TL;DR
You’ve probably heard about the normal method for using a cryptocurrency exchange. Begin trading cryptocurrencies as soon as you sign up with your email, create a secure password, and confirm your account.
That’s how decentralized exchanges work, except you don’t have to sign up for them. There is usually no method to add or remove cryptocurrency. The transaction takes place between the wallets of the two users, with little (if any) interference from a third party.
Using a decentralized exchange can be more difficult, and they may not always have the assets you seek. These may begin as minor components of the cryptocurrency ecosystem, but as technology advances and interest grows, they may become critical.
Contents
Introduction
Defining Decentralized Exchange
How a Centralized Exchange Works
How a Decentralized Exchange Works
- On-Chain Order Books
- Off-chain Order Books
- AMMs are automated market makers.
DEXs: Pros and Cons
- DEXs Pros
- DEX Cons
In conclusion
Introduction
Since the birth of Bitcoin, exchanges have been critical in linking cryptocurrency buyers and sellers. Without these forums attracting a global user base, liquidity would be significantly reduced, and there would be no way to agree on the correct price of assets.
Historically, concentrated players have had sway in this space. However, as a result of the rapidly evolving stack of technologies available, a growing number of instruments for decentralized transactions have emerged.
Here, we’re going deep into the world of decentralized exchanges (DEXs), or marketplaces with no middlemen.
Defining Decentralized Exchanges
A decentralized trade could be any transaction between peer to peer(for example, Atomic Swaps Explained). However, the focus of this research is on a decentralized platform that matches the functionality of centralized exchanges. The blockchain serves as the foundation for their one-of-a-kind infrastructure. Because no one is keeping track of your money, you don’t have to have as much faith in the transaction as you would with a centralized offering.
How a Centralized Exchange Works
Depositing funds is a regular practice in a centralized exchange, whether in fiat currency (by bank transfer or credit/debit card) or cryptocurrency. To deposit crypto, you must give up ownership of the funds. Not in terms of practicality, because you can still withdraw or trade it, but in terms of technicality, because you cannot spend it on the blockchain.
Because you do not have access to the private keys associated with the funds, you must have the exchange sign a transaction on your behalf in order to withdraw them. An exchange may record users’ account balances locally rather than on the blockchain.
The relatively slow speeds of blockchains do not impede trading, and because everything takes place in one central system, the whole workflow is greatly simplified. You now have more alternatives for purchasing and selling cryptocurrency.
However, your autonomy will be compromised because you will have to place your financial trust in the exchange. You are putting yourself and the other party at risk by doing so. What if the group disappears with your Bitcoins? What if someone breaks into the system and steals all of the money?
Many people are at ease with this level of danger. They exclusively employ secure markets with an established track record.
How a Decentralized Exchange Works
DEXs and their centralized equivalents have several commonalities. To begin, there are numerous types of decentralized exchanges to choose from. All of these systems have the feature of fulfilling orders on-chain (through smart contracts) and not forcing users to give up custody of their funds at any moment.
Cross-chain DEXs have seen modest growth, however, the bulk of DEXs focus on assets on a single blockchain (such as Ethereum or Binance Chain).
On-Chain Order Books
Nothing is off-chain in some decentralized exchanges (we’ll get to hybridized approaches in a moment). The distributed ledger stores all order information (including revisions and cancellations). The lack of a middleman, and hence the inability to conceal the source of the instructions, makes this technique perhaps the most open.
The most ideal option is not always the most practicable. It costs money since you’re asking every node on the network to store a copy of the order forever. The process can be slow and inconvenient because you must wait for a miner to place your message on the blockchain.
Several people have mentioned that this method is vulnerable to “front running.” When an insider with knowledge of an approaching transaction uses that knowledge to make a trade before the transaction is finalized, this is referred to as “front running” in the markets. As a result, the frontrunner has access to information that the entire public does not. You can’t get away with it!
Front-running cannot occur in the traditional sense if all transactions are recorded on a public global ledger. A different sort of attack, in which a miner sees the order before it is approved and ensures that their own order is added to the blockchain first, is also feasible.
Stellar and Bitshares are two examples of decentralized exchanges that use on-chain order book systems.
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Off-Chain Order Books
Unauthorized Order Book While comparable to the previous section in some ways, DEXs are more centralized. Rather than posting every order to the blockchain, they are stored off-chain.
