Decentralized Exchanges 101: Three types of DEXes

Decentralized exchanges (DEXex) receive criticism for low liquidity and clunky user interfaces. But critics should remember that DEXes on Ethereum have existed for less than two years and already have made good progress. With the emergence of aggregator tools like DEX.AG, we expect competition among DEXes to accelerate. This should result in decreased price differences across DEXes and force users to consider other factors when deciding where to trade. One such factor is the type of decentralized exchange.

Not all decentralized exchanges are made equal

All decentralized exchanges offer decentralized custody, some allow users to retain custody, and some require users to lock funds into a smart contract in order to trade. If a centralized entity has direct access to your funds, you’re using a centralized exchange, not a DEX.

The main differences among DEXes relates to the level of decentralization. Broadly, three types exist:

1. Centralized orderbook/decentralized custody
2. Decentralized orderbook/decentralized custody
3. Decentralized liquidity pool

• Centralized orderbook/decentralized custody

This type of exchange hosts off-chain orderbooks, but all trades execute on-chain. Thus, the exchange only sends trades to the blockchain when someone takes an order. Under such a system, users can save on gas fees and avoid some types of front-running. But users must trust the centralized entity to maintain the order book competently (e.g., prune inactive orders) and ethically (e.g., not front-run a trader’s order).

Example – IDEX

• Decentralized orderbook/decentralized custody

Some exchanges act more like a bulletin board where users manually make and fill orders. With this type of exchange, the centralized entity merely acts as a host of the website that displays the orderbook. For these DEXes, users must write every order and cancellation to the blockchain, increasing gas costs. Also, orders do not settle until they’ve been included in a valid block by a miner. This can allow front-running – sometimes intentional, sometimes not – e.g., where a user tries to fill an order only to learn later that another user filled the order first. Nobody likes to pay gas for a trade that never occurs, but many traders consider this the possibility of front-running to be a fair cost of greater decentralization.

Examples – 0x relayers such as Radar Relay

• Decentralized liquidity pool

This type of DEX offers the most decentralization. Here, users supply liquidity to the system, which sets and adjusts prices in a manner that maintains a relative equilibrium. These exchanges don’t typically keep any orderbooks. This can feel unfamiliar or restricting, because traders can only place certain types of orders. Also, larger orders can cause price slippage, depending on the size of the liquidity pool. Nonetheless, 2019 has seen an increase in usage and buzz around this type of decentralized exchange, and we expect that the community will continue to innovate and improve upon the current offerings.

Examples – Uniswap, Bancor, Kyber

Make DEX.AG your first stop

Before you trade on any decentralized exchange, use DEX.AG to make sure you’re getting the best price. DEX.AG instantly compares prices across all types of decentralized exchanges. Try it on Settle!