What are Decentralized Exchanges?
Essentially, any exchange between two parties could be a decentralized transaction. The main difference between centralized and decentralized exchanges is that decentralized exchanges exist on the blockchain. That is, no one has access to your assets but you and you don’t have to give as much control as you do with centralized exchanges.
How a Centralized Exchange Functions
Users deposit their money into centralized exchanges. The deposit could be fitat currency or crypto, but as soon as they transfer the funds, they lose control of them. Users hand over their private keys and all transactions are mediated through the exchange. Users still have the ability to trade and withdraw their assets, but they can’t spend them on the blockchain.
On the one hand, centralized exchanges make trading crypto easier. Since all transactions occur on a centralized system and not just on the blockchain, waiting times are reduced. It’s much easier to buy and sell assets on a single platform than to interact with multiple ones.
On the other hand, users give up control over their assets and potentially put themselves at risk. The exchange is now responsible for their assets, but what if something goes wrong, like a cyber attack for instance? What if the exchange is hacked and all of the user’s assets stolen?
How a Decentralized Exchange Functions
Again, the main thing that distinguishes decentralized exchanges from their counterparts is that all transactions happen on the blockchain with smart contracts. Users keep complete control of their assets at all times.
There are several different types of decentralized exchanges. We’ll take a look at the main ones below.
On and Off Chain Order Books
Decentralized exchanges that record absolutely all transactions on the blockchain are known as on-chain order books. Although it’s closest to the ideal, it’s far from practical. On-chain order books suffer from slow transaction speeds because every node must add every transaction to the blockchain before it can go through. Users then pay more fees to ensure their transaction is given preference.
On-chain order books are also susceptible to disruptions from miners. For example, if a miner notices that a transaction is about to happen, they can make sure that their personal transaction is given preference.
Off-chain order book decentralized exchanges are a kind of hybrid where not all transactions are recorded on the blockchain. Instead, they’re hosted by a central authority in control of the order book.
Compared to on-chain order books, off-chains enjoy much faster transaction speeds, since the blockchain isn’t constantly being used. A good example of an off-chain decentralized exchange is Binance DEX.
Automated Market Makers (AMMs) combine smart contracts with incentives to make sure users participate. AMMs are a good example of game-theory in practice. We won’t go into the technical details here, just the general idea.
AMMs are popular because they’re both easy to use and integrate with wallets like MetaMask. Uniswap is a widely-used AMM.
Advantages and Disadvantages of DEXs
We’ve briefly mentioned some advantages and disadvantages of DEXs already. Let’s take a closer look now.
One benefit of DEXs is increased privacy. All you need to use them is a crypto wallet. There’s no need to provide ID information. They are permissionless so no one is going to verify your identity.
Another advantage is increased safety. As we mentioned earlier, DEXs don’t hold user’s funds. Even if there is a major security breach, user information and assets remain safe.
Lastly, there are more tokens to trade. This is the main reason why traders prefer DEX to CEXs, they can find and trade any token available. CEXs only offer the most popular tokens.
DEX are slightly more difficult to use than CEXs, especially if you’re new to trading crypto. Fees can also be higher on DEXs, especially when the network is full of orders. Lastly, CEXs enjoy much higher trading volumes than DEXs. CEXs usually have higher liquidity as well.
Lot’s of decentralized exchanges have popped up in recent years, each trying to carve out a niche in the DeFi space. We think this trend is reflective of a growing shift in how people think about financial markets. With news about privacy breaches and corporations selling user data to governments, many people are looking for something more secure.
Bring.Finance is a decentralized staking platform on Binance Smart Chain. Like DEXs, you can connect with us just through your wallet. Visit our website and socials to learn more about our project.