How Do DEXs Work?
As mentioned, DEXs use smart contracts to automate the process of executing trades and managing liquidity. Here’s a deeper breakdown:
- Automated Market Makers (AMMs): DEXs like Uniswap, PancakeSwap, and SushiSwap use AMMs to determine the price of assets in a pool, based on the amount of liquidity in that pool. When users swap tokens, the price shifts based on supply and demand, without an order book.
- Liquidity Pools: Users provide liquidity by depositing two or more tokens into a pool. In return, they receive liquidity pool (LP) tokens that represent their share in the pool. These LP tokens can be staked or redeemed for the original tokens along with any earned fees.
- Yield Farming: Users can earn additional rewards (often in the form of governance tokens) by staking their LP tokens in yield farming programs.
- Slippage: In DEXs, slippage occurs when the price of a token changes between the time a trade is initiated and completed, due to market movements.
- No Custodians: Unlike centralized exchanges, DEXs do not hold your funds. Instead, you retain control of your assets through your wallet, reducing the risk of hacks and theft at the exchange level.
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