Understanding Decentralized Exchanges; Beginner’s Guide.
Blockchain can potentially eliminate the need for intermediaries by creating a trustless, centralized system. Yet, centralized exchanges seem to disprove this hypothesis. Perhaps this explains the current boom in popularity of decentralized exchanges.
People can trade cryptocurrencies directly with each other on decentralized exchanges without the need for a central authority or middleman.
Decentralized exchanges allow users to exchange their currencies at any time (because liquidity is always available) and without any middleman (through the use of a smart contract).
See also: What is Ethereum the Merge?
What is a crypto exchange?
Crypto exchange services enable users to buy and sell their cryptocurrency (or fiat currency). By serving as an intermediary between the buyer and seller, they facilitate the exchange of cryptocurrencies for fiat or other cryptocurrencies.
Centralized Vs. Decentralized Exchanges
A centralized exchange (or CEX) is a website where users may buy, sell, deposit, and withdraw cryptocurrency. Users use custodial wallets, which means the exchange is primarily responsible for protecting users’ cash. Binance, Huobi, Coinbase, Kraken, and FTX are just a few examples of the many centralized exchanges available.
The earliest exchanges to join the market were centralized ones. Therefore, their trading volume and popularity are greater. However, this is changing due to the recent rise of decentralized cryptocurrency exchanges.
DEX stands for “decentralized exchange” and is a peer-to-peer platform that facilitates users’ direct exchange of cryptocurrencies. They allow traders to buy and sell cryptocurrencies with one another on a blockchain through the use of smart contracts to execute the trades.
Explaining the Mechanisms of Decentralized Exchanges
A decentralized exchange does not assume control of its users’ coins but employs “smart contracts,” which are protocols that are automatically performed to facilitate trade between individuals.
DEXs facilitate trades in three ways: an on-chain order book, an off-chain order book, or an automated market maker approach.
Automated market makers, or AMMs, do not use order books. On centralized exchanges, if you have BAT tokens and wish to acquire Polkadot, you will need to find another user who also has BAT tokens and wants Polkadot and is prepared to trade with you at an agreed price using order books. AMMs replace this system with price-setting algorithms.
As a standard practice, decentralized exchanges use “liquidity pools” to make this possible. This effectively entails the practice of paying users to hold some of their coins in a smart contract, which may then be used for transactions. Therefore, individual users play a pivotal role in making trades possible.
With a single blockchain, a decentralized exchange can easily keep track of all cryptocurrency trades. Therefore, numerous decentralized exchanges are based on the Ethereum blockchain and can trade Ethereum and Ethereum tokens.
Why Decentralized Exchanges Are Rising in Popularity
I’m so SICK of having to do unnecessary biometrics, pins, 2FA, KYC, and other verifications EVERY SINGLE TIME I need to do a simple operation on an exchange! We need a major DEX revolution that gives power to the user. (Anonymous User)
To understand why Dexes are becoming more popular, let’s examine one popular centralized exchange (Coinbase) and another popular decentralized exchange (Uniswap).
Coinbase is an official company with offices and employees. Hence it falls under strict KYC or knows your customer policies. Uniswap, on the other hand, has no real company or office, just a team of distributed developers who built the protocol for the exchange using smart contracts on the Ethereum blockchain.
Their ultimate goal is to eventually move the governance of this protocol to token holders of the Uniswap native token (UNI).
Because they are decentralized, no regulations apply to them, there’s no KYC requirement for customers and anyone can access the exchange on a permissionless basis. This is about the most appealing feature of Dexes and the major reason they have grown in popularity over the years.
Advantages Of Decentralized Exchanges Over Centralized Exchanges
- Privacy
New users can use a centralized exchange by signing up, providing some personal information, and depositing some cash. Sometimes, this might take an unreasonable amount of time.
These centralized cryptocurrency exchanges are required to implement AML and KYC by the authorities and are, therefore, subject to regulation. Where does an exchange keep all of this information? Directly on their servers, which are also vulnerable to hacking.
If you care a lot about privacy, then centralized exchanges might not appeal to you simply because you have a lot of personal information stored on their database. Hence, Decentralized exchanges might work better for you.
2. Not Your Keys, Not Your Coins
On centralized exchanges, you do not have your private keys because your coins are stored in a hot wallet on the exchange’s server. Even though your coins are shown on the exchange, you do not have full possession of them. The exchange acts as a custodian by using custodial wallets.
This means they can censor you and confiscate your coins without recourse.
3. Hacks
Users’ cryptocurrency is stored in “Hot wallets” on centralized exchanges. The issue, though, is here. Cybercriminals frequently target these hot wallet balances.
Many cryptocurrency exchanges (CEXs) have been attacked in the past, including Binance and BitMEX, and sadly, we keep hearing about other CEXs that have been seriously affected.
4. Transparency
Despite their regulations, centralized exchanges’ trading system is still not completely transparent, which means they are still susceptible to manipulations from whales and big account holders.
With decentralized exchanges, you can verify all trades on the blockchain. You can look at the historical actions in the past since everything is publicly accessible on the blockchain.
5. More tokens to choose from
Compared to Coinbase, Uniswap offers more tokens, over 1500 tokens that users can trade. This is way more than you can find on most centralized exchanges. Also, Uniswap offers relatively cheaper prices compared to most centralized exchanges.
6. More ways to make money
As a user, you can potentially profit by providing liquidity on decentralized exchanges like Uniswap via different Uniswap pools. Uniswap charges about 0.3% as trading fees, and these funds go to liquidity providers.
7. Integrations
Uniswap has over 200 Defi integrations with other projects. This is almost impossible with centralized exchanges.
Disadvantages of Decentralized Exchanges
1. Permissionless can be dangerous
Since most decentralized exchanges are permissionless, anyone can launch a token on the smart contract. This also means fake projects can sometimes be launched, and users can get rug pulled. This is why you should do proper research before investing in any project.
2. Risk of smart contract getting hacked
There is also the possibility of a smart contract being compromised or malfunctioning in some manner. If this occurs, the protocol may lose users’ confidence.
3. Only Ethereum-based projects can be traded
With Uniswap, for instance, you can only trade Ethereum-based tokens since the exchange is built on the Ethereum blockchain. Coinbase, on the other hand, can trade tokens from multiple blockchains.
4. High Gas Fees
Congestion on the network can cause gas fees to skyrocket on the Uniswap protocol. However, pancakeswap and other dexes provide a great alternative for Uniswap users.
5. No direct Crypto to Fiat Conversion
Finally, while you can easily convert your crypto to fiat on centralized exchanges, you cannot do so on decentralized exchanges. You will have to fund your wallet first and then connect it to a decentralized exchange to be able to make transactions.
See also: The Story of Bitcoin: The Novel Technology Made by an Invisible Creator.
Conclusion
People can trade cryptocurrencies directly with each other on decentralized exchanges without the need for a central authority or middleman. Decentralized exchanges allow users to exchange their currencies at any time (liquidity is always available) and without any middleman (through the use of a smart contract).
With a single blockchain, a decentralized exchange can easily keep track of all cryptocurrency trades. Because they are decentralized, no regulations apply to them and there’s no KYC requirement for customers. This is about the most appealing feature of Dexes and the major reason they have grown in popularity.
With decentralized exchanges, you can verify all trades on the blockchain. You can look at the historical actions in the past since everything is publicly accessible on the chain. Uniswap charges about 0.3% as trading fees, and these funds go to liquidity providers. It has over 200 Defi integrations with other projects.
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