Key points
- A decentralised exchange (DEX) is an application for trading cryptoassets in which swaps and other operations are executed by smart contracts rather than a centralised trading system.
- The key difference from centralised exchanges is that DEXs do not hold users’ funds and do not control trades. Funds move directly from a user’s wallet connected to the platform. DEXs also have no user-verification procedures.
- DEXs have become a core component of decentralised finance (DeFi). By mid-2022 there were more than 200 DEXs operating across dozens of blockchains.
How do decentralised exchanges differ from centralised ones?
Centralised cryptocurrency exchanges (CEXs), such as Coinbase, Bitfinex or Kraken, are organised much like traditional stock exchanges. They are run by specific legal entities responsible for platform operations, safeguarding users’ funds and complying with laws.
Therefore the administrators of centralised exchanges have access to clients’ funds and can, if needed, block a user, a specific operation or an entire function, such as withdrawals. In addition, every new user must pass know-your-customer (KYC) checks.
By contrast, decentralised exchanges do not intermediate trades, do not hold funds or personal data. Client identification most often relies on blockchain addresses and the connection of non-custodial wallets to the application. Trading and other actions are executed via smart contracts.
In many DEXs key decisions are taken not by founders and developers but by communities of governance-token holders through votes in DAOs. That said, a DEX often has a lead developer who creates and evolves the application’s smart contracts and protocol. The source code of key components is open. DEXs are the primary type of application in DeFi.
When did decentralised exchanges emerge?
Initially all crypto trading was centralised. The first DEX appeared in 2014, NXT Asset Exchange. Similar projects—Counterparty DEX and Block DX—also launched, but drew little attention.
Amid the ICO boom of 2017–2018 thousands of new cryptoassets appeared. They often traded on new DEXs such as EtherDelta, IDEX, DDex and others. These ran mostly on the Ethereum blockchain and supported ERC-20 tokens. Typical problems then included low liquidity, wide spreads, slow execution and high transaction fees.
True popularity came with the automated market maker (AMM). Instead of a traditional order book it uses liquidity pools of asset pairs, with prices calculated by a formula based on their ratio in the pool. This enables a decentralised architecture and guarantees on-chain execution via smart contracts, with speeds comparable to centralised venues.
Bancor was the first to implement AMMs. But the Uniswap exchange, launched in 2018 on Ethereum, made them truly popular. Vitalik Buterin supported the project during development.
The DEX‑AMM model became standard and was copied across other networks, including BNB Chain (PancakeSwap) and Fantom (SpookySwap). AMM DEXs also operate in Solana, Cosmos, Terra and other ecosystems.
Liquidity providers to pools receive the fees earned by the pool for swapping assets in the relevant pair. AMM DEXs also added other features, such as farming, under which liquidity providers are automatically paid governance tokens. These can then be staked, used for participation in a DAO or simply sold.
Since 2021 a new generation of DEXs has emerged. They also use AMMs but enable swaps across blockchains. For example, in the Symbiosis Finance protocol this function is implemented via synthetic (“wrapped”) tokens. Another approach, used by THORChain’s DEX, relies on pools of native assets in different blockchains for swaps.
What are the advantages of DEXs?
Most strengths of decentralised exchanges flow from their distributed architecture. A few key advantages (some are also drawbacks):
- an extremely simple trading interface without order books or multiple order types;
- full customer anonymity, as DEXs require no registration, account creation or KYC with personal data;
- DEXs do not custody users’ cryptoassets, so neither developers nor authorities can freeze balances or impose other restrictions;
- listing new assets on a DEX happens instantly once the relevant liquidity pools are funded;
- the possibility of passive income by contributing assets to liquidity pools;
- DEX users can take part in governance by farming the governance token.
DEXs give users full control over their funds—and full responsibility for their actions.
What are the drawbacks of DEXs?
Several risks and weaknesses stand out:
- In most modern DEXs, swaps are possible only within a single blockchain. Sometimes assets from different networks are added to a DEX via cross-chain bridges, but this complicates trading.
- DEXs are prone to impermanent loss.
- DEXs offer limited trading functionality, lacking familiar options such as multiple order types (for example, limit or stop-loss) or leveraged trades. There are no extras such as a tape or an order book.
- All trades, including erroneous or fraudulent ones, are executed automatically on-chain and cannot be reversed or disputed with support. Cybercriminals often exploit this to sell stolen crypto.
- Execution speed depends on blockchain confirmation times and ranges from seconds to minutes. High-frequency trading on DEXs is therefore impossible.
- DEXs typically have less liquidity than centralised venues. Large orders in illiquid pairs may encounter price slippage, reducing user proceeds;
- Trading fees on DEXs are higher than on centralised exchanges. Users must also pay network fees.
- During swaps, especially at size, users can become victims of price manipulation by MEV bots.
- Because most modern DEXs lack a centralised listing system, scammers issue fake tokens to run criminal schemes, including Pump & Dump and Rug Pull.
- Vulnerabilities in smart-contract code or the web interface leave DEXs exposed to hacks. For example, on 8 June 2022 assets worth $5m were stolen from Osmosis DEX liquidity pools. Such incidents do not threaten exchange users’ funds, but can lead to losses for liquidity providers.
Are decentralised exchanges legal?
For now DEXs operate in a grey area, as legislation does not yet account for all the nuances of their architecture and regulators have not found effective means of oversight.
A central challenge for regulating DEXs is that they are often not linked to specific legal entities or any particular jurisdiction. Some DEX creators do not reveal their identities, complicating the task of identifying those responsible in case of violations.
Even so, attempts to compel DEXs to comply with local laws have been made repeatedly in recent years, especially in the United States. For example, in November 2018 the SEC accused EtherDelta co-founder Zachary Coburn of operating an unregistered national exchange. And in September 2021 the SEC launched an investigation into Uniswap Labs over suspected sales of unregistered securities and violations of anti-money-laundering laws.
As of 2022 regulators in the European Union, the United States, Singapore, Hong Kong and several other countries were actively developing future legislation to oversee DEXs and digital-asset exchange at both local and international levels.
What lies ahead for DEXs?
AMM-based DEXs have won millions of users, attracted tens of billions of dollars in investment and become integral to DeFi and the crypto market more broadly.
Several centralised exchanges have also launched their own DEXs or adopted selected features. In September 2020 the largest crypto exchange, Binance, launched the Binance Liquid Swap service based on AMM technology. This service lets users not only swap several dozen cryptocurrencies but also provide assets to liquidity pools and earn a share of trading fees.
In future, expect DEXs to offer richer functionality for traders and improved interoperability for simple, cheap and fast swaps across different blockchains.