What Is a Decentralized Exchange (DEX)?

Exchanges have been very important to the process of connecting buyers and sellers of cryptocurrencies ever since Bitcoin was first introduced. We would be in a far worse liquidity position and have no means to come to an agreement on the appropriate pricing of assets if these forums did not draw in users from across the world.

Historically speaking, centralized players have held the majority of power in this industry. In spite of this, an increasing variety of tools for decentralized trading have evolved as a result of the quickly developing stack of technologies that are now accessible.

In this piece, we’ll go into the world of decentralized exchanges, also known as DEXs, which are marketplaces that don’t need the participation of any middlemen.

In principle, every transaction that takes place between two peers might be considered a decentralized trade. However, the centralized exchanges’ services are what we’re most interested in for the purposes of this post, therefore we’ll focus on platforms that simulate such exchanges. The primary distinction lies in the fact that their backend is hosted on a blockchain. You don’t have to put any faith in the exchange since no one is keeping custody of your money, and you don’t have to put any trust in it at all if you’re using a decentralized offering.

You may choose to deposit either fiat cash (via a bank transfer or using your credit or debit card) or cryptocurrency when using a conventional centralized exchange. When you deposit cryptocurrency, you are giving up control over that cryptocurrency. Technically speaking, you are unable to spend it on the blockchain, despite the fact that it may still be used for trading and withdrawals. This is not a limitation in terms of its utility.
Since you do not own the private keys to the money, you will need to ask the exchange to sign a transaction on your behalf whenever you want a withdrawal. Since you do not own the private keys, Transactions do not take place on the blockchain while you are trading; rather, the exchange is responsible for allocating balances to users inside its own database.

As a result of the fact that the sluggish speeds of blockchains do not obstruct trade and everything takes place inside the system of a single company, the overall workflow has been tremendously optimized. It is now much simpler to purchase and sell cryptocurrencies, and you have access to a wider variety of trading instruments.

This does come at the expense of one’s freedom, though, since it requires one to entrust one’s financial resources to the exchange. As a consequence of this, you put yourself in a position where you are exposed to some counterparty risk. What happens if the team disappears with the BTC you worked so hard to earn? What happens if a hacker takes control of the system and uses it to steal money?

This level of risk is considered acceptable by a large number of users. They just limit themselves to trustworthy exchanges that have proven track records and safety measures in place to reduce the risk of data breaches.

In some respects, decentralized exchanges (DEXs) are comparable to their centralized counterparts, while in others, there are substantial differences. First things first, let’s take into account the fact that consumers have access to a variety of various kinds of decentralized exchanges. Users do not have to worry about losing control of their cash at any stage since orders are carried out on the blockchain (using smart contracts), which is a feature shared by all of these solutions.
Cross-chain DEXs have received some development attention, although the vast majority of these exchanges are focused on the assets that can be found on a single blockchain (such Ethereum or Binance Chain).

Everything is handled on the blockchain via certain decentralized exchanges (we’ll get into hybridization methods in a minute). Every order that is placed, together with any modifications or cancellations, is recorded on the blockchain. Because you are not relying on a third party to communicate the commands to you, and because there is no way to conceal them, this strategy is likely the most open and honest one.
To make matters worse, it’s also the least practicable option. You will be required to pay a charge due to the fact that you will be requesting that each node in the network permanently record the order. The fact that you have to wait until a miner adds your message to the blockchain is one of the factors that might make the process seem laborious.

Some people think that this model has a problem with front running. When an insider is aware of an upcoming transaction and utilizes that knowledge to execute a trade before the transaction is completed, this is an example of front running, which is a kind of insider trading. As a result, the candidate who is now in first place has access to information that is not generally known. In most cases, doing so is a violation of the law.

It should come as no surprise that there would be no opportunities for front running in the conventional sense if everything is recorded on a global ledger. In spite of this, there is another kind of attack that may be carried out, which is one in which a miner views the order before it is confirmed and then takes measures to guarantee that their own order is added to the blockchain before any other orders.

The Stellar DEX is one type of an on-chain order book that is currently in use.

Implementations of off-chain order books include Binance DEX and IDEX.

Fed up of reading the term “order book?” Great news since the Automated Market Maker (AMM) approach completely eliminates the need for such a strategy. It is just users, game theory, and a little bit of formulaic black magic that are required for it to work. Neither creators nor takers are necessary.
The particulars of AMMs are determined by the implementation; nevertheless, in general, they consist of a collection of smart contracts strung together and the provision of ingenious incentives to encourage user engagement.
The currently existing AMM-based DEXs have a tendency to be rather user-friendly, since they integrate with wallets like as MetaMask and Trust Wallet. However, in order to finalize transactions, an on-chain transaction is required, just as it is with other types of DEXs.

Compliance with KYC/AML, which stands for “Know Your Customer” and “Anti-Money Laundering,” is the rule for many exchanges. Individuals are often required to provide identification papers and proof of address because doing so satisfies regulatory requirements.

For some people, this is a worry about their privacy, while for others it is a concern about their accessibility. What should you do if you don’t have any papers that are legitimate on hand? What if the information were to become public in some way? Because DEXs do not need authorization, nobody verifies your identity when you use one. A cryptocurrency wallet is all that is required of you.

However, when DEXs are largely managed by a centralized body, they must comply with certain legal standards. If the order book is managed from a central location, then the host is required to maintain compliance in certain circumstances.

Realistically, DEXs aren’t nearly as user-friendly as traditional exchanges. Transactions may take place in real time on centralized platforms, and these trades are unaffected by block delays. CEXs provide a more lenient environment for inexperienced bitcoin users who are not comfortable with non-custodial cryptocurrency wallets. In the event that you forget your password, you will easily be able to reset it. However, if you lose your seed phrase, your cash will be gone forever in cyberspace and cannot be recovered.

The amount of transaction conducted on CEXs continues to far outweigh that of DEXs. Perhaps even more significantly, the liquidity of CEXs is often higher than that of other exchanges. A measure of an asset’s liquidity is how quickly it can be bought or sold at a price that is considered fair. In a market that is very liquid, the difference in price between bids and asks is minimal, which indicates a high level of rivalry between buyers and sellers. If the market is illiquid, it will be more difficult for you to locate someone who is willing to exchange the item with you for a price that is acceptable to you.

Because DEXs are still at a very infant stage, there is not always a supply or demand for the digital currency assets that you desire to exchange. It is possible that you will not be able to identify the trading pairs that you wish to utilize, and even if you do find them, the prices at which assets trade may not be fair.

Fees aren’t always higher on DEXs, but they can be, particularly when the network is congested or if you’re using an on-chain order book.