Explained: Decentralized Exchanges
If you’ve been involved with blockchain technology and cryptocurrencies, you’ve probably already heard about crypto exchanges such as Binance, Poloniex, Bittrex, and Coinbase.
Now, there is a new generation of exchanges emerging that are gaining traction and attention from the crypto community.
In this piece, we explain what decentralized exchanges are, why and how they are better than current solutions, and what problems they currently face.
- Decentralized exchanges work as fully autonomous, decentralized applications (DApps), which allow traders to transact without giving control over their money to a trusted central authority, as is the case with their traditional centralized counterparts.
- The main benefits are increased privacy, security, and control over the funds.
- Drawbacks include low liquidity as well as reduced usability and speed.
What is a decentralized exchange?
A decentralized exchange is a trading pair matching system that allows people to place orders and trade cryptocurrencies without relying on an intermediary institution to manage the ledger and hold customers’ funds. Instead, trades occur directly between users (peer to peer) through an automated process. This decentralized application (DApp) utilizes blockchain technology to keep the order books and facilitates trades using smart contracts.
This system is in contrast with the current dominant centralized model in which users deposit their funds and the exchange issues an IOU that can be freely traded on the platform. When a customer orders a withdraw of his funds, these IOU’s are converted back into cryptocurrency and sent to their owner.
Advantages of decentralized exchanges
It is somewhat paradox to rely on centralized entities to trade cryptocurrencies when the entire industry is built upon the idea of disintermediating middlemen. Apart from the ideological reason, decentralized exchanges also feature concrete benefits to its users.
Most decentralized exchanges do not require any form of sign-up process and thus do not collect any of your personal data. As these exchanges are DApps running without a central entity, there is no intermediary that qualifies as a money transmitter, meaning there are no KYC/AML requirements to comply with government regulations and restrictions.
It remains to be seen if the current regulatory environment will adapt to this new kind of exchange, especially if damages occur, resulting from a poorly written smart contract or security flaw. But for the moment, it’s possible to anonymously trade on decentralized exchanges.
If you’ve been following the news lately, you have most likely heard plenty about centralized exchanges being hacked or losing vast amounts of customer funds. Major events include the $72M Bitfinex hack, the famous $472M Mt. Gox security breach or this year’s record-breaking $530M Coincheck theft, just to name a few.
While the specific reasons for each hack vary, there is a structural problem that can be associated with all of them. Every centralized exchange today is custodial, meaning they themselves hold the users’ funds. Having large amounts of cryptocurrency concentrated, it’s no wonder centralized exchanges are a prime target for black-hat hackers.
Decentralized exchanges don’t hold funds and are therefore not targets for malicious actors looking to steal a huge amount of money in a large-scale heist. The custody is distributed across the entire user-base making attacks a lot more costly and less lucrative.
3) Control over funds
Having the funds fully controlled by the individual users does not only vastly increase security from hackers, it also gives complete freedom and power over these funds to the traders. Issues, such as exchanges freezing customers’ funds and delaying or even denying withdrawals of these funds is a thing of the past. With decentralized exchanges, users transact directly with their peers without the need for a centralized platform that is in possession of order books and custody.
Drawbacks of decentralized exchanges
If decentralized exchanges are so much better than their centralized counterparts, why isn’t everybody using them already? These are the disadvantages that we need to address in order to paint the full picture.
1) Low liquidity
Decentralized exchanges are still in their early days and only a small percentage of users have switched to trading on these platforms. This is in part due to usability issues still prevalent with current decentralized solutions (see below). As a results, decentralized exchanges only represent about 1% of the total crypto trading volume.
Today, there is not nearly enough liquidity to allow for high-volume trading. Also, low liquidity creates further negative effects such as price slippages, potential for manipulations and generally higher volatility.
One possible way to mitigate these problems is by pooling together various liquidity sources, which is the main objective of the 0x Project.
Creating an account on a centralized exchange in 2018 is a fairly straightforward process. Anyone that can open a Facebook account should also be able to sign up for a crypto exchange and start trading. On the other hand, decentralized exchanges often require users to familiarize themselves with browser extensions (i.e. Metamask), smart contracts and just generally clumsy user-interfaces.
While decentralized exchanges still try to figure out how to improve the user experience for the most basic trading features, their centralized counterparts often provide traders with sophisticated and easy-to-use features such as technical analysis tools, margin trading and stop-loss orders.
The main reason for the missing user-friendliness is the very nature of these exchanges: decentralization. Even though decentralization results in significant benefits, this also means that the design, development, testing and deployment of new features and user-experience advancements takes significantly more time than with traditional exchanges.
Obviously, when placing a trade on an exchange, it should be executed as close to real-time as possible. Otherwise, you risk missing out on unique investment opportunities.
Unfortunately, order processing times are (so far) rather slow on decentralized exchanges. Every trade intention needs to be broadcasted to the network and receive confirmation by miners. The delay between the time an order is placed and when it actually gets executed increases the potential for price-slippages caused by low liquidity further.
Even worse, this delay opens the doors for malicious actors to take advantage of the transparent nature of blockchain technology. Attackers can use the knowledge of certain trades still pending confirmation to place counter-trades with a higher gas amount which are then executed faster than the original trade (“front-running”).
Which decentralized exchanges are there?
While decentralized exchanges only make up a tiny percentage of the overall market trading volume, there are still numerous projects in the space.
IDEX, EtherDelta and Waves DEX are arguably the most established representatives of this category today, however, they also inherent some first-generation usability issues. More recent entrants include Bancor and 0x, which feature greater flexibility, more trading pairs and improved user-experience.
Even though decentralized exchanges are still in their infancy, they show a promising development in the cryptocurrency ecosystem. However, some future technology advancements, such as atomic swaps or the lightning network, might be able to speed up the adoption. Although it doesn’t seem that decentralized exchanges might be replacing their centralized counterparts anytime soon, they are still an important piece of the crypto landscape and show some promising properties that are currently missing in the market.
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