If there is one fundamental philosophy of blockchain technology, it is decentralization. Decentralization—in which transactions happen without a central third-party intermediary like a bank or financial institution—redistributes authority from a few to many. And it is reengineering how many conventional financial services operate.
And yet, until recently, some investors have been limited to investing in digital assets through centralized exchanges that don’t align with the ecosystem’s core philosophy. This inconsistency inspired the creation of decentralized exchanges, which provide a decentralized platform to exchange assets without having to trust their funds with another entity.
How a Decentralized Exchange (DEX) Works
A decentralized exchange (DEX) is a digital currency exchange that allows users to buy crypto through direct peer-to-peer cryptocurrency transactions over a secure online platform without an intermediary. This is a departure from traditional centralized exchanges, where in a typical transaction a third-party entity (e.g. bank, trading platform, government institution, etc.) takes custody of user funds and oversees the security and transfer of assets between two parties.
With a decentralized exchange, a blockchain or distributed ledger takes the place of the third party. By moving critical operations onto a blockchain, the underlying cryptocurrency technology eliminates single points of failure, allows users to retain control of their assets, and enables safer and more transparent trading. DEXs use smart contracts to execute market transactions by allocating transactions’ operations to autonomous code, but there are multiple variations of order fulfillment with differing degrees of decentralization.
Like digital currencies, decentralized exchanges were created in response to flawed and archaic financial systems that passed along risks of a centralized system to its users, including insufficient security, technical issues, and a lack of transparency.
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Different Types of Decentralized Exchanges
Full decentralization is more of a philosophy than a rule of thumb, as it’s not very practical based on first-layer blockchain scalability limits. Most decentralized exchanges are actually semi-decentralized, using their own servers and off-chain order books to store data and external programs or entities for the exchange of user assets. Due to this reliance on centralized components, semi-decentralized exchanges’ operations may be subject to government oversight. However, perhaps most importantly, users maintain control of the private keys to their funds.
Although DEXs continue to evolve and operate cross-chain with other DApps, DEXs typically operate a single blockchain.One thing all decentralized exchanges have in common is that they execute orders on chain with smart contracts, and at no point do they custody users’ funds.
On-Chain Order Books
For some decentralized exchanges, everything is processed on chain including modifying and canceling orders. Philosophically, this is the most decentralized and transparent process because it circumvents trusting a third party to handle any orders at any time. However, this approach is not very practical in execution.
By placing all stages of an order onto the blockchain, DEXs go through a time-consuming process of asking every node on the network to permanently store the order via miners, as well as pay a fee.
Some criticize the decentralized crypto exchange model because its slow transaction times allow for front-running—where an investor watches the price of an asset closely, waiting at the last minute to buy or sell right before they anticipate the price rising or falling. (Note that this type of “front-running” is different from stock front-running, where an investor purchases a security based on insider info re: a future event that will impact stock price.) Others counter that since all orders are published on a public ledger, there is no exclusive opportunity for any select individual to front-run from a traditional perspective. However, it has been questioned whether a miner can front-run by noticing an order before it’s confirmed and force their own order to get added to the blockchain first.
Off-Chain Order Books
DEXs with off-chain order books are still decentralized to some degree, but are somewhat more centralized than their on-chain counterparts. As opposed to orders being stored on the blockchain, off-chain orders are posted elsewhere such as a centralized entity that governs the order book. Such an entity could exploit access to the order books to front-run or misrepresent orders, however, users’ funds would still be protected from the DEXs non-custodial model.
Some ERC-20 tokens on the Ethereum blockchain provide a DEX that operates similarly. Though some degree of decentralization is sacrificed, a DEX can provide a framework for parties to manage off-chain order books through smart contracts. Hosts can then access a larger liquidity pool and relay orders between traders. Once the parties are matched, the trade can be executed on-chain.
These models can be more advantageous for users than relying on slower on-chain order books. With less congestion and confirmation times caused by primitive blockchain iterations, off-chain order books can provide faster speeds.
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Automated Market Makers (AMM)
An automated market maker (AMM) reinvents order books with pricing algorithms that automatically price any asset pairing in real-time (e.g. Bitcoin-US dollar).
