What Is a Decentralized Exchange (DEX)?
You probably know the drill with “regular” centralized cryptocurrency exchanges. Sign up with your email, come up with a strong password, verify your account, and start trading cryptocurrency.
If you don’t, our ‘Absolute Beginner’s Guide To Cryptocurrency Investing’ will take you through the process step by step.
Decentralized exchanges are like that, minus the hassle of sign-ups. In most cases, there’s no depositing or withdrawing crypto. The trade happens directly between two users’ wallets, with limited (if any!) input from a third-party.
Decentralized exchanges can be a bit trickier to get the hang of, and they might not always have the assets you want. But, as the tech and interest in it grow, these may very well become integral components in the cryptocurrency sphere.
Traditionally, centralized players have dominated this field. However, with the rapidly-evolving stack of technologies available, a growing number of tools for decentralized trades have emerged.
In this article, we’ll take a dive into decentralized exchanges (DEXs), trading venues where no intermediaries are required.
Defining decentralized exchanges
How a centralized exchange works
The general workflow is incredibly streamlined because the slow speeds of blockchains don’t impede trading, and everything occurs in a single entity’s system. Cryptocurrencies are easier to buy and sell, and you have more tools available to you.
This does come at the cost of independence: you need to trust the exchange with your money. As a result, you expose yourself to some counterparty risk. What if the team runs off with your hard-earned BTC? What if a hacker cripples the system and drains the funds?
For many users, this is an acceptable level of risk. They simply stick to reputable exchanges with strong track records and precautions that mitigate data breaches.
How a decentralized exchange works
On-chain order books
Of course, if everything is published on a global ledger, there’s no opportunity to front run in the traditional sense. That said, a different kind of attack can be deployed: one where a miner sees the order before it’s confirmed, and ensures that their own order gets added to the blockchain first.
Off-chain order books
Off-chain order book DEXs are still decentralized in some regards, but they’re admittedly more centralized than the previous entry. Instead of every order being posted to the blockchain, they’re hosted somewhere.
Where? That depends. You could have a centralized entity completely in charge of the order book. If that entity is malicious, then they could game the markets to an extent (i.e., by front running or misrepresenting orders). However, you would still benefit from non-custodial storage.
These approaches are superior from a usability perspective than those that rely on on-chain order books. They don’t face the same constraints in terms of speed, as they don’t use the blockchain as much. Still, the trade must be settled on it, so the off-chain order book model is still inferior to centralized exchanges in terms of speed.
Automated Market Makers (AMM)
Pros of DEXs
This is a privacy concern for some and an accessibility concern for others. What if you don’t have valid documents on hand? What if the information is somehow leaked? Since DEXs are permissionless, no one checks your identity. All you need is a cryptocurrency wallet.
However, there are some legal requirements when DEXs are partially run by a central authority. In some cases, if the order book is centralized, the host must remain compliant.
No counterparty risk
The primary appeal of decentralized cryptocurrency exchanges is that they don’t hold customers’ funds. As such, even catastrophic breaches like the 2014 Mt. Gox hack won’t put users’ funds at risk or expose any sensitive personal information.
Tokens that aren’t listed on centralized exchanges can still be traded freely on DEXs, provided there’s supply and demand.
Cons of DEXs
Trading volumes and liquidity
DEXs are still relatively niche, so there isn’t always supply or demand for the crypto assets you wish to trade. You may not be able to find the trading pairs you want to use, and if you do, assets might not trade at a fair price.