What exactly is a DEX?– A comprehensive walk-through
Introduction
It’s no longer a question on the fate of digital currency. Not with the prevalence of worldwide consumers and skyrocketing adoption of cryptocurrencies. In fact, we have gone past such times.
It’s now a matter of how we can adapt to and easily navigate through the dynamic, intriguing and dazzling world of cryptocurrency.
It is even more pertinent now that we know fully well that the strength of every currency, whether traditional or digital, depends on its use case and market value.
All hail the pandemic year 2020 that triggered the gradual emergence of investment platforms and the high-rise demand for decentralized finance (DeFi). Which in turn, to a certain degree, brought about the need for exchange platforms — either centralized, decentralized or nascent hybrid exchanges — which would serve as a linkage between buyers and sellers, and also as an ultimate solution to crypto users’ transaction needs.
However, centralized exchanges brought a lot of notable risks to the doorsteps of crypto investors, ranging from time-frame issues to the overbearing stress of regulatory procedures to recurrent scams and hacks that greatly affected the crypto industry in tremendous ways. Not only did it call for a search for alternative measures but it also, one way or another, led to the explosive user base of decentralized exchanges. Even the larger ones like Uniswap topped the chart with $1 billion in aggregate trading volume in the past year.
What Are Decentralized Exchanges?
Decentralized exchanges (DEXs) are online trading platforms that allow cryptocurrency buyers and sellers to engage in peer-to-peer transactions through the help of smart contracts, without giving up the custodial power of their assets to a third party or middle-man.
As opposed to centralized exchanges (i.e. Binance, Bitfinex, Kraken etc.) where traders give over their funds to the exchange which acts as an intermediary and purposefully maps out the issuance of IOUs to users for trading in the platform, DEXs strive towards the elimination of any middle-man souvenirs or third-party supervisors. These issues encountered in centralized platforms might have led to the growing and still growing preference of decentralized exchange by cryptocurrency users. According to Forbes, the value of decentralized exchanges climbed from $1.52 billion to a peak of $4.32 billion between June and July of 2020 — which is, by all indication, a whopping increase.
How Does a Decentralized Exchange Work?
The thematic difference between DEX and CEX is the systematic pattern of operation. Whereas centralized exchange doesn’t need to happen on an on-chain framework but, however, uses its own database to solve its user’s transaction needs, decentralized exchange is almost entirely the opposite, weighing upon two categorical spheres: orderbook-based chain (on-chain and off-chain) and Automated Market Makers. Each sphere focuses its assets on either a single blockchain like Ethereum or cross-chain DEXs.
Orderbook-based Chains
Orderbook-based chains are either done on-chain or off-chain.
In DEXs that make use of on-chain order books, every command is written to the blockchain and needs the confirmation of the miners for the transaction. This means that once you place an order as a buyer or seller, you still have to wait for your message to be relayed to the blockchain by a miner, thereby making the trading process incredibly slow. This sometimes can lead to misrepresentation of orders and front running — front running is the process whereby a miner, even though aware of your pending order, uses your information to process another transaction without confirming it. Popular examples are Bitshares and Stellarterm.
In off-chain order books, every command doesn’t have to be written to the blockchain. Rather the hosting and maintenance of orders are done on a separate entity, which is usually centralized, that takes custodianship of the order book. They face the same risks as on-chain order books. Popular examples include 0x, Etherdelta, Binance DEX, and IDEX.
Automated Market Makers (AMM)
AMM-based DEXs are notably the most dominant of the DEXs market. It eliminates any idea of order books and miner’s confirmatory issues, as seen in the previous sphere. Instead, through the aid of smart contracts, it uses different parameters to generate liquidity pools that are reorganized and used for the execution of trades. It’s as user-friendly as centralized exchange, and fights with CEXs for the top spot. Uniswap, PancakeSwap and SushiSwap are popular implementations.
Advantages and Disadvantages of DEX
Advantages
Different features have led to the increasing user base for DEXs, and they are:
- Strict Regulatory Procedures
Centralized platforms are quite strict with their regulatory demands. They task their users with lengthy sign-ups, compliance of KYC (Know-Your-Customer) procedures, and submissions of legal and personal documents to prove their identity. These documents when they are not made available means that the supposed user’s asset becomes lost and irretrievable in the crypto space. This is often a distressful task for traders. Since decentralized exchanges are not entirely hosted by a central entity, and thereby give full custodial authority to the user, they oftentimes have no use for the luggage of identity verification. All that’s needed seems to be a registered crypto wallet.
- Security Reasons
Another shortcoming of centralized exchanges is their custodial model of operation that makes them heavily susceptible to security breaches such as hacking and scam. That’s because they maintain their liquidity pools from keeping their users’ funds on the exchange. A major example of this phenomenon is the Mt. Gox and Coincheck theft that prompted the loss of $472 million and $530 million respectively.
In decentralized exchanges, there are no third-party risks because users are at the frontier of their security. Aside from that, it’s almost uninteresting for thieves and scammers to steal from an individual wallet, unlike a central authority.
- Extended Integration Schemes
DEXs have pushed forward different integration schemes that allow users to engage with the complex nature of the blockchain industry. These include the ability to assess NFTs and decentralized applications (Dapps) for financial projects, be it loan and savings services. Even going as far as allowing the sale of centralized unlisted tokens on the exchange.
Disadvantages
Although decentralized trading platforms have a wide range of unobjectionable advantages, there are certain drawbacks that ought to be considered before usage:
- Efficiency of Use
DEXs have slow transaction speed. This lagging in time can lead to ‘price spillage’ and ‘payment of bulky exchange rates’ for traders. They have limited features to mitigate transactions like stop limit orders, futures, trade margins etc. They are not as user-friendly as centralized trading platforms that use both on-chain and off-chain to smoothly navigate transactions. Also, in some way, CEX provides a better learning atmosphere for new crypto investors.
- Liquidity and Trading Volume Issues
Liquidity depends on how easily and quickly a trader can buy or sell assets at a commendable price. This means that the greater the liquidity the higher the trading volume. DEXs often have lower liquidity than CEXs, which sometimes makes it hard for their users to find trading partners and forces them to sell their assets at an unfair price. This is because, unlike CEXs, DEXs rely on the counts of users using the exchange at a given time.
The Stopping Line
More decentralized platforms have emerged. More are still emerging. Each building a strategy that will overpass the glitches found in previous ones. It’s so delightful to watch: the evolution of DEX platforms, both in usability and technical aspects. Who knows what the future holds?
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