Cryptocurrency trading these days is unimaginable without a cryptocurrency exchange. The majority of crypto trades take place through centralized exchanges even though decentralized exchanges(DEXs) are getting increasingly popular. Wait a second, but what are decentralized crypto exchanges? Who even facilitates an exchange on a DEX?
Decentralized exchanges or DEXs are peer-to-peer(P2P) platforms where crypto traders directly exchange cryptocurrencies with each other without handing over the custody of their funds to an intermediary. Here, intermediaries or brokers are replaced by self-executing smart contracts for the exchange of crypto assets.
The smart contract codes of most DEXs are open-source and can be viewed and audited by anyone. This helps to maintain transparency on the platform in terms of exchange mechanisms and fund movements. Further, most DEXs are non-custodial and let traders retain the custody of their private keys. They don’t ask for any identifying information such as your legal name or address and enable you to trade without compromising your privacy.
This article will help you understand more about decentralized exchanges, their benefits and risks as well as the difference between centralized and decentralized crypto exchanges.
How Do Decentralized Exchanges Work?
Before talking about DEXs, let us first understand how centralized crypto exchanges(CEXs) work. CEXs are like brokers that connect crypto buyers and sellers. You can deposit fiat money or cryptocurrency in the exchange’s wallet and then use it to buy any cryptocurrency listed on the exchange. They act as custodians for your private keys and funds. CEXs also have to comply with Know Your Customer(KYC) and Anti-Money Laundering(AML) protocols.
On the other hand, DEXs have removed the role of the intermediaries and instead leverage self-executing smart contracts to facilitate P2P trading. They don’t have to follow KYC/AML norms and allow users to retain full control over their assets. These platforms seek to maximize the decentralization of ownership and administrative rights. Most of them are, therefore, governed as Decentralized Autonomous Organizations(DAO) where the stakeholder community votes on proposals related to the platform.
While using a DEX, you are required to pay network fees and trading fees. Network fees or gas fees are the cost of the on-chain transaction while trading fees are collected by the platform and often given to liquidity providers as compensation in a proportion specified in the platform’s design.
Types of Decentralized Crypto Exchanges
Automated Market Makers(AMMs)
AMM is the most popular type of decentralized exchange. This is because such platforms have higher liquidity, democratic access to liquidity, and often allow permissionless market creation. DEXs relying on AMM use smart contracts that provide users instant access to liquidity via liquidity pools.
Therefore, while users get liquidity immediately, liquidity providers or users who fund the liquidity pools earn passive income via the trading fees that the platform charges for swapping tokens.
However, AMM-based DEXs have two major problems namely, slippage for traders and impermanent loss for liquidity providers. When there is not enough liquidity on the platform, the trader may end up paying more than the market price on their order. This is called slippage and the larger the order, the higher the possibility of slippage.
The biggest risk that liquidity providers face on a DEX is impermanent loss. It is a result of depositing two assets for a trading pair. So, if the volatile asset’s price rises while the amount held by the liquidity providers drops, the liquidity providers suffer an impermanent loss.
UniSwap, PancakeSwap, Curve Finance, and Balancer are some examples of popular AMM DEXs.
Order Book DEXs
Order books are a collection of open buy and sell orders in the market recorded in real-time. Here, a buy order means that the buyer is willing to buy an asset at a specific price, and a sell order means that the seller is willing to ask a particular price for that asset.Â
The difference or the spread between buying and selling prices determines the market price on the exchange. Order books, therefore, help the platform’s system to match buy and sell orders.
Order book DEXs are further of two types: on-chain and off-chain.
On-chain DEXs
As the name suggests, these exchanges require every interaction within the order book to be recorded on the blockchain. On-chain DEXs may allow leveraged trading but they also often face the problem of low liquidity and less-than-optimal user experience.
Off-chain DEXs
These platforms hold their order books off the blockchain and only settle the trades on the chain. Therefore, off-chain DEXs have better scalability as compared to on-chain ones and offer faster speeds and lower costs to users. They may also allow users to lend funds for leveraged trading.
DEX Aggregators
These platforms aggregate liquidity from other DEXs in order to minimize slippage and offer users the best possible prices and lowest fees in the shortest time possible. DEX aggregators remain non-custodial platforms all while decreasing the possibility of failed transactions and striving to protect users from the pricing effect.
Pros of Decentralized Exchanges
Custody
DEXs are non-custodial platforms. This means that you do not need to give up control of your private keys to transact on the platform. Instead, you connect your external crypto wallet to the platform to trade on it. Most DEXs use protocols such as Automated Market Maker so that trades are automatically executed with the help of smart contracts.
