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Decentralized Exchanges Explained
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What is a decentralized exchange (DEX)? How does it compare to its centralized counterpart? Are we ready for the mainstream adoption of decentralized exchanges? In this article, Liquid has covered everything you need to know about a decentralized exchange and its role in the cryptocurrency space.
What is a Decentralized Exchange?
A decentralized exchange or DEX is a cryptocurrency exchange that facilitates direct peer-to-peer crypto transactions without an intermediary. Decentralized exchanges are important due to their relevance in the decentralized finance (DeFi) ecosystem.
To understand the concept behind a decentralized exchange, first, we need to understand why cryptocurrency exchanges exist in the first place.
Ever since the world was introduced to Bitcoin by one Satoshi Nakamoto in 2009, crypto exchanges have played an essential role in making Bitcoin and other digital coins and tokens accessible to everyone.
Traditionally, crypto exchanges match buyers and sellers and get them to agree on the correct price of the assets based on their demand and supply.
Without signing up with a crypto exchange, buying and selling crypto assets was virtually impossible. The centralized exchange was the first entry point for anyone trying to join the crypto ecosystem.
As technologies have evolved, various decentralized trading tools and platforms have emerged to eliminate intermediaries.
The goal of decentralized exchanges is to facilitate transactions without users having to explicitly put their faith in facilitators. In short, you don’t need to trust or distrust the platform making decentralized, peer-to-peer transactions possible since no centralized entity takes custody of your funds.
Atomic swaps could be one example of a decentralized transaction.
Decentralized exchange (DEX) vs. centralized exchange (CEX)
There are some core differences between decentralized and centralized exchanges. Before we learn how a decentralized exchange works, first, we need to understand how it compares to its traditional, centralized counterpart.
First, the primary difference between decentralized and centralized exchange is that you must sign up and verify your account with a centralized exchange.
Without joining a centralized exchange, you cannot possibly trade crypto assets. On the other hand, decentralized exchanges don’t necessarily require you to sign up to make the transactions.
Decentralized exchanges make a direct trade between two non-custodial wallets possible, with little to no instructions from a third party.
Meaning, unlike centralized exchanges, decentralized exchanges allow for the trade to take place between two users without intermediaries.
In a centralized crypto exchange, most of the control over your account remains in the hands of the third party which runs the exchange. On the other hand, with a decentralized exchange, all the account's control remains with you.
This is another prominent reason why decentralized exchanges are becoming popular. But it’s also responsible for the enhanced complexity of such platforms.
How a decentralized exchange works
Trading on centralized exchanges is based on the Order Book model, where buyers and sellers place orders. While buyers try to buy an asset at the lowest price possible, sellers try to sell it for as high as possible to earn maximum profits. For the trade to occur, both buyer and seller have to agree on the price.
On a decentralized exchange like Uniswap that uses the Automated Market Maker (AMM) model, each asset swap is facilitated by smart contracts acting as a trusted escrow and governing what happens inside the liquidity pool.
That said, decentralized exchanges like Uniswap try to eliminate excessive dependence on external market makers to avoid transactions from being slow and expensive. What’s more, decentralized exchanges also make integration with non-custodial wallets like MetaMask possible, allowing traders to keep the private keys of their funds.
Advantages of a decentralized exchange
- No intermediaries
One of the most apparent benefits of a decentralized exchange is cutting out the middlemen and executing peer-to-peer transactions without central authorities.
Decentralized exchanges reduce counterparty risks since the trade only occurs between two users. As a result, users don’t have to worry about losing funds to third parties.
Limitations of a decentralized exchange
One of the major drawbacks of most decentralized exchanges is the lack of functionality compared to centralized exchanges. As decentralization technologies continue to evolve, we can expect decentralized exchanges to offer a broader range of products and features.
- Transaction fees and speed
Since decentralized exchanges execute on-chain transactions on a blockchain network, transactions can be slow and expensive when the network is congested.
There is no denying that the crypto ecosystem is moving towards a more streamlined autonomous crypto trading experience. Many decentralized exchanges have emerged over the last year, trying to keep the middlemen out of the equation for heightened privacy and security. But decentralization, in general, is fairly in its early stages, and we are hoping to witness more new decentralized tools and platforms come up in the near future.
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