Crypto 101: What is a decentralised exchange (DEX)?
Your beginner’s guide to trading on a decentralised exchange.
Most people who are learning more about cryptocurrency as an asset class will come across the word “decentralise”.
After all, cryptocurrency is BIG on decentralisation — removing power and control from a central authority, having full ownership over their assets, and cutting out the fees that are paid to intermediaries. Hence, when users want to trade this asset class, “decentralised exchange” is the intuitive answer.
DEX are peer-to-peer marketplaces not controlled nor governed by any intermediary. There is no “middleman” between buyers and sellers and trades are executed as long as the conditions (price, quantity etc.) are met, through the use of smart contracts (coded self-executing agreements). The exchange itself is merely a platform for the buyers and sellers to buy/sell cryptocurrencies directly with each other.
Picture this: Your neighbour exchanging a block of butter for a carton of milk with you. No middleman was involved in this exchange.
DEX — the double-edged sword
The number of users of decentralised exchanges is growing at an exponential rate. It is interesting to note that many of the factors supporting the use of DEX also form the case against its usage.
Top 5 DEX based on total value locked (TVL) by DeFi Pulse
Ownership
As mentioned above, one of the main draws of cryptocurrency is taking ownership of one’s own assets. Instead of relying on an intermediary to “safekeep” your financial assets (as typically seen in traditional finance), trading through DEX allows you to be your own custodian.
In order to trade through DEX, you are required to set up a “decentralized cryptocurrency wallet” that is able to interact with the network of the DEX.
This wallet holds the cryptocurrencies that you had purchased without any third-party institution involvement. You own the private key of the wallet and nobody else knows this private key unless you disclose it. This is as opposed to CEX where the users do not know the private key to the wallets and the exchange also serves as the custodian to the assets. Some examples of decentralised cryptocurrency wallets are Metamask, Trust Wallet and Argent Wallet etc.
While having ownership of your private keys may be attractive to some, one of the drawbacks is not being able to recover the cryptocurrencies in the decentralized cryptocurrency wallet to the extent you lose access to the wallet.
It is estimated that 20% of the Bitcoin in circulation currently are lost due to users forgetting the passwords to their wallets (worth about $150 billion). You are entirely responsible for your own cybersecurity measures to reduce the risks of being hacked.
Privacy
Using a DEX does not involve a sign-up process and there is no need to provide any personal information to interact with these platforms. Traders can access a DEX as long as they have a wallet that is compatible with the exchange. As no personal information is required to be provided, this allows users of DEX to remain anonymous. As such, DEX is highly preferred to CEX for people who want privacy.
Due to the privacy that comes with using DEX, it becomes easy for people to abuse the platform to conduct illegal monetary transactions such as money laundering, terrorism financing and bribery etc. This is often the biggest argument against decentralised finance (DeFi) and DEX being a tool to support these illegal activities.
Further, with privacy, it is extremely challenging for you to prove that a particular wallet and the assets held in the wallet belong to you when you are unable to access your wallet.
Fees
One of the many good things that DEX aims to deliver is low trading fees. DEX looks to provide trading platforms where traders are able to trade at a much cheaper rate than CEX at a few cents per trade, without compromising on the speed and quality of the service.
Trading on DEX also provides more customisation to the user. The user can select the speed of the transaction and indicate how much fees he/she wants to pay for that transaction to the network validators. The higher the fees, the higher the likelihood the transaction will be selected to be processed by these validators.
However, not all DEXs are fulfilling the promise of cheap trading fees. The trading fees associated with trading on DEX are determined by the network itself. Depending on the network, the trading fees when trading on DEX may be more expensive than CEX. When a network is congested due to high transaction volume as compared to the capacity of the network, trading fees can be much higher.
For example, a transaction on the Ethereum network costs USD $100 per trade at the time of writing and the same transaction is much cheaper on most CEX. As you can see from the screenshot above, 4 out of the top 5 DEX listed are operating on the Ethereum network.
Coin availability
Most cryptocurrencies, especially the new and obscure ones are available on DEX. As CEX normally have a more stringent listing process, only selected projects are listed on CEX. This means that if the cryptocurrency pair that you are looking to trade is not available on CEX, you will have to turn to trade on DEX.
Given that most of the new cryptocurrencies start trading on DEX and there is no intermediary assessing the legitimacy of a cryptocurrency (in terms of liquidity and volume), traders who use DEX must be extra careful of the cryptocurrency they invest in.
While new cryptocurrencies with small capitalisation promise greater returns, the risks are also higher. Due to the anonymity that DEX provides and the stringent listing process by CEX, scammers usually operate on DEX and there are malicious cryptocurrency scams happening on DEX where developers abandon a project with investors’ funds. These people can repeat such scams over and over again and may never be caught.
Practical aspects of using DEX
Converting Fiat currency to Cryptocurrencies
As a majority of the population receive their income in fiat currency, there is a need to convert the fiat currency to cryptocurrency for further trading. The most straightforward way of doing that is through a CEX.
After this conversion, the cryptocurrency can then be transferred to the decentralised cryptocurrency wallet to trade on DEX. Some DEX and decentralised cryptocurrency wallets offer fiat to cryptocurrency conversion, but the fees are often way higher than what CEX charges. Another option is to arrange for a peer-to-peer transfer with other users separately. Overall, this makes DEX trading more inconvenient and a bigger barrier of entry for investors who are new to cryptocurrency investing. The transfer fees also add up over time.
User interface
The interface of many DEX out there currently is more complicated and less user friendly than CEX. Their design and features are not similar to the traditional exchange platforms that most people are used to. The added customisation feature in DEX may also be confusing to some users. Such an interface poses entry barriers to new users to start using DEX. There are changes to the DEX space every day and developers are already working towards simplifying the platforms with more people starting to use DEX.
Last words (for now)
There is a misconception that trading on DEX is riskier than trading on CEX. This may be because many of the cryptocurrency scams happen on DEX. Scams on DEX are indeed more prevalent due to the privacy it provides and the availability of different cryptocurrencies.
Further, with an intermediary in CEX, some people have the impression that the intermediary will bail them out if anything happens. While the intermediary may bail users out, it is not guaranteed, and they are not obligated to do so.
Most (if not all) scams occur because of user carelessness or hoping for extreme returns. Ultimately, the trading platform is only a tool. The safest thing is to be extra cautious and do your own due diligence before any investments. The whole DeFi and DEX space is evolving rapidly towards providing better user experience and incentives. The future definitely holds bright for this space!
Happy crypto-ing! Remember to DYODD!
Text by Yong Xin Kwek
