What is a Decentralized Exchange?

  • Eric Eissler
    📚 WikiCoin

    Remaining anonymous and still using an exchange is possible with a DEX, but there are downfalls


What is a Decentralized Exchange?

In an era of decentralization made possible with the advent of Blockchain technology, we are seeing many everyday things that we use start to shift from centralized to decentralized forms. Bitcoin is the best example of this as it is a currency that does not have a central issuer, instead it is controlled by all the millions of miner nodes on the network. There is no central authority figure who is controlling it all. So how can decentralization translate to an exchange? Sure there are crypto exchanges, such as Coinbase, Gemini, Bittrex, etc., but these exchanges are still centralized.

The decentralized exchange

A decentralized exchange (DEX) is an exchange market that does not rely on a third party service to hold the customer's funds, such as Coinbase. Instead, trades occur directly between users in a p2p network through an automated process. This system is created by making proxy tokens, which are crypto assets that represent a certain fiat or cryptocurrency. Another way to do this is to use assets, which can represent shares in a company for example, or through a decentralized multi-signature escrow system, among other solutions that are currently in development.

This system contrasts with the current centralized model in which users deposit their funds and the exchange issues an IOU that can be freely traded on the platform. When a user asks to withdraw his funds, these are converted back into the cryptocurrency they represent and sent to their owner.

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Operational DEXs to check out

Key differences between centralized and decentralized exchanges

Anonymity

Decentralized cryptocurrency exchange platforms are all about anonymity. Consider them to be the distributed Blockchain-equivalent of centralized exchanges.

Government regulations that have entered into force has led to the adherence to strict identification laws. It is difficult to trade anonymously on a centralized cryptocurrency exchange platform. Just recently Coinbase forced all its users to add addresses, social security numbers and identity documents, if customers want to continue using the exchange’s services. Who knows what kind of government reporting Coinbase will be forced to do come tax time in early 2019.

Authentication

There is no need to rely on a third-party intermediary for user authentication. With smart contracts in place and a number of Blockchain protocol implementations, the entire system is built to provide trust-less authentication and authorization of crypto exchange transactions. The system is designed to run on it with the smart contacts enforcing the policy of the exchange and ensuring that users can’t double spend and that they are getting promised payments. The third-party authenticator is removed from the equation.

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Benefits of decentralized cryptocurrency exchanges

Funds controlled by users

A decentralized exchange is owned and controlled by all the participants so there is no central authority that has custody of deposits. The control of the money is always in the hands of the customer since the network uses a p2p network. Smart contracts regulate and ensure the proper execution of trades and payments, which occur between users in the network. Additionally, users control their private keys as well as their funds at all times in a decentralized exchange. There are no issues between the exchange authority and the user so some issue, such as lost funds surface.

Transactions: quicker, cheaper

Potential to provide a platform that facilitates faster, cheaper and more cost-effective crypto exchange/trading transactions than centralized exchanges. The removal of the third-party authenticator drastically reduces fees and lag time before buy/sell orders are processed.

Hacks and server downtime mitigated

A decentralized exchange is far less susceptible to attacks than centralized exchanges. There have been many high-profile hacks on major centralized crypto exchange platforms that demonstrate just how susceptible centralized exchanges are to cyber attacks. decentralized exchanges have no single point of entry, akin to a Blockchain. As such, a hacker will need to compromise more than half of the network to be able to commandeer the system. If only one node is taken offline, the entire network is not compromised.

Hardware wallets are easily integrated

Many decentralized exchanges offer smooth integration with hardware wallets, which ensures a much safer transaction. Users can send tokens directly from their hardware wallets to smart contracts on many decentralized exchanges. In centralized exchanges, conversely, this is not possible because users must manually enter private keys to move coins from hardware wallets to centralized exchanges. This opens the transaction to phishing as well as keylogging and stealing keys and passwords.

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Drawbacks of decentralized cryptocurrency exchanges

While it sounds like a decentralized exchange is the panacea for all the ills of the centralized exchanges, we are not there quite yet as these exchanges are still very green and not geared towards a novice user.

Advanced users

Centralized exchanges have easy to understand tabs and buttons on their websites, whereas many decentralized Bitcoin exchanges have a confusing exchange dashboard that takes some getting used to. These are not for the beginner, and since many people in the cryptosphere are new users, they are going to be left out, until the technology simplifies.

Basic trading only

As of now most decentralized exchanges only support the basic cryptocurrency exchange functions: buy and sell. Many of the advanced trading features such as margin trading, stop- loss trading, etc. is one of the reasons why decentralized exchanges have not achieved much popularity in the larger cryptocurrency trading environment. However, as with any technology, we can anticipate that these features will be arriving in due course.

No crypto/fiat trades

The DEXs out there do not have the ability to trade fiat at the moment which requires there to be crypto in the bank already, or the possibility to move it through another centralized exchange, which kind of defeats the purpose of using a DEX if you must pass through a centralized exchange first.

Low liquidity

Since exchanges are not so popular with the masses, that means they have low volumes and low liquidity. This can be a big problem if there is massive sell order that is executed and all the funds dry up. Users are going to be stuck trying to make withdraws until some buy orders come across the transom.  

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Three benefits to decentralized exchanges

  • The user controls his/her funds

  • The user remains anonymous

  • Hacks are mitigated due to decentralized nature, an exchange cannot go down

Three negatives to centralized exchanges

  • The user does not control his/her funds, the exchange does

  • The user cannot remain anonymous, they must submit to providing ID

  • Hack and server downtime can bring down the entire exchange

The future is here!

While DEXs offer potential, they are in the beginning stages and won’t be a major competition for traditional exchanges just yet. However, are more trading tools and feature are added along with the ability to buy and sell fiat, then watch out! Traditional exchanges are going to have some major competition to contend with.  

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Cover image via u.today
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