Crypto-exchanges have played a vital role in pairing both buyers and sellers. There is no doubt that there will be little or no liquidity without these exchanges and no accurate price of assets.
It is essential to know that centralized exchanges have dominated the industry for quite some time now, but rapidly-evolving technologies have caused the emergence of decentralized. A decentralized exchange, popularly referred to as DEX, is one of the fascinating aspects of Decentralized Finance today, and this guide takes a detailed look at it.
What is a Decentralized Exchange?
A decentralized exchange is an exchange market that doesn’t need third-party services, intermediaries, or arbitrators to hold customers’ funds. In a decentralized exchange, trades occur directly between two users through a process powered by blockchain technology. Decentralized exchanges allow codes to specify the resolution of disputes, and users have control over their funds. It is also essential to know that users can get a frictionless financial system with a decentralized exchange.
How does a Decentralized Exchange work?
A decentralized exchange uses lots of digital services to communicate bids or ask prices in real-time. Through this, traders don’t need to be located in the same place to transact assets. There are different types of decentralized exchanges available to users. These exchanges execute orders on-chain, ensuring that users still have control over their funds at any point in time.
On-chain order books
Some decentralized exchanges do most of their transactions on-chain (through hybridized methods). Other transactions are done and written through blockchain; this makes every transaction transparent and not controlled by the exchanges’ owners. Unluckily, these exchanges have high fees since you are demanding every node in the network to record all orders continually. Additionally, executing every order/transaction is tasking because you have to wait till a miner includes your message to the blockchain network.
However, there is a term known as “Front Running,” a setback on this framework. Front-running is a situation whereby someone else, who knows about a transaction that is about to occur, uses the information to his advantage by adding a trade before that transaction occurs. This is a kind of attack because the miner can use it to ensure his order gets added to the blockchain before anyone else. Stellar and Bitshares DEXs are examples of on-chain order books.
Off-chain order books
An off-chain order book is a more centralized model. This is because a centralized body hosts orders that get transferred to a blockchain network. If this centralized body is malicious, then they could attack orders by front running them.
Tokens posted on the Ethereum blockchain network is an example. The ETH-blockchain provides a structure for counterparties referred to as “relayers” to control off-chain order books rather than perform as a singular decentralized exchange to manage off-chain order books.
Automated Market Makers
Automated Market Makers take a whole different approach from order books. It only needs users and not makers. Generally, Automated Market Makers use smart contracts and give incentives to make sure users participate actively; this implementation is known as Uniswap. However, Uniswap is a set of computer programs that run on Ethereum blockchain technology, and it permits decentralized token swaps. Uniswap is an automated liquidity protocol, and it is now one of the most popular projects in the Decentralized Finance program. Other popular projects in the Decentralized Finance movement include Binance DEX and Balancer.
DEXs based on AMM today are very easy to use, and they are integrated with crypto-wallets such as Trust Wallet. It is crucial to know that on-chain transactions must be enabled to ensure trades are performed actively.
Advantages and drawbacks of a Decentralized Exchange
We provided some advantages and disadvantages of DEXs earlier. We will now take a detailed look at them.
Advantages of decentralized Exchanges
- Minimal risks involved
There are minimal risks on decentralized exchanges, and this is because there is no single data source for hackers to infiltrate, although this has recently been proven untrue.
- No need for KYC compliance
Many exchanges require new users to obey the KYC (Know-Your-Customer) and anti-money laundering compliance. In this process, new users are required to submit a means of identification. DEXs exchanges don’t need KYC compliance. For some users, this is a big issue. And for others, it is to their advantage because they may not have valid documents in their possession. In DEXs, no one needs to check your identity; all you need is a crypto-wallet.
- Unlisted tokens
DEXs platforms allow unlisted tokens on centralized exchanges to be traded, as long as there is enough demand and supply.
Disadvantages of Decentralized exchange
- High fees
The fees on DEXs exchanges can be high, especially when the network is clogged.
- Trade volumes
Centralized exchanges have more trading volumes and higher liquidity than decentralized exchanges. There’s no always supply and demand for the digital asset that you want to trade at a particular point in time at DEXs, so you may not get the right trading pairs that you want.
- Order book
Another significant disadvantage of DEXs is the fact that it has to do with the order book. Ideally, an order book should be on-chain, but many online order books are prolonged in pairing traders. Many DEXs have opted for off-chain books. Through off-chain order books, traders can publicize their orders off-chain to be picked by an entity that then passes the order to a smart contract. But off-chain books have their drawbacks because users are usually limited to the kind of orders they can make.
