Decentralized exchange (DEX) is a platform that enables peer-to-peer trading of digital assets (cryptocurrencies or other blockchain-based tokens that represent a particular asset) and does not require users to trust their funds to a third party service. All trades within an exchange occur in a fully decentralized manner, without any central authority involved.
Differences between centralized and decentralized cryptocurrency exchanges
While the concept of cryptocurrencies is decentralized and trustless per se, in order to start trading on a regular exchange, a user is required to deposit (trust) his/her funds to a centralized platform, governed by a particular central entity. Practically speaking, when a user leverages a third-party service to store his/her digital asset, they lose custodianship of that asset.
This leads to multiple problems inherent to centralized crypto exchanges, as their centralized structure and custodianship of multiple assets make them attractive prey for hackers. They are highly vulnerable to malicious activities.
In 2019 only, 5 major cryptocurrency exchanges got hacked, including $41 million (7,000 BTC) theft from Binance – the largest centralized exchange in the world. While that particular case had a happy end for Binance users, who got a full refund from the exchange, not all of the hacks result in the same. In the notorious hack of Mt. Gox exchange back in 2014, the exchange lost 850,000 Bitcoins, which caused extreme harm for the market and its users, with lawsuits still going on as of 2020.
Just as well, centralized exchanges are more prone to fraud: the entire exchange platform can vanish in a single night with users’ funds.
Main features of a decentralized exchange
As opposed to centralized exchanges, decentralized exchanges are more native to the essence of cryptocurrencies, allowing a fully decentralized trading experience, while keeping custody of funds.
The core features of a decentralized exchange are:
- There is no central regulatory authority: all trades are matched automatically and carried out peer-to-peer, with users remaining in full custody of their own funds. Once the trade is settled, the tokens appear automatically in their wallets, without having to go through a centralized exchange wallet.
- There is no single point of failure. A decentralized exchange is distributed in its structure, unable to hack or stop from operating by accessing a central point of control.
- No initial deposit is required to use a decentralized exchange, and there is no withdrawal limit.
- A decentralized exchange platform ensures the highest level of privacy, as they don’t require users to provide personal information to use the platform.
How decentralized exchanges work step-by-step
- A user submits a (buy/sell) request to a relayer that hosts an order book, specifying the parameters of a trade: price/number of tokens.
- An interested user of a decentralized exchange digitally signs it and creates a counterorder – his/her bid
- Both orders are processed in a smart contract on a blockchain, which executes the transaction and transfers tokens to both users’ wallets.
Drawbacks of decentralized exchanges
Decentralized exchanges are typically not newbie-friendly. Having to deal with crypto keys, intimidating interfaces and technical information make them available to most experienced users. Making a mistake (sending funds to a wrong wallet, etc.) is easier on a decentralized exchange.
With no KYC (Know Your Customers) procedures required, decentralized exchanges let users operate anonymously – which attracts the attention of regulatory bodies. In 2018, the United States Securities and Exchanges Commission (SEC) charged the founder of EtherDelta decentralized exchange with operating an unregistered securities exchange, because it was available to use for American investors without proper licensing. The case raised a lot of ethical and legislative questions.
List of decentralized exchanges
- 1. DEX: Top 10 Decentralized Exchange Picks, – Crypto Briefing, Dec 15, 2019
- 2. 5 biggest crypto exchange hacks of 2019, – Bitcoinist, Dec 26, 2019
- 3. Mt. Gox, – Investopedia, updated Feb 20, 2020
- 4. SEC Charges EtherDelta Founder With Operating an Unregistered Exchange, – 2018