Cryptocurrency investors can buy, sell, and trade their cryptocurrencies on different types of exchanges. Some use centralized exchanges, such as well-known companies like Binance, Coinbase, Crypto.com, and Gemini. But using a centralized exchange (CEX) often means creating an account, verifying your identity, and trusting the exchange to keep the crypto safe.
A decentralized exchange (DEX) lets crypto holders remain pseudonymous and keep control of their crypto wallet’s private key. Some popular DEXes have also expanded into other types of decentralized finance (DeFi) services, such as lending and borrowing crypto.
What is a DEX?
A DEX is a decentralized crypto exchange that lets people trade directly from their crypto wallets. The exchange doesn’t take control of their private keys or act as an intermediary. Instead, it uses smart contracts—self-executing programs—to facilitate peer-to-peer exchanges.
For example, an investor who has Ether (ETH)—the Ethereum blockchain’s native cryptocurrency—could go to the popular Uniswap DEX, connect their crypto wallet to share its public key, and trade their ETH for thousands of other cryptos. There’s no need (or even option) to create an account or confirm their identity.
Unlike centralized exchanges, DEXes don’t offer a way to directly trade fiat currency, such as U.S. dollars. Investors can only swap different types of cryptos. However, some DEXes help users create a wallet and add fiat funds to their wallet to get started.
How do decentralized exchanges work?
Similar to other decentralized finance platforms and tools, DEXes run on top of existing smart-contract blockchains. And most DEXes only allow investors to trade cryptos that are part of the same blockchain.
For example, Uniswap was built on the Ethereum blockchain and it allows investors to trade Ether and other Ethereum-based tokens. But someone who wants to trade cryptos on a different blockchain, such as the Binance Smart Chain, would need to use a compatible DEX, like PancakeSwap.
DEXes generally charge a trading fee that gets shared with the people helping keep the DEX running. The fees are often a small percentage of the trade amount, and are often lower than trading fees on CEXes. But investors may need to pay a network or gas fee to cover the cost of processing the transaction on the blockchain.
To facilitate the actual exchange, most DEXes use two trade execution models: order books or automated market makers.
Some DEXes use an order book—a list of orders from people who want to buy or sell cryptos and their associated bid and ask prices—to match buyers and sellers. When there’s a price that works for both parties, the trade occurs.
The mechanism is similar to how centralized exchanges and stock exchanges often work, and the supply and demand can push an asset's price up or down. However, especially with infrequently traded cryptos, it can be difficult for investors to complete trades.
Automated market makers
Automated market makers (AMMs) are an alternative and currently the most popular mechanism for DEXes.
With a DEX running an AMM protocol, investors don’t need to wait for an opposing trader. Instead, they trade with a pool of cryptos that are locked in a smart contract. The pool comes from liquidity providers, who deposit pairs of cryptos into a DEX’s liquidity pool and earn a cut of the trading fees.
Unlike with order books, the price for each crypto isn’t based on current buy and sell orders. It depends on the liquidity pool’s pre-defined algorithm and activity in that individual pool.
Centralized vs. decentralized exchanges: Key differences
While billions of dollars get traded on the top DEX crypto platforms each week, the vast majority of crypto trades take place on centralized exchanges. Here’s how the two types of crypto exchanges differ.
- Custody of the crypto. Centralized exchanges create custodial accounts for users and hold onto the crypto wallets’ private keys. When using a DEX, investors never share or turn over access to their funds.
- Their role in trading. DEXes automate peer-to-peer trading while centralized exchanges may act as intermediaries.
- Account requirements. Investors may need to create an account and verify their identity to use a CEX. With a DEX, investors can connect their wallets and trade while remaining pseudonymous.
- Regulations. Many popular CEXes in the U.S. comply with state and federal regulations. DEXes may comply with some regulations, but they’re relatively unregulated compared to CEXes.
- Consumer protections. CEXes may have insurance, guarantees, and support staff. DEXes may have supporting documents and community members who share advice, but investors are largely on their own.
- Supported cryptos. DEXes might not have a vetting process, which means there are more (but also riskier) cryptos available on the platforms.
- Fees. CEX trading fees tend to be higher, although the exact amount can depend on the type of transaction, order value, and whether the trader is purchasing crypto with fiat currency. DEX trading fees are lower, but traders generally have to pay additional network fees (gas fees), which can lead to higher overall costs.
- Types of orders. CEXes may support more advanced order types, such as stop-limit orders, which can help an investor limit risk.
Pros and cons of using DEXs
With the comparison of DEXes and CEXes in mind, here are some of the pros and cons of using a DEX.
Investors may benefit or prefer using a DEX because it can offer:
- Security. DEXes never take control of private keys and investors don’t need to trust a CEX to protect their funds.
- Privacy. There’s no requirement to create an account and share identity verification documents.
- Access to more cryptos. Investors who want to buy little-known coins or tokens might only be able to purchase them from a DEX.
- Low trading fees. DEXes tend to charge low trading fees. Gas fees could also be low on certain blockchains, and some DEXes are coming up with ways to offer gas-free trades.
Investors may decide to avoid decentralized exchanges for a variety of reasons:
- More difficult to use. DEXes might not have an intuitive interface and many require investors to have a crypto wallet with funds available to trade.
- Few protections. Investors are on their own if they lose their private key.
- Limited liquidity. Trades may take a long time to complete or might not go through at all, especially for little-known cryptos.
- Hacks are still possible. While DEXes don’t store private keys, hacks and bugs in the code could still put investors’ crypto at risk.
The bottom line
A decentralized crypto exchange lets investors trade cryptos without relying on an intermediary or sharing their personal information. These exchanges also give investors the opportunity to buy the latest cryptocurrencies, and often the ability to make money with their crypto by providing liquidity to other traders.
Centralized exchanges are the go-to option for many people because they’re an easy and relatively secure way to invest in and trade crypto. But DEXes are continuing to evolve as new ideas get incorporated into upgrades and people or groups launch new platforms.