If you are a serious or even casual cryptocurrency trader, you may have heard about the term Decentralized Exchange or “DEX”. To explain more clearly, a DEX is an autonomous decentralized app or DApp, allowing crypto traders to trade without having to surrender control of their funds to a third-party intermediary. This infrastructure is entirely different from that of centralized exchanges where the exchanges act as custodians of the trader’s funds.
The whole idea behind the emergence of decentralised exchanges was to eliminate the need for any authority to supervise trades among different parties. Decentralized exchanges thus operate as automated order books or automated market makers as they are also known as, via smart contracts.
So, how does a Decentralized Exchange work?
To understand how DEXs work, you first need to understand the different types of DEXs that exist. This includes On-Chain Order Books, Off-Chain Order Books and Automated Market Makers (AMM).
- Automated Market Makers (AMM)
After exploding in popularity in 2020 thanks to the Defi wave, AMM technology is being used by popular decentralized exchanges such as SushiSwap, Kyber Network and Uniswap just to name a few. DEXs that use AMM have no requirement for order books, instead using smart contracts to produce liquidity pools. These pools automatically execute the trades after considering various parameters.
- On-Chain Order Books
Decentralized exchanges using on-chain order books require the operation of miners for transaction confirmation. The on-chain order books act like network nodes that are assigned to maintain the records of all orders in the exchange.
- Off-Chain Order Books
Off-Chain order books work oppositely to on-chain order books, in the sense that the records of transactions are stored and hosted in a centralized entity. By using relayers, the DEXs manage order books which makes them quasi-decentralized.
Advantages of Decentralized Exchanges
There are several reasons why cryptocurrency traders are turning towards Decentralized exchanges for various functional and security reasons. Some of them are mentioned in brief below.
- The sovereignty of funds: You can freely exercise your sovereignty of funds when using decentralized exchanges. In other words, you have full custody of your funds and can use them as you wish. Your funds are not susceptible to issues like exchanges freezing assets or blocking withdrawals as experienced by centralized exchanges. However, this depends on the type of DEX, as some are quasi-centralized as mentioned above.
- Privacy purposes: Almost all centralized exchanges have some sort of signing-up process requiring users to submit KYC requirements. This forces a lot of users to divulge personal information to the centralized exchange operator. If you want to avoid this, choose decentralized exchanges as records are not maintained by a central authority. You can access a higher degree of privacy when using DEXs even though some countries might implement KYC regulations for cryptocurrency wallets.
- Ensuring security: The biggest risk to funds stored in a centralized exchange is hacking. There have been instances in the past, such as data breaches related to exchanges such as Coincheck, Bitfinex and Mt Gox. Crypto traders lost millions in funds, eroding much of the trust they had with centralized exchanges. For instance, the Coincheck hacking alone cost the exchange about $530 million worth of cryptocurrencies.
Centralized exchanges and their custodial nature are thus the main reasons why they are targeted by hackers. The only way centralized exchanges maintain their liquidity is by storing user funds on their own platform, which gives rise to the threat of data breaches and large scale theft.
Decentralized exchanges on the other hand, are less susceptible to this type of risk. Users can freely trade on these exchanges using their own hot or cold wallets. They do not require any recovery seeds or private keys. This makes the trader responsible for his/her account security. It also makes DEXs less lucrative for hackers to target. Because of the centralized structure of these exchanges, the cost to initiate a hacking attempt will be too costly and difficult for hackers. This makes them less lucrative targets for online threats as the bounty is not as large as those found in exchange wallets.
Examples of Decentralized Exchanges
Cryptocurrency traders have a lot of options when it comes to decentralized cryptocurrency exchanges. Some of the largest and most reliable DEXs are listed below.
- 1inch Exchange
- Perpetual Protocol
- Bancor Network
- Curve Finance
- 0x Protocol
As the cryptocurrency market, on the whole, is still quite new, many questions remain among the general public about security issues. The highly publicised hacks of the above mentioned centralized exchanges did not do any favours for cryptocurrency exchanges as well. Fortunately, DEXs attempt to address this very problem and lessen the concerns that cryptocurrency traders have regarding fund security.