What is Decentralized Crypto Exchange (DEX)?

A Decentralized Exchange known as DEX is an autonomous decentralized application (DApps) that allows users to trade cryptocurrencies without entrusting their funds to a third party.

DEXs eliminates the need for an intermediary to oversee or facilitate trades on the exchange. In place of the central intermediaries that use order books, DEXs deploy automation and non-custodial or self-custody wallets, making the cryptocurrency trade purely peer-to-peer.

DEXs are the top applications in the fast-growing decentralized finance (DeFi) ecosystem. The unique value proposition of DEXs is the platforms' security. Centralized exchanges are operated by institutions or firms that can choose to restrict users' access to their tokens.

A successful cyber-attack such as the Mt. Gox hack that saw the exchange lose over 850,000 BTC in 2014 could be severely costly for the intermediary and user. As the name suggests, DEXs is decentralized, as users have full custody of their private keys and cryptocurrencies. DEXs cover against the growing regulations imposed on blockchain platforms, especially centralized exchanges (CEXs). They are designed to be independent of third-party oversight as DEXs require no sign-up or registration when setting out to swap tokens on a DEX platform. Peers can autonomously trade tokens on a DEX through self-executing smart contracts without the DEX taking custody of the tokens.

How DEXs Work

DEXs achieve automation of trades using an on-chain order book, an off-chain order book, or an Automated Market Maker (AMM).

For on-chain order books, each order to buy, sell or cancel an order is entered onto the blockchain, where other traders can find an order that matches their needs. However, this approach is sluggish and expensive, despite being the most decentralized of the three ways of facilitating trades automatically. Stellar and Bitshares DEXs are some DEXs that utilize on-chain order books.

Off-chain order books have all orders placed out of the blockchain, with only the transaction settled on-chain. However, a DEX deploying an off-chain order book could be susceptible to security risks similar to those of a CEX. Binance DEX and EtherDelta are some platforms that operate off-chain order books.

The third and most common approach for automation of trades in DEXs is deploying an AMM. The AMM eliminates the need for an order book of any kind. AMMs use smart contracts to create liquidity pools that execute trades automatically based on coded parameters. To illustrate, a CEX trader looking to swap token A for token B will require another trader to offer their token B in exchange for token A at your price offer for the exchange. The factors for a successful trade are too many, and one may not have all their wishes met during the transaction.

For a DEX using AMM, the platform incentivizes users to store their tokens in a smart contract, known as a liquidity pool. This way, when one needs to swap token A for B, they only look for a pool in the DEX with an A-B token pair to swap their tokens. The liquidity pool automatically calculates the exchange price and, for every trade, users who kept their funds in the pool, known as liquidity providers, earn rewards. Most DEXs including Bancor, Uniswap, PancakeSwap, Balancer, SushiSwap, and Kyber Network, utilize AMM for facilitating P2P trades on the exchanges.

Advantages of DEXs

Although DeFi tools such as DEXs haven’t fully matured yet, the tools possess important features offering a competitive edge over CEXs. Some noticeable advantages of DEXs include the following:

Security

CEXs are susceptible to hacking, and these breaches can result in the theft of cryptocurrencies. The Mt. Gox exchange, which handled nearly 80% of Bitcoin circulating in 2014, was hacked and lost approximately $500 million worth in BTC at the time (currently worth tens of billions of dollars). Coincheck and Bitfinex are other CEXs that have recorded breaches in the past. These hacks are common due to the custodial approach where the exchange holds the users’ funds centrally, making it a target of threat actors. Since the exchanges hold the private keys for users' funds, the CEXs may scam users and close shop without notice.

DEXs eliminates these risks using a non-custodial approach that allows users to trade directly from their wallets. As such, each user holds their funds and private keys, making it less lucrative to hack individual accounts, as its rewards will be limited for hackers.

