/Building your DEX: What you need to know before you start

Dec 06, 2022

14 min

Blockchain

Building your DEX: What you need to know before you start

Digital Exchanges (DEX) is growing rapidly, with new projects being announced almost every week. While the enthusiasm is admirable, the market still has some maturing to do. For DEXs to reach their full potential as a decentralized solution to centralized exchanges, they must adopt certain best practices and standards that will allow them to scale more efficiently and securely than their predecessors.

A recent study by Grand View Research revealed that the global digital exchange market size was valued at USD 30.18 billion in 2021 and is expected to grow at a compound annual growth rate (CAGR) of 27.8% from 2022 to 2030.

While most of these DEXs are niche marketplaces, focused on specific types of tokens or specific regions, there remains a general thirst for secure and user-friendly decentralized exchanges.

To ensure you stand out from the crowd as a leading DEX provider and not just another also-ran, this blog aims to help you think strategically about designing and implementing your DEX.

What is DEX?

A centralized exchange is controlled by a centralized organization such as a bank that offers other financial services, whereas a decentralized exchange utilizes smart contracts to allow traders to exchange tokens without an intermediary.

Because they are regulated entities that safeguard customers’ funds and provide user-friendly platforms, centralized exchanges account for the majority of cryptocurrency trading volume. In addition, some centralized exchanges offer protection for deposited assets.

A centralized exchange provides the same services as a bank. A bank keeps its clients' funds safe and provides security and surveillance services that individuals cannot deliver independently, thereby facilitating the movement of funds.

Traders protect their funds by interacting directly with the smart contracts behind the trading platform on decentralized exchanges. Because they are responsible for losing their funds if they make mistakes such as losing their private keys or sending funds to the wrong addresses, they guard their funds.

An IOU is a blockchain-based token that has the same value as the underlying asset, and customers' deposited funds or assets can be freely traded on the network through decentralized exchange portals.

Some of the most popular DEXs have been built on top of leading blockchains that support smart contracts. They are built directly on the blockchain using layer-one protocols. The Ethereum blockchain is one example.

The swift growth of DEX spot volume. (Source)

How does DEX work?

All decentralized applications (DEXs) are hosted on a smart contract blockchain. All blockchains, including Bitcoin, are smart contract platforms, but not all of them are suitable for dApp development and deployment. Ethereum, Solana, Avalanche, Fantom, and other smart contract platforms are therefore referred to as “smart contract platforms.”

Ethereum plans to transition from Proof-of-Work (PoW) to Proof-of-Stake (PoS) in 2022, except for the ones that currently run on a PoS consensus mechanism.

Users can directly connect to other traders without market makers' mediation on DEXes.

Noncustodial wallets, such as Trezor, MetaMask, Trust Wallet, Ledger, and others, can also be connected to DEXs directly. There are two primary methods for accomplishing this:

DEX Order Books

It is a simple electronic list of sell and buys orders. Because order books accumulate such enormous amounts of orders, they are often used to provide market sentiment through the depth of market charts.

When placing a limit order, a trader specifies the desired price. If there is low liquidity, the limit order will remain in effect until an appropriate book order match is made. A market order, on the other hand, is an order to buy or sell a specified number of tokens immediately at the best available price.

At the same time, a market order provides the best prices within a given range. All CEXs rely on book orders to facilitate cryptocurrency trading. However, such exchanges have problems maintaining liquidity in a decentralized setting. Without a centralized market maker to cover bid-ask spreads, a DEX would have to be very popular to provide the optimal number of sellers versus buyers.

Furthermore, on-chain order books suffer from front-running because on-chain data is public. All market and limit orders are publicly displayed, therefore accessible to miners. As a result, miners may exploit other traders' information by submitting buy/sell orders in opposition.

An off-chain order book only uses the blockchain to settle trades. Furthermore, an order book's depth of market information can allow us to forecast token prices. For example, crypto whales could use this information to construct fake buy/sell walls for pump-and-dump schemes and wash trading.

It is difficult to take preventative measures because DEXs allow for noncustodial wallets and anonymity. Anonymity is one of DEX's key advantages as well. Some of the most popular order book DEXs are the following:

dYdX
Loopring Exchange
DDEX
ViteX
Binance DEX
Nash Exchange

Automated Market Maker (AMM) DEXs

An automated market-making protocol is typically synonymous with decentralized exchanges. Such a protocol replaces order books entirely and supplants them with a smart contract system.

Instead of traditional match-making services, AMM uses smart contracts as liquidity pools to provide liquidity to others. They collect crypto assets from liquidity providers (LPs) who offer liquidity-providing services in return for an interest rate, which can be either an annual percentage yield (APY) or an annual percentage rate (APR).

In a decentralized manner, an elegant incentive mechanism solves the lack of centralized market makers by turning all LPs into market makers. Because they rely on liquidity pools rather than matching order books, AMMs provide more consistent liquidity.

The most popular AMM DEXs are the following:

Uniswap
Bancor
SushiSwap
Balancer
Gnosis
Curve

Aggregator DEXs

An aggregator is a type of decentralized exchange that combines various protocols involved with liquidity issues. These platforms combine liquidity from multiple DEXs to provide the lowest exchange fees and mitigate slippage risk.

