The world of cryptocurrency trading is a whirlwind of swapping digital currencies. If you need to exchange Bitcoin for Ethereum, you have hundreds of options to choose from.
Even if you buy cryptocurrencies once in a blue moon, you’ll undoubtedly need the services of an exchange such as Coinbase, Kraken, and the like. Up until 2014, many exchanges were centralized until the introduction of NXT.
Of course, countless exchanges still operate using this model as CoinMarketCap lists 307 of these presently. As with any process, radical change was imminent.
The use cases for cryptocurrencies have grown far more advanced than ever imagined, leading to the rise of DeFi (decentralized finance).
Within this sphere is a popular subset of decentralized exchanges, effectively cutting out the middleman while performing efficient transactions for the modern-day user. Let’s learn how these marketplaces function and explore their benefits and drawbacks.
What is a decentralized exchange?
Exchanges facilitate digital currency transactions between buyers and sellers across an extensive list of crypto-to-crypto and fiat-to-crypto markets. A decentralized exchange is simply a cryptocurrency marketplace without an intermediary.
Liquidity technically means the ability to buy and sell an instrument quickly without any abnormal price changes.
Yet, it also refers to the depth of the order book, as in how effectively capable an exchange is in processing orders from hundreds of thousands or millions of users trading different coins.
If you wanted to purchase Ethereum using Bitcoin, an exchange would need to have large amounts of ETH on hand or instantaneously find another user or provider willing to sell it to them.
An order book is essentially a matching engine recording the buying and selling orders, determining which can be partially or fully executed. This mechanism is at the heart of most centralized brokerages and exchanges in many financial markets.
For the exchange’s efforts, they earn a commission and/or spread for every transaction. A decentralized exchange flips this model on its head where the liquidity is primarily provided peer-to-peer by the users themselves or from aggregators.
The inner workings of decentralized exchanges
Decentralized exchanges use blockchain and smart contract technology. Users keep their public and private keys, meaning they retain complete control of their funds without handing over the responsibility to the exchange.
Let’s look at the three main practiced systems used presently to source liquidity.
On-chain, off-chain order books
This framework is semi-decentralized, bringing some of the benefits of centralized exchanges while still taking advantage of blockchain technology.
Exchanges employing this mechanism utilize traditional order books, keeping order information on-chain while users funds’ remain off-chain or in their possession. Binance DEX, dYdX, and Loopring are some of the services using this framework.
Automated market makers
The second liquidity-providing system, which is the most prevalent, is known as the AMM (automated market maker) model.
It primarily involves swapping and is used by the likes of Uniswap, PancakeSwap, etc. The exchange utilizes a deterministic algorithm adjusting prices according to a certain ratio of supplied coins.
The platform will consist of numerous liquidity pools where users fund two different assets to facilitate the swapping of each. For their efforts, they receive fees for every successfully executed order. The swaps-driven model is entirely decentralized.
Aggregators are also quite popular, with 1inch, Matcha, and DeversiFi being some of the exchanges employing this mechanism. This model offers more liquidity than the second system because, rather than sourcing liquidity from a single user set, it does so from other exchanges.
This is why it’s called an aggregator, as it aggregates prices from a wide range of exchanges in a similar vein to how Booking.com does with lodges and other travel-related services.
Pros and cons of decentralized exchanges
Let’s consider the main benefits and pitfalls of decentralized exchanges. This list will also help you understand the core distinctions in DEXs compared to CEXs.
More privacy-focused: DEXs are far more sensitive to personal data as only the user has access to their private keys, and no KYC is required.
More incentivization methods: Users can earn passive income through being liquidity providers with many exchanges. Additionally, several of these marketplaces offer their utility tokens allowing for discounts and access to other interesting products.
Lower hacking risk: We refer to decentralized exchanges as non-custodial since they don’t control traders’ funds. Large-scale hacking events are likelier with centralized exchanges since there is a single point of failure.
Generally reduced fees: With swaps-driven exchanges, in particular, there’s an incentive to use your existing holdings to provide liquidity, ultimately earning you more crypto in fees. However, trading costs are typically lower with CEXs than their counterparts on the whole.
Personal funds custody: Control of the funds remains with the user when using a DEX (although this presents a responsibility challenge of storing the private keys).
No withdrawal limits: Unlike centralized exchanges, DEXs don’t impose any time-sensitive restrictions on withdrawals.
No sign-up process: With a DEX, you simply connect a wallet before you start trading, saving you ample time.
Less user-friendly: Centralized exchanges have more simple-to-understand interfaces. Hence, it does take some time to familiarize yourself with a decentralized exchange. Moreover, there is no dedicated customer service.
Lower liquidity: One of the significant criticisms of DEXs is the slightly inferior liquidity compared to centralized exchanges, meaning price execution may not always be smooth-sailing. Moreover, slippage is reported regularly here.
Responsibility in storing private keys and managing wallets: While controlling the private keys is a benefit, and it’s also a drawback. Users need to take extra security measures with this data through back-ups, recovery seed phrases, etc.
Any loss of the keys most often results in having no access to the funds indefinitely.
Lack of regulation: Generally, the cryptocurrency industry is primarily unregulated because of its decentralized framework. For the most part, exchanges are not obligated to be supervised by any regulatory body (although this may not be the case in some countries).
While DEXs operate on a more distributed framework with no central office, it doesn’t necessarily mean such exchanges cannot be struck by the law’s arm in certain regions.
Decentralized exchanges should continue to be more prevalent over the coming years. They extend the blockchain’s trustlessness, where people can execute transactions from start to finish with no intermediary.
Perhaps the biggest advantage is privacy, which many people feel has been severely neglected in the financial markets. Yet, such exchanges still have a long way to go and need to iron out a few more things to enhance them.