A Deep Dive Into Decentralized Exchanges
What is a Decentralized Exchange?
To exchange or trade one cryptocurrency to another, one can use exchanges. While Centralized Exchanges (CEXs) allow for large trades to happen with plenty of liquidity, users of these exchanges do not have full control of their assets, putting their assets at risk in case the exchanges get hacked and are unable to repay their obligations.
Decentralized exchanges (DEXs) aim to solve this issue by allowing users to exchange cryptocurrencies without giving up custody of their coins. Without storing any funds on centralized exchanges, users do not need to trust the exchanges to stay solvent. DEXs work by using smart contracts and on-chain transactions to reduce or eliminate the need for an intermediary.
Types of DEXs
There are two kinds of DEXs, order book-based DEXs and liquidity pool-based DEXs. Order book DEXs operate similarly to CEXs where users can place buy and sell orders at either their chosen limit prices or at market prices, and assets for trade can be held on users’ own wallets.
However, one of the biggest problems facing order book-based DEXs is liquidity. Users may have to wait a long time for their orders to be filled in the order book. To solve this issue, liquidity pools-based DEXs were introduced.
What are Liquidity Pools?
Liquidity pools are essentially reserves of tokens in smart contracts and users can buy or sell tokens instantly from the available tokens in the liquidity pool. The price of the token is determined algorithmically and increases for large trades. DEXs liquidity pools can be shared across multiple DEX platforms and this pushes up the available liquidity on any single platform.
Liquidity pools reserves are provided by liquidity providers who are incentivized to obtain a proportionate fee of the exchange’s transaction fee. The amount of reserves held by a pool plays a huge role in determining how prices are set by the Automated Market Maker Mechanism.
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