Everything You Need To Know About Decentralized Exchanges
Cryptocurrency exchanges, also known as EXs, are a means for consumers to purchase and sell tokens. They bring together buyers and sellers on a proven platform to trade cryptocurrency and, in doing so, help establish the market price for a given token. Many cryptocurrency exchanges to date have been centralized. That is, they are created and managed by a central authority. Exchanges such as Binance, Kraken, Coinbase, and Gemini are all centrally-managed crypto exchanges with significant user bases.
A newer form of cryptocurrency exchange has entered the marketplace, however, and appears to be gaining traction by the month: decentralized exchanges. A decentralized exchange (DEX) serves the same or a very similar function to a centralized cryptocurrency exchange, yet is not centrally managed. Instead, a decentralized exchange may function largely as the result of smart contracts that execute trades based on programmed code. The idea is to take the middle person — the managers of a given exchange — out of the transaction. Achieving this goal may serve multiple functions.
How Do Decentralized Exchanges Work?
The mechanisms of a decentralized exchange may be illustrated best by comparing them with those of a centralized crypto exchange. So how do centralized crypto exchanges work? First, a person who wants to purchase cryptocurrency chooses an exchange. They complete any necessary sign-up or sign-in processes, and then they deposit their dollars, Euros, or other fiat currency of choice in exchange for some form of cryptocurrency. One may also deposit their own cryptocurrency to be traded on the exchange.
There are some noted benefits of centralized exchanges. Because assets are held by the exchange, transactions do not necessarily have to be facilitated by underlying blockchains. While blockchains have several benefits, speed is not generally considered one of them. Therefore, centralized exchanges may offer transaction speeds that are quicker than decentralized alternatives. When a user puts in a purchase or sale order, it may be processed near-instantaneously by the mechanisms that govern a given exchange.
Essentially, a centralized cryptocurrency exchange functions much in the same way that an app like Robinhood does: you deposit funds into the platform, conduct trades, and can withdraw funds when you desire (with certain legal restrictions). With centralized exchanges, you are ultimately trusting that the managers of the exchange will return your funds when you request them, and that they are not misappropriating your deposited funds in any way. You may also pay a cut of each transaction to those managers. While decentralized exchanges share the same basic function as centralized exchanges, they rely far less on the integrity and actions of human managers.
What Is the Purpose of a Decentralized Exchange?
The purpose of a decentralized exchange is generally the same as a centralized cryptocurrency exchange: to facilitate the purchase and sale of cryptocurrency and other crypto-adjacent assets. With this basic purpose in mind, both centralized and decentralized exchanges may allow investors to engage in a number of different transaction types, from simple cryptocurrency purchases to the placing of options and betting on futures.
The more relevant question may be what the purpose of decentralizing exchanges is. As previously stated, a decentralized exchange is one in which no centralized authority stands between two or more individuals involved in a transaction. Or, at least, no human authority does.
At least in theory, purchases and sales of cryptocurrency issued through decentralized exchanges are executed by smart contracts. Rather than the human managers of an exchange collecting and disbursing funds to buyers and sellers, self-executing smart contracts handle each transaction.
From the simplest of standpoints, the benefits of a decentralized exchange may include:
- A lesser need to trust a central authority to act ethically
- Lower management fees
- Democratic participation in exchange-related management decisions by participants in an exchange
- Greater flexibility in terms of listing, purchasing, and selling less-mainstream tokens, as the Stanford Journal of Blockchain Law & Policy explains
These potential benefits come with some risks, however.
What Are the Cons of Decentralized Exchanges?
Recent history has shown that there is the ideal of decentralized exchanges (to decentralize, decentralize, and then decentralize some more), and then there are more practically-minded alternatives.
Complete decentralization means:
- No central authority
- Confirming every transaction through every node in a blockchain
- Heightened security through distributed hosting
- Maintaining a comprehensive, permanent ledger of transactions on a blockchain
The primary downsides of this ideal is that transactions can become both slow and costly.
To minimize these downsides of full decentralization, hybrid models of decentralized exchanges have emerged. Decentralized exchanges with off-chain order books are one example of how DEXs may outsource elements of their exchange away from the blockchain in the name of efficiency.
Exchanges with off-chain order books may still utilize smart contracts in some capacity to ensure the integrity of a transaction. However, they may also rely on off-chain humans to fulfill certain orders manually. The intent of this is to prevent clogging a certain blockchain pipeline with too many orders on it. The downside is the addition of third parties, which generally moves any blockchain-linked system further away from the ideal of true decentralization. This balance between uber-decentralization and scalability is one that each decentralized exchange must strike in their own unique way.
What Is the Current State of Decentralized Exchanges?
Decentralized exchanges have fallen in line with the broader trend in decentralized finance (DeFi): growth. The general uncertainty that has defined 2020 has further accelerated investment in decentralized exchanges. Cointelegraph notes that a specific brand of algorithm-governed decentralized exchange known as automated market makers (AMMs) are particularly hot right now.
While high demand seems to be proof of value for decentralized exchanges, some concerns remain. One concern is the scalability of blockchains as the number of transactions on a given chain increases. This concern hits on another issue: the relative sluggishness of transactions on decentralized exchanges when compared with centralized alternatives.
As decentralized exchanges continue to feel out the appropriate blend of centralized speed and decentralized security, the hope is that products will continue to evolve to accommodate high demand for decentralized exchanges.