Much like the blockchain itself, decentralized exchange has endured the “buzzword” treatment for a while now, but the hype surrounding this technology is hardly unwarranted. Similar to the way the World Wide Web democratized access to information, decentralized exchanges have the potential to truly democratize access to financial services.
A decentralized exchange, or DEX for short, enables users to trade cryptocurrencies with one another without the need for a supervising central authority. Instead of empowering a third party to look after the exchanges between two users, DEXs allow people to transact directly on a peer-to-peer basis.
While used solely for trading cryptocurrencies at the moment, it’s easy to see how the concept of decentralized exchanges facilitating peer-to-peer transactions could make a significant impact on more traditional financial systems. Exploring this disruptive potential of decentralized exchanges will be the primary goal of today’s text.
The Difference Between Centralized and Decentralized Exchanges
Centralized exchanges of digital assets are performed on trading platforms that function in a way similar to the models traditional brokerages and stock markets have in place. These service providers enable users to buy, sell and exchange cryptocurrencies, but the owners of these platforms maintain total control over all transactions. They are the ones with the authority to allow, pause or block any transaction, an exercise in power maintained simply by not providing the users with the private keys of their account’s wallets.
Obviously, this model of exchanging cryptos puts all of the user’s trust in the hands of the exchange operator. All the funds are stored with the service provider and transactions can only be approved by those who run the platform, much in the same way a bank’s exchange protocol would work with FIAT currencies.
Aside from the irony of chaining cryptocurrencies to the binds of traditional finance systems, you might feel like this is not such a terrible way of keeping transactions in check. After all, if it works well for FIAT, why should such a model present a problem for digital money? And you’d be right, if not for one thing – in order to be in complete control of what’s going on within their systems, owners of centralized exchange platforms keep their systems off-chain, meaning that transactions are not recorded on the blockchain despite tokens exchanging digital hands.
Instead, all of their tokens are stored on servers controlled by platform owners, known also as centralized hot wallets. And by placing massive amounts of coins on a single (or a few) digital locations, centralized exchange platforms are inadvertently making themselves into sweet honeypots for potential hackers. Unfortunately, when a breach occurs, no insurance covers the damage because cryptocurrencies are still widely unregulated. No authority is able to track what happened and retrieve the stolen tokens – instead, the platform simply declares itself bankrupt while users suffer the losses.
Eliminating this problematic single point of failure inherent to centralized systems is precisely why decentralized exchanges were invented.
Like any type of digital exchange, the decentralized ones have a total of four core functions:
- 1. Capital deposits
- 2. Order books
- 3. Order matching
- 4. Actual asset exchange
With DEX, all four of these functions are entirely decentralized. In comparison, centralized exchanges facilitate transactions in which only the asset exchange happens without the direct control of a central entity.
By making sure all aspects of the exchange are unsupervised by a third party looking to keep track of transactions, a decentralized exchange empowers users to be completely in charge of their own digital funds. They provide us with a completely permissionless ecosystem in which the asset owner gets to dictate the full terms of each individual trade.
This is a huge novelty in the world of finances as, up until now, we’ve never had an opportunity to manage digital funds without central entities instructing us on what we can and can not do.
How Does a Decentralized Exchange Work?
At its core, a decentralized exchange is essentially a decentralized application (dApp). The validity of its processes is guaranteed by the execution of smart contracts, chunks of code that give blockchains the behind-the-curtain logic needed to remain operational.
Here’s a simple explanation of how a decentralized exchange works from the perspective of someone wishing to trade digital assets:
- Step 1: You use your wallet address to register for a DEX, no sign up is necessary.
- Step 2: You place an order by stating which cryptocurrencies you’d like to exchange and for what kind of asset (one that’s, of course, available on the DEX you’re currently on). You specify the number of units you wish to sell, the minimal value of what you’ve got and until which time bidding for the assets will be allowed.
- Step 3: Once the selling order and its custom parameters are set, your request becomes public and other users of the network can start submitting bids.
- Step 4: Once the bidding time expires, all the proposals are automatically reviewed and an exchange is executed when the system identifies the best offer, all thanks to smart contracts running in the background.
As you can see, decentralized exchanges are really not that complex. Of course, creating one is a much more daunting task than simply understanding how they work, but the point of our simple example was to clearly demonstrate the non-custodial nature of the DEX process.
From start to finish, users remain completely in control of their funds while trading within these decentralized networks. They only hand over control once the trade has been executed by the DEX network.
