Decentralized exchanges are becoming more common — but how exactly do they differentiate from centralized ones?
What Is a Decentralized Exchange (DEX)?
This type of infrastructure is entirely different from centralized exchanges where users hand over their crypto assets to the exchange, which acts as a custodian and essentially issues IOUs for users to trade with on the platform.
How Does a Decentralized Exchange Work?
There are various types of DEXs, that can be divided in these categories:
On-Chain Order Books
In a DEX that uses on-chain order books, there are network nodes that are assigned to maintain the record of all orders. It also requires the operation of miners to confirm each transaction.
Off-Chain Order Books
As opposed to on-chain order books, records of transactions in off-chain order books are hosted in a centralized entity. They utilize “relayers” to help manage these order books. In this respect, off-chain order book DEXs are only quasi-decentralized, unlike other types of DEXs.
Automated Market Makers (AMM)
Advantages of DEXs
DEXs are lauded for the enhanced privacy, stronger security and greater user control they offer to owners of digital assets.
DEXs are less susceptible to this type of risk, since users can freely trade on these platforms from either cold or hot wallets without having to use their private keys or recovery seeds. Basically, the users are the ones in charge of maintaining the security of their accounts. In addition, it would not be lucrative for hackers to steal funds from individual users since it would likely be too costly and difficult, considering that the crypto bounty won’t nearly be as large as those that are stored in exchange wallets.
Most DEXs do not implement this. Since they are not maintained by any central authority, at present there’s no need to use KYC protocols. This offers users privacy when trading on DEXs. However, rumors have been circulating in late 2020 that U.S. regulators and the Financial Action Task Force (FATF) are looking for a way to enforce KYC on crypto wallets in 2021.
Sovereignty, or control over one’s funds, can be exercised freely in DEXs. Users will have full custody of their funds and will be able to use them as they please. Concerns like exchanges freezing their assets or blocking withdrawals rarely happen in DEXs. It needs to be noted that not all decentralized exchanges are created equal, and in practice they range from quasi-decentralized to fully decentralized.
Disadvantages of DEXs
As revolutionary as they are, decentralized exchanges have their fair share of drawbacks. It is important to weigh these cons before making a decision on which exchange to use.
“Front-running” is also a concern with public order-books. In this scenario, users initiate trades with higher gas fees to have them executed earlier than those that are still pending.
Fortunately, the decentralized finance (DeFi) space has come up with a solution to this through liquidity pools that DEXs can tap.
DEXs: A Conclusion
Coming up with a strategy to maximize returns from your trading activities while maintaining security, convenience and privacy is one of the considerations that has led to the creation of DEXs.
However, it is still important to understand that DEXs are not the silver bullet that will solve all the problems centralized exchanges deal with.DEXs have issues of their own that traders have to always keep in mind whenever planning ahead. With that being said, DeFi is constantly evolving, so we might see all the present disadvantages of DEXs dissipate over time.