What is a DEX exchange
DEXs are not controlled by a single organization acting as an intermediary. For example, the leading centralized cryptocurrency exchange Binance has a managing company that influences the development of the platform. Decentralized exchanges operate on blockchain protocols. They use smart contracts for peer-to-peer transactions. DEXs are part of the DeFi sector since trading on the exchange does not require KYC. This allows buyers and sellers to remain anonymous.
How decentralized exchanges work
Decentralized exchanges function like traditional markets. On DEXs, owners of crypto tokens trade with each other. Validators participate in the exchange, but their work is not visible. They provide cryptocurrency on the DEX so that exchanging traders have enough cryptocurrency. The cryptocurrency provided is called liquidity. Validators receive rewards in the form of a percentage of the trading fee for facilitating the transaction.
Imagine a trader Ethereum sets up a stall and sells Ethereum for Bitcoins. The seller will take a percentage of the profit for setting up this stall. This transaction lacks trust because there is no one to verify the honesty of the seller. However, in WEB 3.0, smart contracts oversee the integrity of buyers and sellers.
Decentralized exchanges operate by linking the user's cryptocurrency wallet to the protocol, thereby granting the protocol permission to view the wallet balance and request further authorization for coin transfers. The user then utilizes the protocol's user interface to select the cryptocurrency they wish to purchase. Given sufficient liquidity to execute the transaction, the protocol requests final permission from the user, specifying the desired transaction size, trading fee, and transaction processing price, after which it completes the transaction.
Differences between DEX and CEX exchanges
Centralized exchanges (CEX), such as Binance, are online trading platforms that connect buyers and sellers through an order book. CEXs operate similarly to traditional brokerage accounts, which is why they are so popular among investors.
Decentralized exchanges (DEX), such as PancakeSwap or Uniswap, operate autonomously through financial protocols based on smart contracts. Using these contracts, crypto traders trade cryptocurrencies. All transactions are visible as transactions on the blockchain.
The main difference between DEX and CEX is that centralized exchanges control the cryptocurrency balance within the platform. On DEX, traders maintain control over their balance during trading since DEX exchanges cryptocurrency from the connected wallet. This is the essence of how the DeFi sector operates.