What Are Decentralised Exchanges, and How Do They Work?

A decentralised exchange lets people trade crypto assets directly from their own wallets, without depositing funds onto a company’s platform first. Most of today’s decentralised exchanges run on a design called an automated market maker, which is meaningfully different from how a traditional order book exchange works.

Order Books vs. Automated Market Makers

Centralised exchanges, and some decentralised ones, use an order book: a live list of buy and sell orders at different prices, matched against each other as they align. This is the same basic model used by traditional stock exchanges, and it works well when there are enough active traders placing orders to keep the book deep and prices tight.

Most popular decentralised exchanges, including Uniswap, instead use an automated market maker, or AMM, model. Rather than matching individual buyers and sellers, an AMM lets people trade against a shared pool of pre-deposited funds, with prices set by a formula based on the ratio of assets in that pool rather than by a live order book. This means a trade can execute instantly against the pool itself, without needing another trader to be online and willing to take the other side at that exact moment.

How Liquidity Pools Work

A liquidity pool is the shared reserve of two, or sometimes more, assets that an AMM trades against. Anyone can typically become a liquidity provider by depositing a matched value of both assets into the pool, and in return they generally earn a share of the trading fees paid by people swapping through that pool. The pool’s pricing formula automatically adjusts the exchange rate as trades shift the ratio of assets held inside it, which is what allows the pool to keep functioning without a centralised market maker actively managing prices.

This design is powerful because it lets essentially any token be traded the moment someone creates a pool for it, but it also means a pool’s depth, meaning how much value it holds, directly affects how much a given trade will move the price.

Slippage: Why the Price You See Isn’t Always the Price You Get

Slippage is the difference between the price you expected when you submitted a trade and the price you actually received once it executed. In an AMM, slippage happens because a trade itself shifts the ratio of assets in the pool as it executes: a larger trade, relative to the size of the pool, moves the price more, so the last portion of a large trade fills at a worse rate than the first portion. Thinly traded pools, where the pool holds relatively little value, tend to produce more slippage for the same trade size than deep, heavily used pools.

Most decentralised exchange interfaces let you set a maximum slippage tolerance before confirming a trade, which cancels the transaction if the price moves against you by more than you are willing to accept. Setting this too loose can mean a worse fill than expected; setting it too tight in a fast-moving or thin market can mean your transaction repeatedly fails to execute at all.

Impermanent Loss

Impermanent loss is a risk specific to liquidity providers, not traders. It occurs when the two assets in a pool move in price relative to each other after you deposit them. Because the pool’s formula automatically rebalances the ratio of assets as trades happen, a liquidity provider ends up holding relatively more of whichever asset became less valuable and relatively less of whichever asset became more valuable, compared with simply holding the original two assets separately without depositing them.

The word impermanent reflects the fact that this gap shrinks or disappears if the relative prices move back toward where they were when you deposited; it only becomes a permanent, realised loss once you withdraw from the pool while that price divergence still exists. In practice, trading fees earned as a liquidity provider are meant to help offset this risk, but they do not always fully make up for it, particularly in pools pairing two assets whose prices tend to move quite differently from one another. As a general illustration only, and not a real trade: picture depositing into a pool holding two assets of equal value at the time of deposit. If one of those assets then rises considerably in price relative to the other, a liquidity provider will typically end up with less upside than someone who had simply held both assets separately, purely because of how the pool automatically rebalanced along the way. This is not financial advice, and actual outcomes depend heavily on which specific assets and pool you are looking at.

Self-Custody Trading: What You Gain and What You Take On

Trading on a decentralised exchange generally means you retain control of your funds in your own wallet until the moment of the trade, rather than depositing them onto a company’s platform in advance. This removes a category of risk that comes with trusting a centralised platform to safeguard customer funds and honour withdrawals. It also means the responsibility for wallet security, verifying you are interacting with the genuine contract for a given exchange, and avoiding malicious approvals shifts entirely onto you. There is generally no customer support line and no institution able to reverse a mistaken transaction. Approving a token for spending by a smart contract, a routine step before most swaps, is itself worth understanding rather than clicking through automatically, since an approval can in principle be used by a malicious or compromised contract to move more of that token than you intended.

The Bottom Line

Decentralised exchanges built on the AMM model let people trade directly from their own wallets against shared liquidity pools rather than a live order book, which is what makes it possible to trade almost any token instantly. That convenience comes with its own mechanics worth understanding: slippage grows with trade size relative to pool depth, and liquidity providers take on impermanent loss risk in exchange for a share of trading fees. Self-custody removes reliance on a centralised platform but places the full weight of security and diligence on the individual trader. This is not financial advice; understanding how the specific pool you are using actually works is a reasonable first step before committing meaningful funds to it.