A decentralized exchange, or DEX for short, is like a stock exchange run by a smart contract on the Ethereum blockchain. Although both allow you to trade assets, a decentralized exchange trades cryptocurrency only and so does not require a centralized authority to operate. Instead, a decentralized exchange uses a smart contract to enforce the rules, execute trades, and securely handle funds when necessary.
In order to examine the differences, let’s break down what a centralized exchange looks like in traditional finance.
Exchanges are where you buy and sell things. More specifically, financial exchanges are where you trade financial assets and commodities. In traditional finance, these assets are held in custody by a central exchange who takes orders from buyers and sellers for commodities, stock, securities, currencies, and more.
To execute a trade, you submit an order to the exchange who then either puts it onto their orderbooks to be filled later or fills the order with an existing order on the books. When you make an order which gets put in the orderbook, it’s called a maker order. And when your trade order is filled by taking an existing one off the books, your order is considered a taker order.
DEXes are exchanges built using smart contracts
Decentralized exchanges are smart contracts written to perform a similar process as the one described above. They allow users to trade cryptocurrencies like ETH for other coins or tokens simply by interacting with their contracts from their wallet.
When you submit trade orders to a DEX, you’re submitting a transaction to their smart contract on the blockchain. Some DEXes have orderbooks with maker and taker orders. Whereas, other DEXes have pools or reserves of currencies ready to swaps or trades.
Using a decentralized exchange reduces your risk of hack or theft
There’s a risk to putting your money in someone else’s hands. This is especially true when it comes to cryptocurrency. Centralized cryptocurrency exchanges hold millions of dollars of their customers’ funds and are prime targets for hackers and thieves.
Decentralized exchanges reduce this risk by either letting you keep your funds in your wallet until the order is filled. Or rather, the funds are held in a smart contract secured by the Ethereum blockchain.
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