Privacy and Anonymity
Most centralized exchanges require users to follow KYC norms. This includes asking for users’ full legal names, their pictures, and a copy of their government-issued ID. Therefore, people who are iffy about handing over their personal information to a corporation prefer DEXs which don’t have any KYC or AML requirements.
Token Diversity
Centralized exchanges have to first vet and then make sure that tokens comply with local regulations before listing them on their platform. They can also decide not to list certain tokens based on factors like trading activity and security standards.
It is easier to list tokens on a decentralized exchange where people can trade them on a P2P basis. You are more likely to find new projects or tokens on a decentralized exchange first rather than a centralized one.
Security
As discussed above, DEXs do not hold funds on your behalf. You just connect your wallet to the platform and interact with it when you wish to. Therefore, even if the DEX is hacked, your funds remain safe. The only risk may be to liquidity providers who stake their tokens to provide liquidity on the platform.
Low Fees
In the absence of any intermediaries, DEXs are able to charge lower fees as compared to centralized exchanges. They charge gas fees according to the structure of their underlying blockchain and though it can be very high at times due to network conditions, charges are, on average, lower on decentralized exchanges.
Cons of Decentralized Exchanges
Anonymous Transactions
DEXs don’t ask for any sort of ID verification and anyone can freely trade on them. Depending on the perspective, this can be a benefit as well as a disadvantage. While DEXs help traders maintain their privacy, this can be an issue from a legal perspective due to money laundering and terror financing concerns.
Scalability Issues
DEXs are affected by the structure and limitations of their underlying blockchain network. Ethereum, on which most DEXs are built, often faces scalability issues leading to network congestion or downtime which makes trading on them very expensive at times. This is, however, expected to change with the Ethereum 2.0 upgrade.
Not Beginner-Friendly
You need to have technical knowledge and prior experience with crypto trading for trading on a DEX. These platforms are not very accessible for beginner traders who are unfamiliar with decentralized blockchain technology. For example, you need to know about smart contracts, how crypto wallets work, and how to fund your wallet with the right token for each network to be able to trade safely on a DEX.
Liquidity Problems
Though DEXs are gaining popularity, many of them still have lower liquidity as compared to their centralized counterparts. Poor liquidity increases the possibility and amount of slippage. Though asset liquidity has been increasing on DEXs, most trading still takes place through centralized exchanges.
Smart Contract Vulnerabilities
Though smart contracts are convenient for automating transactions and enabling P2P trades, they are still vulnerable to bugs, hacks, and other vulnerabilities that can cause liquidity providers to lose their tokens.
Token Quality
It is very easy to list tokens on decentralized exchanges. While this is great if you want early access to new tokens, this also means that all sorts of tokens are listed on the platform without any sort of verification. This makes users more vulnerable to investing in low-quality or even malicious tokens. Rug pull schemes are a common way of scamming investors by taking advantage of the permissionless markets on DEXs.
Frequently Asked Questions(FAQs)
What is an example of a Decentralized Exchange?
UniSwap, PancakeSwap, Curve Finance, and dYdX are some examples of decentralized cryptocurrency exchanges. All of them, except PancakeSwap, are Ethereum-based platforms that allow users to swap cryptocurrencies without the interference of any centralized authority.
What is the difference between Centralized and Decentralized Cryptocurrency Exchanges?
The biggest difference between centralized and decentralized crypto exchanges is related to the role of intermediaries. Centralized exchanges are run by central companies and act as intermediaries between crypto buyers and sellers. On the other hand, decentralized exchanges facilitate P2P trading by allowing crypto buyers and sellers to trade and swap cryptocurrencies directly.
Is Decentralized Exchange Safe?
Decentralized exchanges are safe in the sense that you are never asked to transfer your funds or your private keys to the platform. Therefore, a platform failure will have no effect on your crypto holdings. However, this also means that the onus of ensuring the security of your crypto assets is on you. You have to make sure that your assets are stored securely and be responsible for their safety.
The Bottom Line
Decentralized exchanges are non-custodial platforms that strive to provide users with a seamless trading experience while maintaining their privacy and retaining control of their assets. They have several benefits but like anything else suffer from certain limitations. These exchanges are not as accessible as centralized ones for new traders and require a technical understanding of certain crypto concepts for trading on them.
However, technology is always evolving and decentralized exchanges have come a long way from the time of low liquidity and are now addressing scalability problems with layer-2 networks such as zk-rollups. They have also democratized administrative rights by enabling stakeholders to vote on key proposals related to the platform. DEXs, therefore, remain an important part of the crypto ecosystem and continue to innovate in the field of decentralized finance.