Since DEX trades are facilitated by deterministic smart contracts, they carry strong guarantees that they will execute in exactly the manner the user intended, without the intervention of centralized parties. In contrast to the opaque execution methods and potential for censorship present in traditional financial markets, DEXs offer strong execution guarantees and increased transparency into the underlying mechanics of trading.
As there are no custodians involved and users can participate using their self-hosted wallets, DEXs reduce counterparty risk. DEXs can also reduce some of the systemic risks of the blockchain industry by reducing the amount of capital concentrated in the wallets of a small number of centralized exchanges. In 2014, the Mt. Gox centralized exchange handled a significant portion of all Bitcoin trading volume before it abruptly ceased operations amid the loss of hundreds of thousands of bitcoin.
DEXs also help increase financial inclusion. While there have been cases of specific user interfaces limiting access based on geographic location or other factors, accessing a DEX’s smart contracts only requires an Internet connection and a compatible self-hosted wallet. As users are able to sign in in a straightforward manner using their wallet address, the onboarding process for a DEX is seamless and practically instantaneous compared to a centralized exchange.
DEX Risks and Considerations #
DEXs have democratized access to trading and liquidity provision through strong execution guarantees, increased transparency, and permissionless access. However, DEXs also carry a set of risks, which include but are not limited to:
- Smart contract risk—Blockchains are considered highly secure for executing financial transactions. However, the code quality of a smart contract is nevertheless dependent on the skill level and experience of team that developed it. Smart contract bugs, hacks, vulnerabilities, and exploits can occur, leaving DEX users susceptible to a loss of funds. Developers can mitigate this risk through security audits, peer-reviewed code, and sound testing practices, but diligence is always required.
- Liquidity risk—While DEXs are becoming increasingly popular, some DEX markets have poor liquidity conditions, leading to large amounts of slippage and a suboptimal user experience. Due to how the network effects of liquidity works (high liquidity attracts more liquidity, low liquidity attracts less liquidity), significant portions of trading activity is still conducted on centralized exchanges, which often leads to less liquidity on DEX trading pairs.
- Frontrunning risk—Due to the public nature of blockchain transactions, DEX trades may be frontrun by arbitrageurs or maximal extractable value (MEV) bots trying to siphon value from unwitting users. Similar to high-frequency traders in traditional markets, these bots try to exploit market inefficiencies by paying higher transaction fees and optimizing network latency to exploit ordinary users’ DEX trades.
- Centralization risk—While many DEXs aim to maximize their decentralization and censorship resistance, points of centralization can still be present. These include the DEX’s matching engine being hosted on centralized servers, the development team having administrative access to the DEX’s smart contracts, and the use of low-quality token bridging infrastructure among others.
- Network risk—As the exchange of assets is facilitated by a blockchain, using a DEX may be prohibitively expensive or outright impossible if the network experiences congestion or downtime, leaving DEX users susceptible to market movements.
- Token risk—As many DEXs feature permissionless market creation—the ability for anyone to create a market for any token—the risks of buying low-quality or malicious tokens can be higher than in centralized exchanges. DEX users need to consider the risks associated with participating in early-stage projects.
In addition to the above, some users may find having full custody of their private keys a daunting prospect. While having full control over one’s assets is one of the main benefits offered by the Web3 vision, many users may prefer to have a third party entrusted with the custody of their assets. However, following good security and key management practices can allow more users to enjoy the benefits of maintaining full control over their assets while accessing a sophisticated ecosystem of open-source financial services.