A Decentralized Exchange, commonly referred to as DEX, can be compared to a stock exchange that is operated by a smart contract on an Ethereum blockchain. While a DEX and stock exchange both enable users to trade assets, a decentralized exchange trades cryptocurrency exclusively. This means that it does not require a centralized authority to operate.
The decentralized exchange makes use of a smart contract to implement the rules, execute trades, and securely handle funds when required. In order to better understand decentralized exchanges, we first analyze centralized exchanges.
What Is A Centralized Exchange?
In terms of traditional finance, a financial exchange occurs when users trade commodities and financial assets. These financial assets are usually held in safekeeping by a central exchange that receives orders from both sellers and buyers for stock, securities, commodities, and currencies, amongst others. In order to execute a trade, users must submit an order to the central exchange.
These orders are either put into the central exchange’s order books to be completed later, or to fill in the order together with an existing order on the books. This leads to the creation of either a Maker Order or Taker Order.
A maker order is when a central exchange receives an order and puts it into their order book, while a taker order is when the central exchange fulfills the order by taking an existing one of the books.
Limitations Of Centralized Exchanges
Although centralized exchanges offer a comprehensive platform to their users, there are major limitations that persuade people to switch to decentralized exchanges. These limitations are:
- A key aspect of centralized exchanges is that they collect the data of the people who use them and store it in a centralized server. Users also need to use a combination of an email and password in order to access their funds, and that information is also stored on a centralized server. This makes the servers an attractive platform for hackers who may be tempted to get rich quickly.
- Centralized exchanges are also constrained by censorship. An influential aspect of cryptocurrencies is that it is decentralized and cannot be controlled or monitored by government institutions or authoritative bodies. It is highly plausible for government institutions to intervene and restrict access to a user’s funds at a bank. In the same light, a centralized exchange may succumb to government regulations that may restrict a user’s access to their funds.
Engaging with decentralized cryptocurrency exchanges is a way to mitigate such limitations as they operate on a peer-to-peer network and make use of automated algorithms in order to verify transactions.
How Do Decentralized Exchanges Work?
Decentralized cryptocurrency exchanges do not make use of a central controlling server or a collection of central servers to regulate the data of their users. Consequently, this eliminates the requirement for a third-party escrow to withhold the funds of their investors while they conduct transactions. The main differences between centralized and decentralized platforms are:
- In centralized exchanges, the order books and the funds of a user are held by the server while the transaction is being processed. In decentralized exchanges, however, the need for a centralized server is completely mitigated. All transactions are performed directly with peers with the intervention of any central server. This is incredible as all user funds are controlled by the participants of that transaction.
- It is increasingly difficult for centralized exchanges to maintain the anonymity of their users as the regulatory environment surrounding exchanges has tightened considerably. Users are therefore unhappy with sharing information on centralized exchanges and are more inclined to transact with cryptocurrencies where the anonymity of their transactions is assured. Additionally, decentralized exchanges are equivalent to the distributed blockchain that ensures that all user transactions are encrypted and anonymous. This makes the privacy of all users certain, and also protects it from any government intervention.
Decentralized Exchanges and Smart Contracts
Decentralized exchanges are actually smart contracts that are written to enable users to trade cryptocurrencies. Smart contracts are what converts ETH, Ethereum networks’ native currency, into programmable money.
The contracts come in the form of applications or scripts that are programmed to operate on the Ethereum network that has the capability of creating and managing digital assets. Smart contracts enable users to build intricate unalterable agreements without the need for any third-party intervention.
Users perform their trading by trading their cryptocurrencies like ETH for other coins or tokens through a simple process of interaction with the smart contracts from their wallets. When they submit trade orders to a decentralized exchange, they are actually submitting a transaction to their smart contract on the blockchain. Some of the exchanges have maker and taker orders while others have pools or reserves of currencies that are ready to be swapped or traded.
There are fantastic benefits for using decentralized exchanges and the major benefits are discussed below:
- These exchanges ensure cost-effective and faster transactions. By eliminating third parties in the transaction process, the process become much more efficient as transactions can be performed noticeably faster at a much-reduced cost. Furthermore, because users are transacting on a peer-to-peer network, there is a massive reduction in the lag that is typically associated with processing transactions on centralized exchanges.
- Unlike centralized platforms that are vulnerable to being exposed and hacked leading to information being misappropriated, decentralized exchanges are that much more secure. There is a very low possibility of them succumbing to hackers as all user information is not stored on a central server or collection of central servers. In the event that a hacker is successful in intercepting the system and gaining sensitive information, that attack would be isolated, and gaining access to the entire network will be almost impossible.
- Decentralized systems have great integration capabilities with hardware wallets. They can directly integrate with wallets such as Trezor and Ledger Nano S. Centralized exchanges create a risk for keylogging attacks as users are required to input their private keys in order to move their tokens from the wallet to the exchanges. Decentralized exchanges, on the other hand, allows users to directly transfer from their hardware wallets to their smart contracts that are offered.
