DEX (Decentralized Exchange) is known for trying to offer alternatives to centralized exchanges by operating as a decentralized exchange. DEX (Decentralized Exchange) is also described as a peer-to-peer marketplace that connects cryptocurrency buyers and sellers.
Unlike centralized exchanges (Centralized Exchange), decentralized platforms are not supervised, in other words, when the user trades on the DEX platform, they are under the control of their own private keys. In the absence of a centralized authority, DEXs use smart contracts that are self-executing under certain conditions and record each transaction on the blockchain. The protection of these transactions represents an accelerating segment of the digital asset market and is leading to new financial products.
Traditional stock and price exchanges bring buyers and sellers together in one place, allowing investors to easily enter and exit positions at specific points, providing liquidity to the market. Greater liquidity increases the likelihood that there will be people willing to trade with the buyer or seller on the other side of the actual trade. Cryptocurrency exchanges, also known as centralized exchanges, facilitate the trading of blockchain-based digital assets, while their platforms can be centralized or decentralized. Centralized exchanges function as trusted intermediaries in transactions, often acting as custodians who can store and protect private keys and, accordingly, funds.
Leading centralized crypto exchanges facilitate every aspect of the digital asset trading experience, from security and fair market pricing to regulatory compliance, consumer protection and access to the latest digital assets. Many centralized exchanges require fiat or cryptocurrency to be deposited into an exchange-held crypto wallet before trading. Funds can also be transferred to a crypto wallet other than the exchange wallet. In addition, crypto can be exchanged for fiat and money can be withdrawn from bank accounts.
In September 2020, CEXs accounted for approximately 95% of all crypto trading volume, while Decentralized Exchanges (Decentralized Exchanges) have emerged as an alternative to CEX platforms, offering peer to peer trading and access to the emerging Decentralized Finance sector. There are currently more than thirty-five decentralized exchange options.
In January 2019, DEX platforms represented just 0.11% of global trading volume, rising to 6% by August 2020. Monthly trading volume on decentralized exchanges was worth $20 billion as of October 2020. DEX platforms take a different approach to facilitate the trading of digital assets. Instead of using a brokerage to clear trades, DEXs leverage the functionality of self-executing smart contracts. DEXs follow a non-custodial course, where one can retain control of the generated private keys and cryptocurrency funds. There is no counterparty risk problem for DEXs, in other words, there is no credit liability risk and “Know Your Customer” (Know Your Customer) or Anti-Money Laundering protocols.
Advantages of DEXs
Even in the early stages of developing decentralized crypto exchanges, they offer advantages that affect digital asset custody, diversity, transaction security, trading fees and investor privacy.
DEXs are non-custodial, i.e., merchants do not need to relinquish control of private keys to trade. Instead, externally held wallets interact with DEXs and self-transact through smart contracts. Centralized exchanges, on the other hand, take on a custodian role for funds by controlling private keys. This creates the need for individuals to relinquish control of private keys. With such a requirement, centralized exchanges offer assurance and protection.
In October 2020, there are over 7,400 cryptocurrencies on the market. CEXs exercise control over the cryptocurrencies they list, generally listing only those with sufficient trading activity, prevalence, and effective security standards to ensure profitability and regulatory compliance. Many altcoins are only accessible to individuals through DEXs, where peer to peer transactions can take place without high trading volumes. This access provides a wider opportunity for participation in digital assets and an increase in financial inclusion.
In CEXs, each transaction is supervised and recorded by a central authority, the exchange. DEXs, on the other hand, execute transactions through smart contracts and record them on the blockchain, enabling reliable transactions. Since DEXs do not hold individuals’ money, they are less likely to be targeted by hackers.
Decentralized exchanges operate using self-executing smart contracts. DEXs use the same “gas” fee structure as the Ethereum blockchain on which they are built. DEXs charge a low fee of approximately 0.3% for exchanges. While these fees fluctuate depending on network usage, they are much lower than the costs of centralized alternatives.
Individual traders using decentralized exchanges do not need to disclose their private keys. This is because the wallets are held externally and the DEX is not responsible for the funds. Also, for this reason, individuals are generally not required to complete KYC (Know Your Customer) and AML (Anti-Money Laundering) procedures when using DEXs. Although this is advantageous in terms of convenience, it can potentially create legal problems.
Disadvantages of DEXs
The disadvantages arising from the use of a decentralized exchange also pose obstacles to its widespread adoption. These shortcomings also affect DEX’s scalability, user experience, market liquidity and capital mobility.
Blockchain scalability depends on the number of transactions the network can process before reaching capacity. For example, the Bitcoin network processes 4.6 transactions per second (Transactions Per Second, TPS), while Ethereum reaches 15 transactions per second (TPS). Decentralized exchanges operate using smart contracts that live on blockchain networks. Therefore, DEXs are bound by the limits of the underlying network infrastructures.
DEXs are currently in the early stages of development and may be difficult to use for individuals who are less familiar with decentralized blockchain technology. Firstly, users need to be familiar with external wallet platforms to interact with a DEX. Next, they need to fund their wallet by transferring fiat or cryptocurrency. Finally, they need to connect this wallet to the DEX interface to trade. The process of depositing funds for trading on the DEX platform is noticeably simpler than on the CEX platform.
As DEXs are still new in many respects and support a variety of trading partners, market segregation has a negative impact on market liquidity. However, asset liquidity is increasing significantly with the growth of DeFi (Decentralized Finance).
Open and Closed Ramps
Current DEX technology does not facilitate the purchase of digital assets with fiat currency such as the US dollar. In other words, there is no fiat trading or transfer of funds to a bank account. While stable coin technology has emerged to replicate the role of fiat money in the DeFi (Decentralized Finance) ecosystem, the lack of fiat on and off ramps is a barrier to entry for new users.
Exchanges of the Future
Although centralized exchanges still dominate crypto markets and serve the needs of everyday crypto sellers and investors, decentralized alternatives offer an interesting alternative. Through on-chain smart contracts, DEXs provide a reliable method to connect buyers and sellers and offer new models of fair participation and governance for partners. In addition, these platforms are still in the updating phase and further improvement of the user experience, development of infrastructure, improved scaling mechanisms and increased connectivity to centralized crypto and legacy financial institutions will be necessary to drive future adoption.
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