What Are Decentralized Exchanges and Why Are They Important?
By: Hannah Oreskovich
Whether you’re in the crypto space or you’re just generally interested in blockchain technology, it’s likely you’ve heard the 2018 buzz around decentralized exchanges, or the “DEX” ecosystem.
The DEX space often promises better security, a more trustless exchange environment, and even an expanded world of investment products thanks to MARKET Protocol. So what is a decentralized exchange and why are DEXs important in creating a more open financial system?
First, it helps to understand what defines a centralized exchange. In a centralized exchange- like the New York Stock Exchange or Coinbase- a third party handles asset custody and order books. This means you as the user have to trust that the third party will protect your assets and whatever personal data you may be required to give them to use their platform. Due to the way they store the funds and information, they represent a single point of failure. Unfortunately, hackers frequently target centralized exchanges for these reasons, as we’ve seen in hacks against the likes of Mt. Gox, Bitfinex, and Coincheck. Some individuals have lost millions of dollars because of these hacks.
With a centralized exchange in possession of both assets and personal data, another issue that arises is locked funds. Centralized exchanges can, without reason, lock an individual’s assets for an extended period of time. This can have major implications for traders in the cryptocurrency space who can lose their earnings as a result of not being able to buy or sell assets they “hold.” Much like the issue of hacker security, locked funds can also result in losses for users in a centralized exchange.
It’s also important to know that centralized exchanges essentially settle in IOUs (“I owe you”), which means that users are forced to trade and transact with representations of their assets and not the actual assets themselves. So for example, if you send bitcoin (BTC) to a friend on Coinbase, all your friend receives is an IOU from Coinbase until they decide to actually withdraw the BTC. This means that neither you nor your friend is really in control of your assets when using a centralized exchange.
If the centralized marketplace was hacked or if there were issues of market manipulation or hardware failure, the fact that users aren’t really the custodians of their own funds could present major security, withdrawal, and even increased latency issues. For all of these reasons, centralized markets leave much to be desired in the investment world and can be a rather inefficient means of trade and transaction.
This brings us to the world of DEXs. In a DEX, the third party handling assets is eliminated and replaced with smart contracts. Computer scientist Nick Szabo first defined smart contracts in 1996 as, “a set of promises, specified in digital form, including protocols within which the parties perform on these promises.” Thus, smart contracts in a decentralized exchange are the digital protocols that enforce or facilitate contract negotiation. Instead of having a third party holding your funds, you remain the custodian of both your assets and your personal information.
The exchange itself is protected through a decentralized network of nodes that secure the native blockchain. This provides a more secure market environment since the single point of failure of the third party institution is omitted, making it much harder for hackers to attack. In fact, as of this writing, decentralized exchanges have yet to be hacked at all. As an added plus, the DEX environment of trustless custody of funds also removes the locked assets issue of a centralized exchange entirely; the user is always in control of the funds.
The IOU problem of a centralized exchange is also removed in a DEX. It’s a direct, trustless transaction that is settled immediately through smart contracts instead of upon fund withdrawal. This allows for more efficient trades and transactions in the investment marketplace.
Through decentralization, MARKET Procol is greatly expanding the world of investment products available beyond the typical fiat to cryptocurrency exchange. MARKET Protocol, a decentralized derivatives protocol, is designed to deliver on-chain, cross-chain, and even off-chain relationships. It allows a user to gain price exposure to assets like oil, stocks, bonds, bitcoin, and even digital gold by using ERC20 tokens as collateral. For traders using MARKET Protocol, there is no need to take custody of the underlying asset or constantly move coins from wallet to wallet at all.
With MARKET Protocol, traders settle contracts based on the value of the underlying asset, creating relationships like SALT/ETH or TSLA/DGX. The protocol allows traders to hedge utility tokens as well. All of this can be done securely with a trustless custody of funds, and settled without a single point of failure thanks to a decentralized exchange like DDEX.
The Growing Open Financial System
Though the current DEX ecosystem can be harder initially for investors to familiarize themselves with since it lacks the user-friendly infrastructure of many centralized exchanges, DEXs have some clear advantages over centralized exchanges in terms of security and trustless custody.
With MARKET Protocol, DEXs will even have an expansion of available financial instruments. Still, it’s important to remember that currently both centralized and decentralized markets play a critical role in this space. As Co-Founder & CEO of Coinbase Brian Armstrong recently said, “… there will be both centralized and decentralized products which help create an open financial system.”
With that as the goal, it will be interesting to see how the DEX ecosystem continues to evolve and solidify its importance in the expansion of the cryptocurrency and blockchain industries.