What is a Decentralized Exchange?
With the emergence of cryptocurrencies, is the emergence of the need to trade them for one another crypto and for fiat currencies. This brought exchanges to the market. Most people in the crypto space are familiar with the traditional centralized exchanges, but there is a new group of exchanges known as Decentralized Exchanges or as commonly referred to as DEXs.
These are exchanges used mainly for trading tokens which are created on blockchains like Ethereum and Binance Smart Chain. Those tokens are used on decentralized exchanges without the need for any central authority. As the ecosystem continues to grow, there is also an increasing number of DEXs to accommodate the ever increasing need for such platforms for trading of tokens.
This article explains what a decentralized exchange is. It also covers the types of decentralized exchanges, the differences between a centralized and decentralized exchange, the advantages and disadvantages of using decentralized exchanges.
For those with a firm understanding of traditional exchanges whether in crypto or mainstream trading, the idea of a decentralized exchange can be quite strange. So what exactly is it? Simply put, a decentralized exchange is one that is decentralized, with no central control. This type of exchange allows everyone to participate in the governance of the space, usually by holding some tokens.
They are particularly suited for trading DeFi tokens as well as creating and launching new ones. Because of the lack of central control, you don’t even need to sign up to use one. These exchanges are still in their initial stage of existence and so are still a bit crude compared to the centralized ones, but they can also be quite fun to use as we will see shortly.
Types of decentralized exchanges
While all DEXs are equal, some are more equal than others. Therefor there are a few categories even among DEXs as follows:
On-chain order books
Centralized exchanges use order books to record buy and sell orders. Interestingly, some DEXs operate in a similar manner – by using on-chain order books. They rely on the blockchain to record transactions just like centralized exchanges. Miners are involved, and so fees are paid. The obvious advantage of this type of exchange is that transactions cannot be faked as the blockchain is infallible.
Off-chain order books
This is the opposite of on-chain order books. DEXs in this category store transactions offline with a centralized custodian. Transactions are however still settled on the blockchain when the two parties involved in such a transaction are matched. The risk involved in using this kind of DEX is even greater than the first as the centralized entity that holds the history initially can decide to influence transaction flow when it finally gets to the blockchain.
Automated market makers (AMMs)
These are like the most advanced DEXs in the true sense of the word. Rather than use order books, these exchanges are built with smart contracts that execute trades independently. Users can trade assets automatically using liquidity pools that allow trading of DeFi tokens against ETH. Rather than allow every buyer or seller to determine price, prices of assets are determined automatically by the DEX protocol.
Examples of AMMs:
How is a decentralized exchange different from a centralized exchange?
The key difference between a centralized exchange and a decentralized one is that the first has central control while the second doesn’t. This has enormous implications as far as the use of the exchange is concerned. For a centralized exchange, you need to deposit your funds in a wallet that you don’t own the private keys. In other words, you have to trust the exchange with the funds and that is a level of risk in itself. Decentralized exchanges don’t need that and trades occur directly from users’ wallets.
Secondly, while a central authority has to give approval for assets to be listed on a centralized exchange, anyone can list a token on a DEX without permission from anyone. While some CEXs (centralized exchanges) do not require user information, most of them request for KYC as a condition to use at least some of their services. Users of DEXs remain completely anonymous as no personal information is required to use the platform.
Advantages of DEXs
Decentralized exchanges sure have some advantages to their use, which include the following:
- Full privacy: As mentioned earlier, you don’t need to reveal any personal information to use a DEX, this makes it an advantage in the current digital world where privacy is becoming almost impossible to have.
- Create and list your own token: Anyone can create and list a token on a DEX. This allows talented developers who may be prevented from listing their tokens on centralized exchanges to work on their projects and list them with no hindrance.
- Control your funds: Users don’t need to deposit funds on DEXs. This means you can be in full control of your funds throughout the trading process.
Disadvantages of DEXs
- Scams: The ability for anyone to create and list a token is also a great weakness that has attracted bad players to DEXs. Scammers can list tokens and then drain the liquidity in a scam known as a rug pull. This makes it impossible to sell their worthless token that you bought, leaving you at a loss. Most token creators remain anonymous.
- Not easy to use: DEXs require users to have a certain level of knowledge to operate wallets and connect them for use etc. this makes it more difficult to use than the centralized ones.
- Fees can be outrageous: With the coming of DeFi, fees on the Ethereum blockchain for example have skyrocketed. There are cases where users are required to pay fees that are up to 90% or more of the amount they wish to swap.