An Introduction to Decentralized Exchanges
In the past few years, there has been a dramatic increase in the number of decentralized exchanges (DEXs). This is largely due to the increasing use of blockchain technology and cryptocurrencies.
It’s impossible to ignore the importance of exchanges in facilitating cryptocurrencies, as they provide the mechanism through which users may purchase and sell cryptocurrencies and tokens. Cryptocurrency exchanges, like many other aspects of the industry, have seen considerable advancements in the previous two years.
This post will explain what a DEX is, how it works, and the benefits of using one.
What are decentralized exchanges?
Decentralized exchanges allow consumers to trade digital assets without having to rely on a third party. This is in contrast to centralized exchanges, where trading is done through a third party.
Another difference is that with centralized exchanges, users lose control of their coin after it is deposited. With decentralized exchange, users are in total control of their coins. The platform allows complete independence and control for users.
How does a DEX work?
On a decentralized exchange, coins are traded using a smart contract. A smart contract is just a blockchain-based program or application that takes over the role of an intermediary. It is smart contracts that allow decentralized exchanges to operate without a third party.
Decentralized exchanges are classified into three basic types:
1) On-chain order book
On this type of DEX, Orders, modifications, and cancellations are all recorded on the blockchain. Orders are not communicated through a third-party intermediary, so they are visible to anyone.
As a side note, this is the most time-consuming kind of DEX to implement. Every node on the network has to preserve a permanent record of all orders which results in processing delays. The process can be long while you wait for a miner to add your order to the blockchain.
Bitshares and Stellar exchanges are examples of platforms that use on-chain order books.
2) Off-chain order book
This type of DEX is still considered decentralized, but they are more centralized in comparison to on-chain order books. A server is used to keep orders in an off-chain order book, not the blockchain.
With one central entity in charge of the order book, there is more potential for market manipulation (i.e., by front running or misrepresenting orders).
Examples of platforms using off-chain order books include Binance DEX and EtherDelta.
3) Automated market makers (AMM)
Automated market makers (AMMs) connect a collection of smart contracts and provide creative incentives to ensure user engagement. Users who contribute their digital assets to a liquidity pool are rewarded with a portion of the transaction fees for trades in that pool.
This ensures that there is always enough liquidity in the market for trades to occur. Essentially, AMMs take over the function of order books to further decentralize the marketplace.
Examples of platforms using AMMs are Uniswap, Kyber Network, and Sushiswap.
Benefits of decentralized exchanges
There are numerous advantages to decentralized exchanges, not just for the creators of the exchanges, but also for users.
Since users do not need to use their private keys or recovery seeds when trading on a DEX, these platforms are less vulnerable than centralized exchanges. When it comes to protecting their own accounts, users are ultimately accountable.
Because users’ login information is not stored on a central server, decentralized exchanges prevent hackers from gaining access to users’ accounts. Exit fraud (i.e., running away with users’ funds) is not an option on a decentralized exchange.
Decentralized exchanges are also safe from tampering by any single entity. Since smart contracts are used to manage the funds on a decentralized exchange, the firms behind the DEX have no control over the tokens being traded by users.
In order to participate in a centralized exchange, you must meet Know Your Customer standards. These are a set of rules that investing and financial services businesses use to authenticate consumers, their risk profiles, and their financial profiles. Coin holders are forced to provide their private data to the exchange operator as a result.
In contrast, decentralized exchanges remove the requirement for users to put their trust in a centralized body to keep their assets safe. No central authority maintains them; hence there is currently no need for KYC protocols.
Consequently, trading on DEXs is now more discreet. When using Binance or Bittrex, users can be confident knowing that their private data will be safe from unauthorized access.
Challenges associated with using decentralized exchanges
Scalability and low speed
Decentralized exchanges, like most blockchain-based solutions, have a slow processing speed and low volume. Because of this, these platforms are unable to onboard as many people as centralized marketplaces.
These scalability difficulties have a direct impact on trading on DEX systems in terms of on-chain order books and transaction settlements. DEX’s scalability has resulted in performance concerns, such as slower updates, stale orders, and erroneous orders owing to time mismatches.
Most existing DEX systems do not provide the optimal user experience for novices. In order to benefit from these systems, users must have a solid foundation in cryptography.
Existing platforms also have limited functionality, limiting the entire trading potential and experience of a user. For example, users are restricted in the types of orders they can place with third parties.
Today’s best decentralized exchanges
Decentralized exchanges have tremendous advantages, and you’re probably thinking about what DEX you can use right now to take back control of your trading funds. Here is a list of decentralized exchanges that you can start using today:
- Kyber Network
- Waves DEX
One of the factors that led to the formation of DEXs was the need for a trading method that would optimize profits while also providing traders with security, convenience, and privacy.
In spite of this, it is vital to recognize that DEXs are not a silver bullet that can cure all of the issues that centralized exchanges face.
Trading DEXs has its own unique set of challenges, and traders must be aware of these while planning ahead. As DeFi continues to evolve, however, we expect to see increased capabilities and more user-friendly features that will allow decentralized exchanges to reach their full potential.
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