Advantages of using a DEX
Trading on decentralized exchanges can be expensive, especially if network transaction fees are high when the trades are executed. Nevertheless, there are numerous advantages of using DEX platforms.
Centralized exchanges have to individually vet tokens and ensure they comply with local regulations before listing them. Decentralized exchanges can include any token minted on the blockchain they are built upon, meaning that new projects will likely list on these exchanges before being available on their centralized counterparts.
While this can mean traders can get in as early as possible on projects, it also implies that all sorts of scams are listed on DEXs. A common scam is known as a “rug pull,” a typical exit scam. Rug pulls occur when the team behind a project dumps the tokens used to provide liquidity on these exchanges’ pools when their price goes up, making it impossible for other trades to sell.
When users exchange one cryptocurrency for another, their anonymity is preserved on DEXs. In contrast to centralized exchanges, users do not need to go through a standard identification process known as Know Your Customer (KYC). KYC processes involve collecting traders’ personal information, including their full legal name and a photograph of their government-issued identification document. As a result, DEXs attract a large number of people who do not wish to be identified.
Reduced security risks
Experienced cryptocurrency users who custody their funds are at a reduced risk of being hacked using DEXs, as these exchanges do not control their funds. Instead, traders guard their funds and only interact with the exchange when they wish to do so. If the platform gets hacked, only liquidity providers may be at risk.
Reduced counterparty risk
Counterparty risk happens when the other party involved in a transaction does not fulfill its part of the deal and defaults on its contractual obligations. Because decentralized exchanges operate without intermediaries and are based on smart contracts, this risk is eliminated.
To ensure no other risks arise when using a DEX, users can quickly do a web search to find out whether the exchange’s smart contracts have been audited and can make decisions based on other traders’ experience.
Disadvantages of using DEXs
Despite the above advantages, there are various drawbacks of decentralized exchanges including a lack of technical knowledge needed to interact with these exchanges, the amount of smart contract vulnerabilities and unvetted token listings.
Specific knowledge is required
DEXs are accessible using cryptocurrency wallets that can interact with smart contracts. Not only do users have to know how to use these wallets, they also have to understand security-related concepts associated with keeping their funds secure.
These wallets have to be funded with the correct tokens for each network. Without a network’s native token, other funds may get stuck, as the trader cannot pay the fee required to move them. Specific knowledge is required to both choose a wallet and fund it with the correct tokens.
Moreover, avoiding slippage can be challenging even for experienced investors, or even near impossible when purchasing tokens with less liquidity. Often, slippage tolerance on DEX platforms has to be manually adjusted for orders. Additionally, adjusting slippage can be technical, and some users may not fully understand what it means.
Without specific knowledge, traders can commit various errors which may lead to a loss of funds. Withdrawing coins to the wrong network, overpaying transaction fees and losing out to impermanent loss are just a few examples of what could go wrong.
Smart contract vulnerabilities
Smart contracts on blockchains like Ethereum are publicly available and anyone can review their code. Moreover, smart contracts of large decentralized exchanges are audited by reputable firms that help secure the code.
To err is human. Therefore, exploitable bugs can still slip past audits and other code reviews. Auditors may even be unable to foresee potential new exploits that can cost liquidity providers their tokens.
Unvetted token listings
Anyone can list a new token on a decentralized exchange and provide liquidity by pairing it with other coins. This can leave investors susceptible to scams such as rug pulls that make them believe that they are buying a different token.
Some DEXs counter these risks by asking users to verify the smart contract of the tokens they are looking to buy. While this solution works for experienced users, it circles back to specific knowledge problems for others.
Before buying, traders can try to get as much information as possible about a token by reading its white paper, joining its community on social media and looking for potential audits on the project. This type of due diligence helps avoid common scams where malicious actors take advantage of unsuspecting users.