DEXs, a decentralized application with built-in economic functions, offer crypto enthusiasts different ways to think about asset trading, without giving up custody of their crypto. Unlike centralized exchanges governed by a company or organization, DEXs rely on the code to maintain their functionality. Given the scope of crypto currencies in enabling a parallel financial system and their contribution to the DeFi ecosystem, building a decentralized exchange from the grounds up is sometimes considered a good option to leverage such strategic initiatives.
Use Case: Building a Decentralized Exchange
Problem Statement
Traditional centralized exchanges suffer from single-party control over funds and data, creating a single point of failure and potential for misuse. Additionally, there are privacy and custodial risks.
Realization Approach
By following the AMM (Automated Market Marker) mechanism of managing liquidity pools, DEX operates in a decentralized and fully automated way, offering incentives to users contributing to the pool.
Solution Space
Launching a new DEX may be driven by several motivating factors. One consideration is addressing a market gap, targeting specific niches or under served markets to offer specialized trading services or unique liquidity pool structures. Another key motivation is integrating with broader blockchain ecosystems and DeFi projects to create synergies and attract users from allied platforms.
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In this blog post, we shift our focus to the dynamic landscape of the cryptocurrency market, zeroing in on the pivotal role played by Decentralized Exchanges (DEXs).
DEXs operate under a mechanism that allows users to contribute liquidity to the platform, creating a pool for others to trade. Each trade incurs a trading fee subsequently directed to the individuals who have supplied liquidity to the platform.Smart contracts rule the pool with mathematical precision in order to facilitate trustless and immediate trading. Uniswap, a prominent player in the DeFi arena, establishes industry benchmarks, serving as a guiding beacon for developers to glean insights and inspiration;
Let’s dive in and navigate through the process of building a decentralized exchange with the help of GetBlock services. We will also uncover what decentralized exchange is, how it works on the example of Uniswap, and what to consider before diving into this venture of building your very own DEX.
What are Decentralized Exchanges (DEXs)
In the world of decentralized finance, users engage in asset trading by interacting with liquidity pools, facilitated by smart contracts. Given the pivotal role of smart contracts in upholding DEX functionality, these exchanges can be succinctly defined as decentralized applications (dApps) operating on programmable blockchains, such as Ethereum and its EVM-compatible counterparts.
Here’s where the magic happens: users gain the power to supply liquidity for any token, enabling instant trading while earning a share of the fees paid by fellow traders. Incentivizing liquidity providers, this model encourages them to lock their funds and sustain the reserves, fostering a dynamic and liquid trading environment.
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Image by Appinventiv
Aside from trading, many platforms embrace all kinds of DeFi services facilitating staking, lending, and yield farming to name a few.
How does a DEX differ from a centralized exchange?
Centralized cryptocurrency exchanges (CEXs) are not inherently different from traditional financial institution services. They accept deposits, hold them in custody, and allow users to trade inside their database offering services of matching demand and supply between crypto investors.
While an intermediary ensures both parties stay committed to their side of the bargain, they also hold the power to assess the deposits coming in and restrict withdrawals based on their compliance policy.
DeFi, on the other hand, establishes peer-to-peer marketplaces where investors shape the market, free from centralized control. DEXs are often viewed as reliable sources for asset acquisition considering it’s purely governed by a code, i.e. smart contracts.
Another significant difference between CEX and DEX is the custodial character of centralized exchanges as they also act as storage for user funds, while with decentralized platforms funds are deposited directly to user wallets.
Advantages and disadvantages of DEXs
Decentralized finance products are gradually capturing their audience and adapting to user preferences. However, the complexity of using DEXs often hinders the widespread adoption. Despite this challenge, the compelling advantages of these services continue to attract users.
To start with, users retain custody of their funds, generating and distributing value among themselves without the risk of restriction. Moreover, no personal information is required to be revealed as users only need a cryptocurrency wallet to participate.
