the platform of your choice. PancakeSwap, for example, runs on the BNB Smart Chain (BSC) platform and as such is subject to using tokens and wallets that are compatible with it. Your wallet can be added as an extension to your browser in many instances, making it easy and convenient to access!
Next, it is important to purchase the correct tokens and add them to your wallet. At this juncture, it is important to double-check for compatibility between your wallet, tokens, and the platform of choice for your exchange. This can ensure that you are able to trade seamlessly and quickly while also reducing the risk of wasted funds in the event of non-compatibility.
In the event of a trade, it is important to audit Smart Contracts thoroughly and also to examine the white paper of new tokens closely. This can mitigate the risk of falling prey to scams or malicious practices to a large extent and ensure that your foray into decentralized finance is rewarding and secure.
Finally, as DEXs are non-custodial, it is important to ensure that you have access to your wallet and assets at all times. This can mean storing access keys safely in the event that you forget them. It is equally important to stay up-to-date on important news regarding exchanges, platforms, tokens, and even traders.
When using DEXs, it is important to remember that the end-user is responsible for vetting transactions in the absence of a regulatory body or centralized agency.
Several innovative use cases of DEXs, such as flash loans, make a strong case for the technology’s continued presence and growth. While the limitations of blockchain technology are very much present, it is essential to remember that it is still in the very early stages of its evolution.
With further improvements, the risks associated with decentralized exchanges could be diminished or eliminated entirely! There is a lot to love about DEXs – they are fast, accessible, secure, and address many of the issues that centralized, traditional banking models currently face.
DEXs have a lot of potential for improvement and further innovation, making the future look very promising. As long as you take the necessary precautions, there is no reason to indicate that you cannot be a part of that future and make a healthy profit while you are at it!
So, that’s about DEXs in a nutshell. Want to check out what you learned? A simple quiz that might not want to miss.