What is a Decentralized Exchange (DEX)?

Everything you need to know about DEX

From the early days of Bitcoin, exchanges have played a vital role in matching cryptocurrency buyers with sellers. Without these forums to attract a global user base, our liquidity will be greatly reduced and we will not be able to reach a consensus on the correct price of assets. Traditionally, centralized players have dominated this field. However, with the rapid development of available technologies, more and more decentralized trading tools have emerged. In this article, we will delve into decentralized exchanges (DEX), which are trading venues that do not require intermediaries.

Definition of decentralized exchanges (DEX)

In theory, every peer-to-peer swap could be defined as a decentralized trade. But in this article we will be mainly focussing on platforms that mirror the functions of centralized exchanges. One of its main differences is the fact that their backend exists primarily on a blockchain. No one is able to take control or custody of your funds, and you do not have to worry about trusting exchanges to an extent you do not feel comfortable with. A decentralized exchange means your money will always be regulated by yourself.

How does a centralized exchange work?

With most of the typical centralized exchanges, you deposit your money through FIAT (credit/debit card, bank transfers) or cryptocurrency. But when you deposit cryptocurrency you give up control of it. You will still be able to use your crypto through trading or by being able to withdraw it, however if you look at it from a technical standpoint; you will be unable to spend it on the blockchain.

You do not own any private keys attached to the funds. This means that when you want to withdraw your cryptocurrency through a centralized exchange you first ask the exchange to sign a transaction on your behalf. When you’re trading, all of the transactions done do not occur on-chain, instead the exchange assigns balances to users in their own database.

The over-all workflow on centralized exchanges is very fast & smooth as you have a lot of tools that make trading done easily for everyone, you can buy and sell your cryptocurrency with just a few clicks.Whereas speaking from a decentralized blockchain standpoint, trading would be more complicated to do so because the blockchain’s low speed is too big of an obstacle.

However, trading on a centralized exchange comes with a cost: independency, as you will have to trust your exchange with your money. You expose yourself to counterparty risk.The worst case probabilities would be their team running off with all of your hard earned cryptocurrency, or perhaps a hacker who shuts down the exchange security and hacks all the funds?

Many users see this as an acceptable risk. They simply stick to well-known exchanges with secure track records and strong precautions that mitigate security and data breaches.

How does a decentralized (DEX) exchange work?

DEX’s are equal to their centralized counterparts in some ways but strongly differ in other aspects. First of all note that there are a couple of different types of DEX available to users. The most common DEX theme among those is that orders are executed on-chain (making use of smart-contracts) and that users remain in full control over their funds at any point.

On-chain order books

In a DEX that uses on-chain order books, there are network nodes which are assigned to maintain the record of all orders. It also requires the assistance of miners to confirm each transaction. Some mention-worthy platforms that use on-chain order books are Bitshares and StellarTerm

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. Due to the fact that the off-chain order books are hosted in a centralized entity off-chain order books are quasi-decentralized, unlike other types of DEX. Binance DEX, 0x and EtherDelta are well-known DEX’s using off-chain order books.

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 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.

Security

One of the biggest risk factors that centralized exchanges is hacking. Security breaches of exchanges like Coincheck, Mt. Gox and Bitfinex have had a very negative impact on the crypto industry and heavily damaged the public’s trust in cryptocurrency. When Coincheck suffered a security breach back in 2018 they suffered an estimate of $530 million, breaking the previous record of Mt. Gox of $472 million.

DEX are less receptive to this type of risk. Users have control over their own account security without the need of having to use their private keys or recovery seeds, trading can be done freely from either active or inactive wallets. In addition to this, it would not be lucrative for hackers to steal funds from individual users because this will be way too expensive and the reward is unknown, unlike an exchange wallet which will always be large.

Privacy

Every centralized exchange requires its users to comply with Know Your Customer (KYC) when signing up. This instantly forces cryptocurrency holders to give up their personal data to the exchange operator.

Most of the DEX’s do not implement KYC. This is because there is no authority on the exchange which offers privacy when trading unlike a centralized exchange. Rumors have been spreading since late 2020 that in the U.S regulators and the Financial Action Task Force (FATF) are looking for a way to implement KYC on crypto wallets in 2021.

While DEX have made lots of improvements there are also some downsides to mention before choosing your exchange platform.

The transaction speed of orders on DEX can be quite slow. This is because the trade has to be broadcasted to the network and confirmed by miners before the order can be processed. As a result this can lead to price slippage, where your transaction doesn’t execute due to changes in the values of the cryptocurrencies being swapped.

‘’Frontrunning’’ is also a concern with public order books. In this scenario, users will initiate trades with higher gas fees to have them executed earlier than those that are still pending.

Liquidity is achieved by centralized exchanges through enormous capital. DEXs often have a problem on this end, because unlike centralized exchanges, DEX heavily depends on the number of users that are actively trading on the platform. Also they often haven’t got access to any funds 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 DEX’s can tap.

One project that has been solving many limitations within DEXes is 1inch, read more about the 1inch platform here: 1inch token