Privacy

CEXs must comply with anti-money laundering (AML) and know your customer (KYC) regulations within their jurisdiction. While signing up, users have to give up their personal information, which isn’t always guaranteed to be kept secure. As a result, many CEX users that are conscious of their privacy may opt to skip signing up to the CEX. Further, some individuals may not have access to all the documentation required during sign-up. With DEX, you need no permissions to start trading. Just connect your crypto wallet and start swapping!

Multiple Tokens

Many DEXs support a wide variety of tokens. Users can mint new tokens and start swapping them instantly. Unlike CEXs, which have several red tapes that slow token listing, DEXs' permission-less nature accelerates DeFi adoption and development.

Disadvantages of DEXs

Since the introduction of DEXs they have certainly disrupted regular cryptocurrency trading. But even with the advantages listed above, the platform does have some shortcomings when compared to CEXs. Some of the disadvantages of DEXs are as follows:

Slow Transactions

DEXs are bound by the blockchains’ transaction limits, which when exceeded, often result in the slow processing of transactions. DEXs are built on poorly scalable blockchains that offer slow transactions in comparison to CEX. When facilitating transactions, buy or sell orders are first listed on the network and verified by nodes before processing the orders. This process often results in delays, and even transactions failing. This process can see transactions fail to execute at undesirable prices known as price slippage.

Limited Liquidity

CEXs barely break a sweat in providing liquidity for transactions. In contrast, DEXs need many users to actively use the platform and provide liquidity to the pools to facilitate trades. Trading volumes are also significantly higher in CEXs than DEXs, making it more affordable to trade on CEXs.

Average User-Experience (UX)

DEXs are still in their early development stages, and most features have not been implemented yet. Some that have been deployed do not serve as comparable in user convenience to that of CEXs. DEXs also offer a complex usability experience, especially for new users. Unlike in CEXs, where someone can retrieve a forgotten password, a trader who forgets their DEX seed phrase will lose all their tokens forever.

The Future of DEXs

Since the uptake of DeFi in 2020, DEXs have gained popularity among crypto users. Curve Finance, an Ethereum-based DeFi protocol has over $8 billion in total value locked (TVL) as of July 3, 2021, with nearly $20 billion TVL for the top 24 DEXs. More DEXs have launched on Ethereum and Binance Smart Chain (BSC), including multiple forks of Uniswap and PancakeSwap.

Despite the dominance of CEXs over DEXs in the crypto market, DEXs offer a unique value proposition for traders looking to embrace ultimate decentralization by trading on a decentralized platform. This blockchain tool is built for the inevitable future decentralized world where intermediary or custodian services will be redundant or unnecessary.

There are many DEXs in the DeFi ecosystem today. Each proposes a unique solution to enlist a competitive edge over its counterparts, and this vigorous development early in DEXs’ deployment will improve and straighten out the UX.

As the technology behind DEXs advances, more users are more likely to give up the risk-plagued and privacy-limited CEXs. Many blockchains like Solana and Ethereum are improving their scalability and this will benefit DEXs to facilitate trades at speeds comparable or faster than CEXs.

Summary

DEXs are still an emerging technology as an underlying blockchain infrastructure. These trading platforms have significantly opened access to crypto markets for privacy-focused users looking for a secure way to swap tokens. However, their infancy means the technology is still rough around the edges and may not be as convenient or well-advanced as CEXs. To take on CEXs, DEXs have to be at par or exceed the convenience of CEXs by increasing trading volumes and liquidity, in addition to facilitating faster transactions.

As the DeFi ecosystem grows, so do DEXs. These exchanges have become the face of DeFi and power most DApps through a limitless token listing. Users can start to swap new coins as soon as they launch. This way, the project developers also access funds to speed up development from users who truly trust the project.

The P2P nature of DEXs brings the control of finance back to its users rather than that of central institutions. As we have seen in the past, these institutions don't guarantee protection, and with complete trust users run the risk of losing all their assets. Therefore, DEXs are a great way for users to take full control of your digital assets, their private keys, and your tokens.

Published: 2021-07-05

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