Understanding DEX in One Article: How Decentralized Exchanges Work

In the world of cryptocurrency trading, two different camps are confronting each other. On one side are traditional centralized exchanges (CEX), which control the majority of trading volume; on the other side are the rapidly emerging decentralized exchanges (DEX). So, what is a DEX? Simply put, a DEX is a permissionless, non-custodial trading platform. Most DEXs do not require KYC verification, and users can trade freely without registration or login. DEX stands for Decentralized Exchange, representing a new way of trading.

In the early stages of DEX development, there was a critical period when the monthly DEX trading volume exceeded $4 billion, accounting for 4% of centralized exchange trading volume, setting a historical record at the time. Meanwhile, the DEX share increased from 2.1% to 3.95% month-over-month, a growth rate that clearly indicates market demand for decentralized trading. Today, DEXs have become an indispensable part of the crypto ecosystem, with market acceptance continuously rising.

Two Trading Models of DEX: Order Book and Liquidity Pool

When discussing what a DEX is, it’s essential to understand its two main operational modes. The first is the order book DEX, which adopts a peer-to-peer (P2P) matching model. Trades are only completed when a buyer’s order matches a seller’s order. This model performs well on centralized exchanges due to ample liquidity and tight spreads. However, when migrated to decentralized exchanges, it faces challenges.

Order book DEXs allow users to submit two types of orders. Limit orders let traders set their own purchase price and amount, while market orders execute immediately at the best available price. Projects like IDEX, EthFinex, and EtherDelta have adopted this model. The advantage of this type of DEX is an experience close to traditional exchanges, simply changing login from an account to a wallet connection. With sufficient depth, assets are transferred directly back to the wallet via smart contracts, giving users a genuine sense of blockchain’s trustless trading.

The second mode—liquidity pool DEXs—offers a completely different logic. In this mode, there’s no need to wait for an counterparty; all trades interact with a pre-set pool of funds. After submitting a trade, an algorithm automatically determines the execution price. Each trade flows through the same liquidity pool, resulting in faster transactions and a smoother user experience.

Why Do DeFi Era Need Automated Market Makers?

Many wonder: why haven’t order book DEXs become mainstream, and instead, liquidity pool models have taken over? The answer lies in the unique nature of the DeFi ecosystem. Tokens in DeFi are often in early development stages, with limited followers and market participants. This creates a vicious cycle: insufficient liquidity → high price volatility → traders avoid trading → even less liquidity.

In such an environment, order book DEXs cannot operate effectively because there aren’t enough traders providing quotes simultaneously, leading to frequent order mismatches and poor trading experience. Automated Market Maker (AMM) algorithms cleverly solve this problem by pooling liquidity provider funds and using mathematical models to automatically offer quotes, enabling continuous trading regardless of market participation levels.

Although AMM technology has existed in academic and game theory fields for over a decade, it only exploded in the crypto community in recent years. AMMs not only mimic traditional market makers’ trading behaviors but also achieve full automation through smart contracts. They eliminate the need for centralized entities to maintain order books, allowing anyone to become a liquidity provider and earn a share of trading fees. This democratization has propelled DeFi’s rapid growth.

How Do Automated Market Makers Revolutionize the DEX Ecosystem

The core innovation of the AMM model lies in the design of liquidity pools. Unlike order book DEXs, AMM-based DEXs do not rely on buy-sell price negotiations. Instead, they provide quotes for each trade through predefined algorithms. Each AMM DEX can design its own algorithmic logic, resulting in subtle differences in trading mechanisms across platforms.

So far, Uniswap has become the dominant leader in the DEX space. It adopts the AMM model, allowing anyone to provide liquidity and earn platform fees. The fees earned by liquidity providers on Uniswap are generated from the trading activity of other users. This design makes providing liquidity a viable investment method, attracting substantial capital inflow.

In addition to Uniswap, projects like Bancor, Balancer, and Curve are continuously innovating AMM technology. Curve, in particular, is optimized for stablecoin trading pairs, offering lower slippage. Balancer allows users to create custom liquidity pools with different weightings. These innovations make AMMs increasingly flexible and adaptable to various trading scenarios.

The advantages of AMMs far surpass traditional market makers: they offer a secure and reliable trading environment, are borderless, and do not require custody of funds. These features enable DEXs to serve users worldwide around the clock, completely eliminating the geographical and time restrictions of centralized exchanges.

The Central Role of DEXs in the DeFi Ecosystem

Decentralized exchanges are no longer just a simple concept of what a DEX is. They have evolved into vital infrastructure within the DeFi ecosystem. The development of DeFi applications depends heavily on DEX support—whether it’s liquidity mining, yield farming, or derivatives trading, DEXs provide indispensable trading channels.

As technology continues to evolve, modern DEXs are becoming increasingly user-friendly. User interfaces are more intuitive, trading processes are simpler, and transaction costs are decreasing. Once capital efficiency is further improved and downside risks are effectively managed, the capital scale in DeFi will likely experience explosive growth, with DEXs being the main beneficiaries.

For users wanting to experience DEXs firsthand, the best way is to try it yourself. Whether swapping tokens on Uniswap or providing liquidity on other AMM platforms, you’ll find that DEXs are not complicated but rather full of blockchain’s charm and potential. Ultimately, choosing which DEX to use depends on which platform best suits your trading needs.

DEX as the Future of DeFi Infrastructure

Decentralized exchanges have moved from the periphery to the center stage—an undeniable fact. What is a DEX? It’s not just a new trading tool but a manifestation of blockchain’s democratization spirit. The emergence of AMM technology allows anyone to become a market liquidity provider, breaking the monopoly traditionally held by market makers in finance.

The development of DEXs proves the feasibility of decentralized architecture. While ensuring security, transparency, and trustlessness, they can still offer user experiences comparable to centralized exchanges. With ongoing ecosystem improvements and technological advancements, DEXs will deepen their role in DeFi, serving as bridges connecting assets, liquidity, and traders. Once you truly understand how DEXs operate, you’ll see why they are reshaping the landscape of financial markets.