This self-reliance eliminates the need to trust a centralized entity for fund management, reducing the vulnerability of assets to potential hacker attacks. More benefits and drawbacks are listed in the table below.
| # | Category | Pros | Cons |
|---|---|---|---|
| 1 | Availability | Increased selection of tokens | No fiat trading involved; Risks of lower liquidity compared to centralized counterparties |
| 2 | Security | Eliminating middlemen and third-party frauds | Traders are solely responsible for asset security |
| 3 | User experience | The only requirement to connect a crypto wallet promotes accessibility | Less streamlined user experience compared to CEXs |
| 4 | No-KYC policy | Full user control over assets and anonymous trading | Lack of dedicated support teams to resolve any issues |
| 5 | Transparency | Guaranteed by a decentralized ledger that keeps score of all the activity | Open-source code, potentially exposing contract vulnerabilities to exploitation by hackers |
On the downside, decentralized exchanges offer an open invitation for anyone to provide liquidity, making tokens accessible to a broader audience. However, this inclusivity increases the chances of coming across unvetted projects.
Another significant concern revolves around potential smart contract vulnerabilities, which can pave the way for malicious activities. Therefore, it is imperative to conduct meticulous checks and audits when creating a DEX to safeguard user trust.
Why build a DEX?
Decentralized finance services have experienced a substantial surge in user demand over the past year, influenced in part by failures in centralized crypto exchanges. Traders, prioritizing the security of their funds, turn to trusted DEXs for a more secure alternative.
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Image from DeFiLlama
Additionally, Uniswap’s open-source code has paved the way for individuals to create more DEXs and extend the benefits of secure trading to a diverse range of blockchains.
Now that we’ve explored the growing demand for decentralized finance, let’s review how to build a decentralized exchange leveraging the powerful services provided by GetBlock. We will also tap into a high-level overview of Uniswap’s design for inspiration and review key points to consider in the process of creating your own DEX.
Planning for Building a Decentralized Exchange
Before we embark on a journey to create our DEX, it’s beneficial to understand the workings of major players and conduct research on existing exchanges. This section serves as a valuable resource for those curious about the operational dynamics of decentralized exchanges and provides developers with an overview of the design principles employed by similar applications.
Uniswap often comes to mind as the quintessential decentralized exchange, holding the top spot in the DeFi market cap according to CoinGecko. Let’s now take a brief look at the key building components of the Uniswap dApp.
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Image from Uniswap
It’s worth noting that the platform has progressed to its third version and is actively working on introducing the fourth. However, for the purpose of our exploration, we’ll focus on V2. This version implements a simpler architecture and has been successfully forked and utilized by many popular exchanges, including PancakeSwap.
The AMM Model
Automated Market Maker is a major DeFi primitive that powers decentralized exchanges as opposed to order books that are traditional for centralized financial platforms.
In the AMM system, users set up a liquidity pool or deposit to an existing pool. Whenever a trade occurs, liquidity providers (LPs) earn fees proportionate to the user’s share of that pool.
In Uniswap, it’s a portion of the protocol’s 0.3% trading fees. Since the volume that moves through the popular pools is substantial, even small-time liquidity providers can make a profit by just adding their crypto to the pool.
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Image by Uniswap
Unlike the order book which only swings into action when there’s an overlap in the system, AMM is constantly active — the trades are managed around the clock without having to wait for a buyer or a seller to agree on a price.
Liquidity Pool and Liquidity Token
A Uniswap pool operates as a smart contract designed to “store” a specific quantity of reserves.
Liquidity providers (LPs) deposit a desired amount of asset X plus asset Y of equal value to a smart contract pool and form this reserve.
As a confirmation representing contributed liquidity, LPs provided liquidity tokens minted in return, which is gaining interest proportionate to fees traders charged. Withdrawing funds from a pool results in burning these tokens so that upon redeeming their LP tokens, users get paid the interest amount added to the initial deposit.
Smart Contracts
The terms of agreement between buyers and sellers participating in DeFi swaps are written into the code, providing more transparent and secure trading. From the smart contract perspective, DEX is made of a series of Solidity codes.
The smart contract system for V2 of Uniswap is intentionally made binary, comprising of Core and Periphery contracts. By adopting this approach, the developer team prioritizes security by minimizing the code in Core, focusing solely on essential features. Non-critical functions are relegated to Periphery, reducing the audit scope and enhancing overall security.
For further explanation on Uniswap internal working and the detailed step-by-step guide on building a decentralized exchange, refer to the original post on GetBlock.