Main Reasons Why Decentralized Exchanges Hold So Much Promise
While there’s a surplus of promising blockchain use cases to choose from, peer-to-peer networks for exchanging digital assets could easily turn out to be among the most disruptive forms of blockchain application. There’s a total of three key reasons why we’re firm believers in the disruptive ability of DEX and these are:
They Have No Middlemen
Probably the most obvious upside of decentralized exchanges is that the entire process cuts out the middleman while facilitating a peer-to-peer environment.
This absence of central authority is what makes DEXs such a unique concept. Without decentralized exchanges, the peoples’ ability to manage cryptocurrencies would always be subject to third parties, which would make cryptos hardly more democratic than traditional currencies.
No matter what your stance on the current state of the cryptocurrency world is, it’s hard to ignore just how revolutionary the lack of middlemen really is. We’ve always had central authorities dictating how we manage our digital money, but now the model of decentralized exchanges is offering up an alternative in which we can be completely in charge of our own assets.
They Offer Top-of-the-Line Security
Massive security attacks, an inherent problem of all centralized exchange models, are not an issue with DEXs.
Thanks to the security levels provided by blockchain technology, decentralized exchanges can not fall victim to single points of failure. Each user is in private control of their own funds and there’s no storing the assets together, which means that there’s no way to hack the system in a way that allows access to the majority of tokens.
However, while it’s certain that decentralized exchanges are indeed significantly more secure than their centralized counterparts, it’s important to note that they are not entirely bulletproof.
The main problem lies with the use of smart contracts. They can contain some vulnerabilities, such as underflows, overflows, reentrancy attacks, etc. The human factor is also something worth mentioning – if you make a mistake during a DEX, like accidentally asking for less money or paying something more than its worth, there’s no one to bail you out.
Nevertheless, in terms of pure system security, DEX is among the safest methods of exchanging currencies digitally, which will certainly play a significant part in its future applications.
They Provide a Better User Experience
The final merit of decentralized exchanges we’d like to point out is the overall better user experience they offer when compared to what centralized systems put their users through.
A decentralized exchange facilitates faster and cheaper transactions than any centralized exchange, which is to be expected as there’s no third-party authenticator slowing the network down by checking and taking cuts out of transactions.
Furthermore, DEXs have far less friction then their centralized counterpart as they don’t require sign-ups – all you have to do is connect your wallet codes and you’re ready to start trading.
The Two Main Drawbacks of Decentralized Exchanges
While the spike in the development of decentralized exchanges is encouraging, there are some shortcomings to this technology that need to be taken into account.
If we put those more easily solvable aside, there are two main drawbacks to DEXs that need to be amended sooner rather than later: lack of system functionality and the absence of FIAT exchanges.
In order to maintain the trade simplicity we described earlier, decentralized exchanges tend to be very bare-bone, which can lead to issues with speed and liquidity. Most decentralized exchanges only support basic market functions, which takes features such as margin trading and stop loss out the window. All currently operational DEXs are relatively small in size, so figuring out a way to create a vast yet sustainable and well-oiled decentralized exchange should be a top priority.
The absence of FIAT currencies is a more logical drawback of the two. Since there’s a total lack of Know Your Customer (KYC) and Anti Money Laundering (AML) regulations within DEX networks, FIAT exchanges are simply not something these exchanges can host. Their inclusion would necessitate the introduction of a point of centralization, something the entire technology was developed in order to avoid. Nevertheless, the absence of FIAT currencies is a problem for some and, at least at this moment, we don’t see a way they can be included without breaking down the fundamental parts of DEX’s identity.
Decentralized Exchange Could Shape The Future of Finances
At this particular time, it’s fair to say that decentralized exchanges are still too far off from achieving the liquidity, scalability and functionality needed for mass adoption. However, the good news is that there are massive strides being made every day, so it’s only a matter of time before the DEX technology takes a leap that matches the ambitions we have for them.
What also makes us optimistic is that the pros of decentralized exchanges cast a shadow so thick over its cons that it’s clear this technology will be making waves in the following years. Sure, the functionality and scalability issues are real, and the absence of FIAT currencies problematic, but turning peer-to-peer networks for trading digital assets into the go-to method of how we manage funds is simply an idea too thrilling not to pursue.
We’ll have to wait and see how long it takes before DEXs starts to take foot with adoptions outside of the crypto world. What’s certain is that, as the general public grows in blockchain savviness, we’re bound to see a move towards holders of digital assets wanting more control and security in their engagement with exchanges.
And as soon as that moment comes, decentralized exchanges will be poised to make their mark on the financial world.