You can use centralized and decentralized exchanges for crypto trading. The former may be preferable when you are starting out or want to trust a well-known company. But the latter is the only option if you want to exchange lesser-known crypto and have full control of your crypto wallet.
Most people invest in cryptocurrencies on a centralized exchange. This is probably the most affordable and secure option for average users. But it’s also important to understand decentralized exchanges, which you should use if you want to buy certain types of crypto and participate in different parts of crypto ecosystems.
In this article, we’ll basically talk about decentralized exchanges. We will see what they are and what they are not, how they work, their advantages and disadvantages. Let’s go.
What is a decentralized exchange?
Decentralization is one of the core values of the crypto movement. Crypto exchanges are freely conducted without approval, regulatory oversight or high commissions from banks and other financial institutions.
This is one of the benefits of using and investing in cryptocurrencies. Each DEX is intended to bring the benefits of decentralization to the buying, selling, and managing of crypto portfolios.
A DEX is therefore a peer-to-peer market. A market where users can exchange cryptocurrencies on a non-prison basis without the need for an intermediary to facilitate the transfer and custody of funds.
DEXs replace traditional intermediaries such as banks, smart contract brokers. These smart contracts are based on blockchain technology that facilitate the exchange of digital assets.
Compared to traditional financial transactions, which are opaque and go through intermediaries that offer extremely limited insight into their actions, DEXs offer complete transparency into the movement of funds and the mechanisms that facilitate exchanges.
Counterparty and systemic risk are therefore reduced, unlike in centralized or traditional systems.
Following this logic, DEXs are considered a cornerstone of decentralized finance (DeFi). They serve as a lego monetary key on which more sophisticated financial products can be built through the possibility of unlicensed compounding.
The most popular DEXs, such as Venice Swap, Uniswap and Sushiswap, use the Ethereum blockchain and are part of the developing DeFi toolkit.
How does a decentralized exchange work?
On a centralized cryptocurrency exchange, you start by creating an account and encounter the site’s KYC Terms and Conditions. After depositing money or connecting your existing crypto wallet, you can buy, sell and exchange cryptocurrencies, make a quick transaction or build a long-term portfolio.
CEXs like Coinbase make it possible to trade fiat currencies against cryptocurrencies (and vice versa) or cryptocurrencies. On the other hand, DEXs do not allow exchanges between fiat currencies and cryptocurrencies. Instead, they exclusively exchange cryptocurrency tokens with other cryptocurrency tokens.
On a decentralized cryptocurrency exchange, you connect your cryptocurrency wallet to software on the exchange’s website. If you want to buy or exchange crypto assets, all you must do is identify what you’re looking for.
The decentralized app tells you the price, and if you approve, you accept the transaction. You never log in, provide a name or email address, or create an account.
DEX does not match you with an individual seller. Instead, they use Automated Market Makers (AMMs) to offer you coins and tokens from a pool of liquidity.
This pool of liquidity is an amount of cryptocurrency that other users have allocated for a specific period of time. When you buy cryptocurrency on a decentralized exchange, you are buying from a liquidity pool.
Those who have a wallet in Trust Wallet for example, can buy their cryptocurrency in the liquidity pool of PancakeSwap, UniSwap or many others.
What are the advantages of a decentralized exchange?
Most of the strengths of decentralized exchanges come from their distributed architecture. Here are some key advantages (although some of them are also disadvantages):
Wide variety of brands
If you want to find a token with a boom just at the beginning of its launch, exchanges are the place to get it. DEX offers a virtually limitless range of tokens, from the familiar to the most bizarre and downright random.
Indeed, anyone can create a token based on the Ethereum network and create a liquidity pool for a crypto or token. For this reason, in a decentralized exchange you will find a wider variety of projects: “verified” projects and ” unverified ” projects.
Low risk of hacking
Since all the money from a DEX transaction is stored in users’ wallets, these transactions are theoretically less prone to hacking. This is quite relevant, as DEXs also reduce what is known as “counterparty risk“.
This risk is the likelihood that one of the parties involved, including possibly the central authority in a transaction outside of DeFi, will default on the transaction.
User and transaction anonymity
No personal information is required to use the most popular exchanges/DEX. In Trust Wallet, for example, you are only asked for your password when creating the wallet.
Decentralized exchanges: for finance de domain
There are many financial transactions that in the future could be transferred to the blockchain and sooner or later could be managed through exchanges. For example: peer-to-peer lending.
Fast transactions and anonymity allow DEX to become increasingly popular in developing economies, where a strong banking infrastructure may not be required over time. Anyone with a smartphone and an internet connection can make transactions through DEX.
However, DEXs have more than just advantages. They also have disadvantages. Here are a few.
What are the disadvantages of a decentralized exchange?
DEX has democratized access to trading and liquidity through powerful smart contracts. However, they also come with a set of risks:
Smart contract risk
Blockchains are considered extremely secure for executing financial transactions. However, the quality of a smart contract’s code still depends on the skill level and experience of the team that developed it.
Bugs, hacks, vulnerabilities, and smart contract exploits may occur leaving DEX users vulnerable to loss of funds. Developers can mitigate this risk through security controls, peer-reviewed code and good testing practices. Due diligence is always required.
As DEX becomes more popular, some DEX markets have poor liquidity conditions. These conditions can lead to large amounts of slippage and a sub-optimal user experience.
Because of the way the liquidity network effects work, a significant amount of trading activity is still conducted on CEX. Which often leads to less liquidity in DEX trading pairs.
Risk of concentration
While many DEXs aim to maximize their resistance to decentralization and censorship, points of concentration may still exist. These include the DEX matching engine hosted on centralized servers, the development team having administrator access to DEX smart contracts, and the use of low-quality token bridging infrastructure, among others.
As asset exchange is facilitated by a blockchain, using a DEX can be prohibitively expensive or completely impossible if the network experiences congestion or outages, leaving DEX users susceptible to market movements.
As many DEXs offer permissionless marketing – the ability for anyone to create a market for any token – the risks of purchasing low-quality or malicious tokens may be higher than on CEXs.
DEX users should consider the risks associated with participating in early-stage projects.
DEXs are a fundamental pillar of the cryptocurrency ecosystem. They allow users to exchange digital assets in a peer-to-peer manner without the need for intermediaries.
DEXs have received increasing adoption in recent years due to the instant liquidity they can enable for newly released tokens, the seamless integration experience, and the democratizing access to transactions and liquidity they provide.
Whether most of the transactional activity will move to DEX remains to be seen. However, DEXs are expected to remain vital infrastructure for the cryptocurrency ecosystem and will continue to see improvements in transaction scalability, smart contract security, governance infrastructure and user experience.