Decentralized exchanges are becoming more common — but how exactly do they differentiate from centralized ones?
Thanks to the crazy returns of investment on altcoins during the 2017 bull run and the 2020 DeFi boom, more and more users have been drawn to cryptocurrency trading in recent years. As a result, we’ve seen the development of innovative exchange platforms that are marketed as complete solutions to everyone’s crypto trading needs.
However, centralized exchanges carry significant risks for investors, with billions of dollars in mainly Bitcoin and Ethereum lost in sophisticated hacks and scams each year, which has also drawn the ire of regulators who are now increasingly regulating it and impacting user privacy in the process. To address these issues, decentralized exchanges have grown in popularity in recent years.
What Is a Decentralized Exchange (DEX)?
Decentralized exchanges or DEXs are autonomous decentralized applications (DApps) that allow cryptocurrency buyers or sellers to trade without having to give up control over their funds to any intermediary or custodian.
This type of infrastructure is entirely different from centralized exchanges where users hand over their crypto assets to the exchange, which acts as a custodian and essentially issues IOUs for users to trade with on the platform.
DEXs were initially conceptualized to eliminate the need for any authority to supervise and approve trades made within a particular exchange. Through the help of smart contracts, DEXs operate automated order books (or automated market makers) and trades. This makes them “truly peer-to-peer.”
How Does a Decentralized Exchange Work?
There are various types of DEXs, that can be divided in these categories:
On-Chain Order Books
In a DEX that uses on-chain order books, there are network nodes that are assigned to maintain the record of all orders. It also requires the operation of miners to confirm each transaction.
Some of the well-known platforms that use on-chain order books include the Bitshares and StellarTerm exchanges.
Off-Chain Order Books
As opposed to on-chain order books, records of transactions in off-chain order books are hosted in a centralized entity. They utilize “relayers” to help manage these order books. In this respect, off-chain order book DEXs are only quasi-decentralized, unlike other types of DEXs.
Automated Market Makers (AMM)
Automated market makers exploded in popularity in 2020, driving much of the DeFi boom, and are used by popular DEX platforms like Uniswap, SushiSwap and Kyber Network. AMMs have no need for order books. Instead, they utilize smart contracts to form liquidity pools that automatically execute trades based on certain parameters.
Advantages of DEXs
DEXs are lauded for the enhanced privacy, stronger security and greater user control they offer to owners of digital assets.
Security
The biggest risk inherent to centralized exchanges is hacking. Security breaches of exchanges like Coincheck, Mt. Gox and Bitfinex, have devastated the crypto industry and seriously eroded the public’s trust. The Coincheck theft alone resulted in a loss of $530 million worth of cryptocurrencies, breaking the previous record of Mt. Gox of $472 million.
The custodial nature of centralized exchanges is often singled out as the main reason why they are usual targets for hackers and thieves. They maintain their liquidity by keeping the funds of their users on the platform, which makes them susceptible to large-scale theft. It also allows them to conduct an “exit scam,” where they claim an event has caused them to lose control of the private keys and the connected funds. The most notable example is QuadrigaCX.
DEXs are less susceptible to this type of risk, since users can freely trade on these platforms from either cold or hot wallets without having to use their private keys or recovery seeds. Basically, the users are the ones in charge of maintaining the security of their accounts. In addition, it would not be lucrative for hackers to steal funds from individual users since it would likely be too costly and difficult, considering that the crypto bounty won’t nearly be as large as those that are stored in exchange wallets.
Privacy
All centralized exchanges require sign-ups to comply with Know Your Customer (KYC) requirements. This forces cryptocurrency holders to give up their personal data to the exchange operator.
Most DEXs do not implement this. Since they are not maintained by any central authority, at present there’s no need to use KYC protocols. This offers users privacy when trading on DEXs. However, rumors have been circulating in late 2020 that U.S. regulators and the Financial Action Task Force (FATF) are looking for a way to enforce KYC on crypto wallets in 2021.
Sovereignty
Sovereignty, or control over one’s funds, can be exercised freely in DEXs. Users will have full custody of their funds and will be able to use them as they please. Concerns like exchanges freezing their assets or blocking withdrawals rarely happen in DEXs. It needs to be noted that not all decentralized exchanges are created equal, and in practice they range from quasi-decentralized to fully decentralized.
Disadvantages of DEXs
As revolutionary as they are, decentralized exchanges have their fair share of drawbacks. It is important to weigh these cons before making a decision on which exchange to use.
Transaction Speed
The processing of orders on DEXs can be slow. This is because trading calls have to first be broadcasted to the network and confirmed by miners before they are processed. This is why trades on DEXs are more likely to suffer from “price slippage,” where the transaction doesn’t execute due to changes in the values of the cryptocurrencies being swapped.
“Front-running” is also a concern with public order-books. In this scenario, users initiate trades with higher gas fees to have them executed earlier than those that are still pending.
Liquidity Issues
Liquidity is achieved by centralized exchanges through enormous capital. DEXs often have a problem on this end because, unlike centralized exchanges, their liquidity heavily relies on the number of users actively trading on the platform. They also often do not have access to any fund which they can move around to facilitate trades.
Fortunately, the decentralized finance (DeFi) space has come up with a solution to this through liquidity pools that DEXs can tap.
DEXs: A Conclusion
Coming up with a strategy to maximize returns from your trading activities while maintaining security, convenience and privacy is one of the considerations that has led to the creation of DEXs.
However, it is still important to understand that DEXs are not the silver bullet that will solve all the problems centralized exchanges deal with.DEXs have issues of their own that traders have to always keep in mind whenever planning ahead. With that being said, DeFi is constantly evolving, so we might see all the present disadvantages of DEXs dissipate over time.
