More and more people have been driven to cryptocurrency in recent years as a result of the ludicrously high returns on altcoin investments during the 2017 bull run and the 2020 DeFi bubble. As such, we’ve witnessed the rise of new exchange platforms that claim to be one-stop shops for all of your crypto trading requirements.
However, centralized exchanges pose significant threats to investors. Billions of dollars (largely in Bitcoin and Ethereum) have been lost each year to sophisticated hacks and scams, rousing the ire of authorities who are now progressively regulating the space, compromising user privacy. Decentralized exchanges have become increasingly popular as a means to overcome these difficulties.
DEXs, or decentralized exchanges, are self-contained decentralized apps (DApps) that allow buyers and sellers of cryptocurrency to trade without having to entrust their funds to a third-party middleman or custodian.
This infrastructure diverges from centralized exchanges (CEXs). CEXs require users to commit their crypto assets to the exchange which operates as a custodian and creates IOUs for users to trade with on the platform.
DEXs were designed to eliminate the need for any authority to supervise and authorize transactions conducted within an exchange. DEXs employ smart contracts to run automated order books (or automated market makers) and transactions. As a result, they are truly peer-to-peer.
There are several types of DEXs that can be grouped into the following categories
Network nodes preserve a record of all orders in a DEX that use on-chain order books. Miners are also employed to validate each transaction. The BitShares and StellarTerm exchanges are two notable platforms that employ on-chain order books.
Unlike on-chain order books, off-chain order books keep records of transactions in a centralized organization. “Relayers” are employed to keep these order books up to date. This type of DEX is thus only quasi-decentralized. Off-chain order books are used by DEXs such as Binance DEX, 0x, and EtherDelta.
Automated market makers (AMMs) are employed by prominent DEX platforms including Uniswap, SushiSwap, and Kyber Network. AMMs grew in popularity in 2020 driving the DeFi boom. Order books are unnecessary for AMMs. Instead, they use smart contracts to create liquidity pools that execute transactions automatically based on preset criteria.
DEXs are celebrated for providing more privacy, security, and user control for owners of digital assets.
Hacking is the most significant danger associated with centralized exchanges. Businesses like Coincheck, Mt. Gox, and Bitfinex have been decimated by security breaches. As a result, the public’s faith in crypto has been badly shaken. Hacking at Coincheck alone resulted in a loss of $530 million in cryptocurrency, shattering Mt. Gox’s previous theft record of $472 million.
The custodial nature of centralized exchanges is frequently cited as the primary motivation for hackers and criminals to try their hand at attacking them. These exchanges preserve their liquidity by keeping users’ cash on the platform, making them vulnerable to large-scale theft. This also increases the danger of “exit scams” – when a promoter of a cryptocurrency exchange disappears with investors’ money. QuadrigaCX and Confido are notorious examples.
DEXs are less vulnerable to this sort of danger as users can trade from either cold or hot wallets without having to utilize their private keys or recovery seeds on these platforms. Users are primarily responsible for protecting the security of their accounts. In addition, stealing assets from individual users would be unprofitable for hackers given the cost and complication of doing so, especially since their reward would be just a fraction of the assets held in the exchange wallets.
All centralized exchange sign-ups must comply with Know Your Customer (KYC) rules. As a result, Bitcoin owners are required to hand over their personal information to the exchange operator.
Given that DEXs are not maintained by a central body, there is no need to employ KYC protocols. Users have anonymity when trading on DEXs. However, in late 2020, there were indications that US regulators and the Financial Action Task Force (FATF) were searching for the means by which to implement KYC on crypto wallets in 2021.
DEXs allow users to exercise complete control over their wealth, using their funds in any way they see fit. It is rare for exchanges to suspend assets or prevent withdrawals in DEXs. It’s vital to keep in mind that not all decentralized exchanges are created equal: exchanges can range from quasi-decentralized to fully decentralized.
As revolutionary as DEXs are, they are not without flaws. Before deciding which exchange to utilize, it’s critical to weigh their advantages and disadvantages.
Orders on DEXs might take a long time to process. This is due to the fact that before trade calls can be handled, they must first be broadcast to the network and validated by miners. This is why DEX trades are more prone to “price slippage,” which occurs when the value of the cryptocurrency being swapped differs from the price at which the trade is executed. With public order books, “front-running” is also an issue. This enables users to conduct deals with greater gas fees, for example, to get them processed sooner than those who are still waiting.
Liquidity is achieved by controlled exchanges and massive money. DEXs frequently face liquidity issues since, unlike centralized exchanges, their liquidity is predominantly reliant on the number of active users trading on the platform. In addition, DEXs do not always have access to a fund that they can shift around to make deals easier.
Fortunately, the decentralized finance (DeFi) community has devised a solution to this problem in the form of liquidity pools that DEXs may use.
One of the central motivations for the creation of DEXs was to develop a method to optimize rewards from trading activity while ensuring security, convenience, and privacy. In this, they were broadly successful.
However, it’s important to keep in mind that DEXs are not a panacea for all of the issues that centralized exchanges face. DEXs have a unique set of problems for traders to consider. With that being said, DeFi is always improving: the current drawbacks of DEXs may be resolved over time.