Unlike traditional market-making, whereby firms provide an accurate price and a tight spread on an order book, AMMs decentralize this process and allow users to create a market on a blockchain. No counterparty is needed to make a trade—the AMM simply interacts with a blockchain to “create” a market. Instead of transacting directly with another person, exchange, or market-maker, users trade with smart contracts and provide liquidity. Unfortunately, there are no order types on an AMM because prices are algorithmically determined, resulting in a sort of market order.
As with other DEX models, an on-chain transaction must occur to settle any trade. As opposed to some DEXs, AMMs tend to be relatively user-friendly and integrate with popular cryptocurrency wallets.
Pros of Decentralized Exchanges
There are many reasons fans and followers of crypto have embraced decentralized exchanges. These are some of the highlights:
No KYC/AML or ID Verification
DEXs are trustless, meaning users’ funds, privacy, and limited personal data are well preserved. Decentralized exchange users can easily and securely access a DEX without needing to create an on-exchange account, undergo identity verification, or provide personal information.
No Counterparty Risk
Because users don’t have to transfer their assets to an exchange, decentralized exchanges can reduce risks of theft and loss of funds due to hacks. DEXs can also prevent price manipulation or fake trading volume and allow users to maintain a degree of anonymity due to a lack of Know Your Customer (KYC) cryptocurrency rules and regulations.
All Tokens Can be Traded
With a DEX, users can trade new and obscure cryptocurrencies that previously were difficult to exchange elsewhere, either on a DEX or a DApp (decentralized application) built in conjunction. Typically, centralized exchanges only support a dozen or so projects and most only support the most popular cryptocurrencies, making smaller and less popular tokens more difficult to trade, especially as centralized exchanges restrict users from other countries.
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Cons of a Decentralized Exchange
While decentralized exchanges offer some groundbreaking benefits, they also come with a few drawbacks.
No Recovery Ability
Unlike centralized exchanges run by private companies with employees, DEXs fundamentally have no recovery ability for lost, stolen, or misplaced funds. Due to a lack of a KYC process or ability to cancel a transaction in the event of a compromised account or loss of private key, users are unable to recover data or be returned their assets. There is no support team or help hotline to notify of missing funds or a lost private key. Because all transactions are processed and stored in smart contracts on the blockchain without any owners or overseers, refunds are incompatible with the network’s model and users are generally unable to regain access to their assets.
Many traders prefer centralized services with a greater liquidity pool, choice of instruments, currency pairs, and order types. Decentralized exchanges usually have lower liquidity than centralized platforms because they are new and have low liquidity, yet paradoxically must attract new users to generate more liquidity.
Transactions take time to be checked and validated on a blockchain network and the processing speed depends on the network’s miners, not the exchange.
Limited Trading Functionality
Due to decentralized exchanges only recently becoming operable, they tend to focus on executing simple buy and sell orders. Users may find advanced trading functions such as stop losses, margin trading, and lending are unavailable on most DEXs.
DEXs have suffered from the same network congestion issues relating to scalability issues as their underlying blockchain networks like Ethereum. Ethereum’s first network iteration, like other blockchains, was built to function securely at a smaller scale before scaling solutions were later implemented. Though a transformative network upgrade designed with massive scalability solutions has been in development since 2018, DEXs remain subject to first-layer network transaction ceilings.
Challenges to DEX Adoption
With superior technology, fewer blockchain security risks, and the ability to self-custody funds, the adoption of decentralized exchanges seems obvious. So why are DEXs not already mainstream? Despite the launch and rise in popularity of numerous DEXs between 2019-2020, some factors may slow down adoption.
• Many investors lack awareness surrounding:
• Security risks of centralized exchanges
• Self-custody as a security option
• How to securely self-custody funds (managing private keys)
• Existence of decentralized exchanges
• Advantages of decentralized exchanges
DEXs also present a few technical barriers to entry:
• Not user-friendly enough
• Network congestion during periods of high volume
• Transactions on current network iterations take time to be validated on blockchains
• High transactions fees during periods of high volume
• Users will only join the DEX with high liquidity
• Must be cross-chain interoperability for DeFi platforms to interact with each other
• Need for fiat on-ramps and less volatile token prices
Decentralized exchanges are a trustless solution that allows users to buy and sell cryptocurrency without handing over their assets to a third party. Though full decentralization is not yet a reality, different types of DEXs provide varying levels of security, privacy, and efficiency from which investors can choose.
As DEXs continue to develop and become more practical for more users, user adoption will become a focal point as DEXs look to siphon liquidity from other markets.
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