Through the use of noncustodial wallets, aggregators can tap into the liquidity of centralized exchanges while still providing the best prices for online shopping. This way, aggregators serve as websites that offer the best prices for online shopping.

Two of the most popular DEX aggregators are 1inch and DeversiFi.

Why a decentralized exchange platform is a good decision?

There are a few advantages to using a decentralized exchange over a centralized one, according to experts. Increased transparency and independence from a single entity are just a few of them. It will be difficult for DEXs to enforce KYC verification, as they are part of creating a self-regulated peer-to-peer crypto community. Their popularity stems from creating a financial system where everyone can participate without restrictions.

DEX: Pros & Cons

Pros	Cons
Anonymity Unlike centralized exchanges, which require users to submit Know-Your-Customer (KYC) information, decentralized exchanges allow entirely anonymous trading. The KYC process is meant to prevent money laundering and other illicit activity on these platforms. DEXs are still considerably more private than their centralized counterparts since you don’t need to hand over sensitive personal information.	User-friendliness DEXs are often less user-friendly than centralized exchanges, leading to a steep learning curve for anyone unfamiliar with the space. Poor customer service has also plagued DEXs. Any DEX is only as good as its community support.
Token availability Since these platforms are not subject to geographical restrictions, any ERC-20 token is tradable on DEXs. This gives users a much more comprehensive range of assets to trade compared to traditional exchanges.	Transaction Fees dependent on the chain The transaction fees of DEXs depend on the chain it exists on and the ecosystem of this chain. For example, Uniswap has high fees because it operates on Ethereum. But DEXs do not have trading fees like in CEXs.
Censorship-resistant The decentralized nature of these exchanges also makes these exchanges more censorship-resistant than their centralized counterparts. Because no central entity can be shut down or censored, DEXs can typically operate more freely in jurisdictions where crypto activity is heavily restricted. On the other hand, this decentralization may also make it more difficult for governments to regulate a DEX. This means users are responsible for their actions without a regulatory safety net.	Limited adaptability Because DEXs are still in their early stages of development, the number of DeFi coins and tokens listed on them is often quite limited compared to centralized exchanges. This can take it challenging to find the right trading pair in a liquidity pool, and you may have to use a DEX aggregator to find what you are looking for.

DEX app development approach

When building a DEX system, remember that decentralized exchange platforms are built on blockchain architecture and have a specific structure. Find a developer team with the right skills and expertise to meet such demands.

Research Phase

You may have to conduct user research, A/B tests, user interviews, and other research to inform your design. It's worth gathering information about the market, its big players, common issues, and the audience's needs so that you can achieve an efficient outcome.

Having a clear picture of the future platform is critical in this phase. You should be able to pinpoint potential problems, rank the primary objectives, and establish the project's milestones.

Listing the Required Features

When building a DEX platform, pay special attention to the required features and complexity. The structure isn't the only thing that distinguishes a decentralized system from a centralized one.

Here are the most typical features a common decentralized exchange should include:

Trading engine
Order book
History of transactions
Analytical tools
AMM integration
Crypto wallet integration
Flexible payment system
NFT marketplace, etc.

Find a dev team

Choosing the right technology stack is crucial for decentralized exchange platform development. The system must be secure, reliable, and stable, and the dedicated development team must make sure all required features are implemented, keep consistent documentation, and test frequently.

The structure of the product should be optimized so that the trading engine, protocols, and aggregation tools work properly. You may also have to turn to APIs to provide your platform with the necessary third-party integration.

Here's a quick rundown of all the steps that will start your journey to DEX development:

Step 1. UX/UI design

You can avoid UX issues by examining the logic of how users engage with transactions based on your specifications and market research in the design team's excellent user experience for your platform.

Step 2: Develop the front end.

The developers produce a user-visible side of your exchange at this point. The front end is responsible for how things look and feel. It is the user interface design implementation.

Step 3: Back-end development

The inner section contains the logic for your platform and all necessary actions. An exchange’s trading platform may be developed using a typical exchange platform, depending on the exchange’s registration region. Your infrastructure is tailor-made to satisfy your requirements, and a unique trading engine is created. APIs from a wide range of third-party resources may be utilized for greater integration.

Step 4: Enhanced security functions are being developed

To ensure the platform's reliability for both you and future users, experts add numerous security safeguards at this stage of development. An encrypted database and password-protected user access are two of the most critical security features.

Step 5: Placement of digital currency on the exchange

When you decide which cryptocurrencies you want to offer on your open-source exchange platform, the development team adds virtual coins to the platform.

Conclusion

DEXs, which debuted in 2014, has gained popularity as a result of the rise of DEFi. Reliance on the Automated Market Maker system has enabled DEXs to transcend their conventional order book model shortcomings. Even though decentralized crypto exchanges have been recognized as critical venues for borrowing money to leverage their positions or offer liquidity for obtaining trading fees, they have been used by many.

The use of smart contracts in DEXs continues to present risks, although DEXs have enabled users to earn passive income on their crypto holdings by depositing them in liquidity pools.

It can be exciting to build a completely decentralized cryptocurrency exchange platform, and such a platform may require expert developers with abundant experience. You should not begin developing your project unless or until you find such a platform.