- One of the most attractive features of decentralized exchanges is that the users control funds. There are no central authorities that have control of the funds of their users. The control of funds is completely in the hands of the users, as all transactions are facilitated using peer-to-peer network architecture.
It is important to know some of the limitations that users may experience when engaging with these exchanges.
- They have less functionality. When compared to centralized exchanges, decentralized exchanges lack many useful features such as margin trading and stop loss. These features may negatively affect the performance of a trader. Although these features are in the pipeline for an introduction on decentralized exchange platforms, centralized exchanges already have these features in place.
- They may be difficult to use. Centralized exchanges have maintained popularity because their platforms are very easy to use and they provide a lot of helpful information to their users. On the contrary, decentralized exchanges can be a bit trickier as users need to navigate through many smart contracts. Even seasoned users may experience the negative effects of this and many have to also consider remembering their private keys while working on the systems.
These limitations have given users a reason to dub the systems as not user friendly.
The Most Popular Exchanges
IDEX is a decentralized exchange that concentrates on trading Ethereum based ERC-20 tokens and combines the efficiency of a centralized exchange with the safety of blockchain settlement.
The focal display consists of a Japanese candlesticks chart that describes the performance of any given asset. Users can analyze the latest trades made on the blockchain and can effortlessly buy or sell assets from the main screen.
EtherDelta is built specifically for trading Ethereum ERC-20 tokens and Ethereum pairs. The entire exchange is powered by Ethereum-based smart contracts that are responsible for deposits, withdrawals, and wallet integration.
EtherDelta and IDEX have a similar UI, with a candlesticks chart as the main screen. Similar to IDEX, EtherDelta also provides all the vital information to traders on the main screen. Traders typically use the platform to buy, sell, or withdraw their cryptocurrency assets.
Kyber Network is known to be a secure, instant, and liquid Ethereum-based decentralized exchange for cryptocurrencies that is based on peer-to-peer protocol.
This exchange doesn’t have a sign-up feature, which enables users to login directly via a wallet of their choice and immediately start trading. Kyber Network holds a significant amount of reserve to facilitate transactions almost instantly.
Bisq offers traders a desktop application that they can utilize to trade their cryptocurrency assets anonymously. Bisq supports fiat currencies and other alternate cryptocurrencies and does not require detailed information for registration or approval from a central authority. Traders can merely download the app and start trading assets instantly.
The system is peer-to-peer with no single point of failure and supports 126 cryptocurrencies.
This platform is another decentralized exchange that is focused on trading with Ethereum tokens. Radar Relay allows users to trade their Ethereum tokens directly from their wallet, mitigating the need for a middleman. The platform is peer-to-peer and shifts tokens between two wallets. Therefore, there is no intermediary service, and the tokens move directly from one client to another.
Unlike modern wallets, Radar Relay never holds the custody of the tokens and requires no signups, deposits, or withdrawals. Additionally, it has off-chain order books, is interoperable, and has the ability to integrate wallets.
Bancor Network is a smart contract powered decentralized exchange that solves the problem of liquidity which many decentralized exchanges are faced with. Due to this feature, Bancor has a very steady network. Furthermore, the platform is less volatile and provides its investors with constant prices for tokens.
Bancor has a remarkable web application with a great UI that users can use to perform the simple functions of buying and selling cryptocurrencies. Unlike IDEX and EtherDelta, Bancor’s UI is clutter-free and has precisely grouped the token assets for easy access.
Ox Protocol and Relayers
0x offers centralized databases, called Relayers, to help advance Ethereum’s scaling issues. Relayers facilitate activity between users before interacting with Ethereum’s blockchain. These Relayers naturally operate as off-chain matching engines to pair orders. When an order is executed, the transfer of digital assets occurs on-chain.
Airswap Protocol also stems from the Ethereum family and does not require any identifying information for traders to begin trading, nor do they charge fees.
Like 0x, Airswap balances certain off-chain activity for efficiency with other on-chain activity for security. Instead of Relayers, off-chain activity in Airswap is executed through a lightweight peer discovery engine that ensures that there is a real intent to buy and sell specific assets.
Binance leverages the flexibility of the Ethereum blockchain and uses elected Validators that produce blocks and manage the network.
To incentivize honest maintenance, Validators charge specific fees for their services. Since there are far fewer nodes on the Binance Chain when compared to Ethereum, Binance DEX can confirm transactions on the network in a matter of seconds.
1Inchexchange is a popular facilitator of decentralized exchanges that offers swap features, limit order features, and yield farming features. Users can connect their wallet on 1inchexchange, and start using the platform without requiring detailed personal information. The platform uses an instrument called Chi token to reduce the cost of ETH Gas, which can be costly.
Changelly is another popular decentralized exchange that allows users to instantly exchange cryptocurrency. Users don’t have to know the identity of the other user and everything is done in an instant. Users can anonymously exchange their coins quickly, securely, and anonymously.