The idea of decentralized digital assets is central to the role of cryptocurrencies. This is based on the concept of peer-to-peer (P2P) trading of assets without the involvement of intermediaries or third parties. But the need to exchange, sell or buy crypto leads users to centralized exchanges (CEXs), many of which contradict the principles of decentralization. That is why decentralized exchanges (DEXs) are gaining popularity. Let us take a closer look at what they are and what their purpose is.

What Is a DEX?

A decentralized exchange uses the P2P network principle, linking users via smart contracts that automatically enforce the terms of the exchange and carry out the transaction on the blockchain. In this way, the DEX platform increases the security of digital transactions.

A DEX is essentially a platform for finding matches in orders to buy or sell tokens. Decentralized exchanges have no governing body and are maintained by smart contracts or user communities.

How DEXs Work

How DEXs work

A DEX blockchain network will use smart contracts to carry out the following functions:

  1. On-chain order book. This system stores all purchase requests, cancellations, and transactions on the blockchain. This can result in a slower process and sometimes be more expensive than other methods.
  2. Off-chain order book. This allows all requests and cancellations to be made off-chain, and only the transaction itself is held on the blockchain. This system makes the exchange process faster and cheaper but more vulnerable to cyberattacks.
  3. Automated Market Maker (AMM). By avoiding the order book and using AMMs, the DEX trades automatically according to a set algorithm.

Most DEXs use AMM protocols to create liquidity pools. These pools are funded by the users, who receive a percentage of the commission for their trouble. Thus, the entire workload (and profit) from market-making is distributed among users willing to keep some assets in a smart contract. Supply and demand determine the asset value and the commission for pooling.

How DEXs Differ from CEXs

How DEXs Differ from CEXs

Centralized exchanges are traditional exchanges for trading virtual assets managed centrally by a specific company. This means that all trades and personal data on the exchange are available to that company. Anonymous trading on such exchanges is not possible.

Among the main differences between DEXs and CEXs are:

  1. A DEX processes transactions automatically, while on CEXs, they are validated.
  2. Transaction details on DEXs are stored in a blockchain as opposed to CEXs, which store all data on a server.
  3. A DEX generates liquidity pools using AMMs, while CEXs provide liquidity themselves.
  4. Due to the lack of intermediaries, DEX commissions are lower than those of CEXs, which must provide their own resources.
  5. The transaction speed on DEXs is often lower than on CEXs, due to blockchain’s scalability issues.
  6. Since there is no need to register on the platform to use a DEX, users can remain anonymous. CEXs are required to comply with KYC procedures and identify their customers.
  7. There is no need to transfer funds to third-party platforms to conduct transactions on DEXs, which greatly reduces the likelihood of hacking attacks on decentralized exchanges. For transactions on CEXs, the user needs to transfer and store assets on the exchange, which attracts the attention of hackers and incurs additional commission costs.

Benefits and Drawbacks of DEXs

Benefits and Drawbacks of DEXs

In summary, the main advantages of using DEXs are:

  1. Absolute anonymity of users as there is no need to be authenticated to start trading.
  2. Low commissions because there are no intermediaries.
  3. Opportunity to receive rewards by acting as a liquidity provider.
  4. A wider range of trading pairs, allowing you to exchange almost any token.
  5. Full control over your assets, as there is no need to withdraw funds from a wallet.

Among the disadvantages of using decentralized exchanges are the following:

  1. The presence of scalability issues reduces the transaction speed.
  2. The liquidity of less common tokens may be lower on DEXs than on CEXs, as it directly depends on the number of market makers.
  3. The user interface on a DEX is more complex than that of a CEX, which reduces its popularity among newcomers and ordinary users.
  4. The lack of opportunities to trade and withdraw funds in fiat currency using DEXs.
  5. No options for advanced traders.
  6. Anyone can list a new token on DEXs, making it more likely to be a scam.

DEXs are widely popular despite all the disadvantages, and the capitalization of these platforms grows each year. For example, the capitalization of the UNI token belonging to the decentralized exchange Uniswap increased by almost 700% in 2021, according to CoinMarketCap.

There is no doubt that a DEX is a very attractive option for crypto traders, which is why CEXs are gradually beginning to implement some functionalities of decentralized exchanges. In time, we may see the creation of an online exchange that combines the advantages of DEXs and CEXs and eliminates their disadvantages.

Author: Natalie Antonenko
#Exchange