Users also have to cancel orders only through on-chain, making it very expensive. Since every order gets committed to a blockchain network, they have to be in line to be processed, and they can be hijacked and front-runned by an attacker.
What is a Centralized Exchange?
A centralized exchange is a platform where you can trade digital assets. A central body secures and controls the exchange. Also, the central body acquires digital assets on behalf of traders on the platform. Trades on a centralized exchange aren’t monitored through blockchain. However, centralized exchanges require users to submit a means of identification to verify their accounts. The more details you provide about yourself, the higher your withdrawal quota.
How does a centralized exchange work?
At the moment, more than 90% of transactions are handled on centralized exchanges. These exchanges provide more liquidity and better trading volumes. Users get quick transactions and support.
Centralized exchanges are just like traditional stock exchanges, where the owners of the exchange monitor transactions. Furthermore, transactions are performed under the precepts provided by the owners.
Users of a centralized exchange deposit money to the exchange, and in turn, the owners of the exchange become responsible for trading orders in real-time. Here, users can’t assess their private keys.
Centralized exchanges are victims of breakdowns and attacks because a central body manages them.
Difference between Decentralized Exchanges and Centralized Exchanges
As stated earlier, centralized exchanges are controlled and managed by a central body. On the other hand, decentralized exchanges are handled and owned by users. Members of a DEX platform have the opportunity to control trades in their accounts, and this is one of the reasons why DEXs are now prominent – more than ever before.
There is more security on a DEX platform than on CEX. Hackers can easily hack a CEX platform than a DEX platform. This is due to the fact that these attackers can hack private keys used by the central body to access every fund in the platform.
There are many reported cases of such incidents before, and CEXs put in a lot of effort to ensure they are secured. Whereas, in a DEX platform, there are minimal risks to losing your money. DEXs platforms are very secure; there is no way multiple users can lose their funds due to a single incident unless linked to the DEXs gates.
Recently, many centralized exchanges are beginning to offer decentralized accounts to their users.
CEXs platforms enact charges to their customers. However, the fees vary from platform to platform. On the other hand, DEXs platforms have minimal costs for every trade performed.
At the moment, CEXs platforms are even more popular than DEXs. This due to the fact that they started operating first before DEXs platforms today. Even though DEXs have spectacular advantages over CEXs, they aren’t that popular due to the inadequate infrastructure and liquidity.
Nevertheless, as more DEX platforms continue to unfold, the popularity may increase. Lots of companies are now creating more DEXs like Binance’s decentralized exchange.
DEXs platforms aren’t as fast as CEXs. According to a survey, it takes an average of 10 milliseconds to execute orders on CEXs platforms. On the other hand, DEXs platforms take one minute to complete orders, which is considered a big difference.
Centralized exchanges have more liquidity than decentralized ones because lots of users make particular orders. These orders are influenced according to market trends. However, if a digital token is in high demand, various users will trade it. Additionally, CEXs platforms have market makers that add more liquidity to them. At the same time, DEXs platforms don’t have much liquidity, and orders take so much time before it is executed, which is why DEXs platforms aren’t that popular.
CEXs platforms are more regulated than DEXs. In a CEX platform, you must submit a means of identification and adhere to the company’s local regulatory authority regulations.
In DEX platforms, there are no regulations because it is challenging to actualize due to the distributed blockchain. This means that if a country decides to halt crypto-exchanges, DEXs will still operate without any problems.
CEX platforms have more features than DEXs. In a CEX platform, users can use lots of advanced order types to trade, manage tools, and execute margin trading.
On the other hand, DEX platforms are very limited to the features you can use. They don’t offer margin trading, management tools, and advanced order types like most CEX platforms today. Probably, as there are more tech-advancements in DEXs, we may see more features coming through.
Lots of decentralized exchanges have been created over the years. Each of them tends to advance further on earlier attempts to better user experience and develop more features. However, the base of DeFi projects is self-sovereignty, where users have sole ownership of what happens in their account.
Through the rise of DeFi, ETH-based decentralized exchanges have increased when it comes to the number of users. Hence, if the pace goes on like this, we may see a big revolution in technology that would change the industry in the future.
Hopefully, this guide has been able to give you great insights into one of the most exciting aspects of DeFi, which is the decentralized exchange.