Where? This is questionable. A single regulatory body could be in charge of overseeing the order book. A criminal could potentially manipulate market prices (by front-running or falsifying orders). Even so, you may require the assistance of a non-custodial storage facility.
One such protocol is the 0x standard for launching ERC-20 coins on the Ethereum blockchain and other tokens. Rather than acting as a centralized DEX, it supports the operations of third-party “relayers” in handling off-chain order books. Using 0x smart contracts and other technologies, hosts can gain access to a common liquidity pool and relay orders across users. The transaction occurs on the blockchain after the buyers and sellers are matched.
These are more user-friendly than solutions that use on-chain order books. They are not subject to the same time constraints because they rely less on the blockchain. Because the trade must still be resolved on it, the off-chain order book model is slower than centralized exchanges.
Some of the exchanges that have incorporated off-chain order books are Binance DEX, IDEX, and EtherDelta.
AMMs are Automated Market Makers
Are you sick of hearing the words “order book?” Excellent, because the AMM approach fully eliminates the need for such a middleman. It doesn’t require makers or takers, just users, some game theory, and some formulaic black magic.
AMMs can range from a handful of smart contracts to a comprehensive system of user rewards and penalties, depending on the nature of the implementation. We won’t go into depth about these specific implementations, but What Is Uniswap and How Does It Work? provides a fair overview of the Uniswap DEX.
With wallet interfaces with services like MetaMask and Trust Wallet, the current crop of AMM-based DEXs is surprisingly user-friendly. However, like with other DEXs, an on-chain transaction is still required to settle transactions.
Both Uniswap and Kyber Network (which employs the Bancor protocol) are engaged in this space, allowing ERC-20 tokens to be exchanged.
DEXs: Pros And Cons
So far, we’ve addressed the advantages and disadvantages of DEXs in broad strokes. Let’s take a closer look at them.
DEXs Pros
No KYC
Many markets need “Know Your Customer” and “Anti-Money Laundering” (KYC/AML). Regulatory procedures often require people to submit identification and address verification.
This may be a privacy concern for some, while it may be an accessibility issue for others. What happens if adequate identification is not readily available? Worst-case scenario: someone finds out. Because DEXs are permissionless, users’ identities are not validated. In other words, all you need is a cryptocurrency wallet.
When a governing body has some control over DEXs, they must abide by certain legal standards. If the order book has been combined, the host may be required to maintain compliance.
Removal of all Counterparty Risk
The main selling point of decentralized cryptocurrency exchanges is that they do not hold their users’ money on deposit. Even in the event of a catastrophic breach, such as the one that occurred in 2014 with the Mt. Gox exchange, users should not be concerned about their money or personal data being compromised.
Alternative Tokens
Even if a cryptocurrency isn’t listed on a major exchange, it can still be traded freely on a decentralized exchange (DEX) if there’s enough demand.
DEX Cons
Usability
DEXs simply aren’t as user-friendly as physical transactions. Transactions on centralized exchanges happen instantly, regardless of how long it takes to mine a block. For inexperienced users, CEXs provide a more forgiving environment than standard non-custodial cryptocurrency wallets. If you have forgotten your password, it is simple to change it. However, if you forget your seed phrase, you will lose your money for good.
Trading Volumes and Liquidity
Nonetheless, the trading volume of CEXs is far greater than that of DEXs. Furthermore, and perhaps most importantly, CEXs often provide higher levels of liquidity. The term “liquidity” refers to the ease with which an asset can be acquired or sold at a reasonable price. When buyers and sellers compete strongly, the difference between bid and ask prices narrows. Finding a willing buyer or seller at a fair price for an asset in an illiquid market is more difficult.
Because DEXs are relatively uncommon, the crypto assets you want to trade may not always be available. Sometimes assets don’t trade at a decent price, and other times you can’t even find the trading pairings you want to use.
Fees
There are times when costs on DEXs are higher, such as when the network is busy or when using an on-chain order book, although this is not always the case.
In Conclusion
Other decentralized exchanges have emerged since their beginnings, each one building on the last in an effort to deliver a more simplified user experience and a strong trading platform. This notion, like cryptocurrencies, does not require users to rely on a trusted third party and thus appears to be in keeping with the spirit of independence.
DEXs built on Ethereum have grown in popularity alongside DeFi. If this tendency continues, the tech sector as a whole will undoubtedly see greater innovation in the future.