Decentralized Cryptocurrency Exchanges: A Comprehensive Overview
Decentralized Exchange Series (5 part series — PART 1)
Cryptocurrency exchanges are for all intents and purposes, the backbone of the cryptocurrency market. Evert tradable asset needs a market where it can be traded and that is what these exchanges do, they facilitate cryptocurrency commerce by virtue of their platforms service solutions. Within the world of cryptocurrency exchanges, there are basically two types of exchange platform; centralized and decentralized. The focus of this article is on decentralized cryptocurrency exchange platforms.
What are Decentralized Cryptocurrency Exchanges?
To understand what a decentralized cryptocurrency exchange is, it is necessary to first know what a cryptocurrency exchange does. Within the digital currency market, a cryptocurrency exchange is a platform that enables the conversion of fiat money to cryptocurrency and vice-versa as well as the conversion of different cryptocurrency pairs.
A decentralized cryptocurrency exchange is one in which the architecture of the platform has no central controlling server (or bundle of servers). As a result, no third-party escrow intermediary is required to hold the funds of the participants in the exchange transaction.
Differences Between Centralized and Decentralized Cryptocurrency Exchanges
· Control of Funds
Users of centralized exchange platforms make deposits to the exchange in order to facilitate an exchange/trading transaction. These funds are controlled by the centralized exchanged service. This means that order-books, as well as custody, is firmly in the hands of the centralized platform service
In a decentralized cryptocurrency exchange platform, users transact directly with their peers without the need for a central server. There is a no centralized platform service that is in possession of order books and custody. Funds are therefore controlled by the users and participants in the platform.
Some centralized platforms used to allow anonymous trading accounts on their platforms. However, the raft of government regulations that have sprung in recent months has led to the adherence to strict KYC and AML laws. It is difficult to trade anonymously on a centralized cryptocurrency exchange platform.
Decentralized cryptocurrency exchange platforms are all about anonymity. Consider them to be the distributed blockchain-equivalent of centralized exchanges.
Users of centralized crypto exchanges rely on the platform to authenticate and authorize their transactions. In a way, the platform is a third-party intermediary providing trusted crypto exchange services.
In the case of decentralized crypto exchanges, there is no need to rely on a third-party intermediary. By means of smart contracts and a number of blockchain protocol implementations, the entire system is built to provide trust-less authentication and authorization of crypto exchange transactions.
Merits of Decentralized Cryptocurrency Exchanges
1. Faster and Cheaper Transactions
Potential to provide a platform that facilitates faster, cheaper and more cost-effective crypto exchange/trading transactions than centralized exchanges. The removal of the third-party authenticator drastically reduces fees and lag time before buy/sell orders are processed.
2. Potentially More Difficult to Hack
Less susceptible to malicious attacks and hacks than their centralized counterparts. There have been a number of high-profile hacks on major centralized crypto exchange platforms that show just how susceptible they are to digital attacks. Because it is a decentralized exchange, there is no single point of entry, just like a blockchain. As such, a hacker will need to compromise more than half of the network to be able to commandeer the system.
3. Seamless Integration with Secure Hardware Wallets
This is a major advantage on the part of decentralized exchanges. A number of decentralized exchanges offer seamless integration with popular hardware wallets like Trezor and Ledger Nano S which ensures a much safer transaction space. Users can send coins directly from their hardware wallets to the smart contract of many decentralized exchanges. In centralized exchanges, this isn’t possible as users have to manually enter private keys in order to move coins from hardware wallet to centralized exchanges. This puts the user at risk of malicious phishing as well as keylogging attacks.
4. Funds Controlled by Users Rather Than a Central Corporation
A decentralized exchange is owned and controlled by all the participants so there is no central corporation that has custody of customer deposits. The control of the money is always in the hands of the users since the network uses a P2P network architecture. Transactions occur between peers in the network by means of smart contracts which can only be controlled using the private keys of the participants. Users control their private keys as well as their funds at all times in a decentralized exchange.
Demerits of Decentralized Cryptocurrency Exchanges
1. Difficult to Use
There is a reason why centralized exchange services like Coinbase and Binance are popular, they are easy to use. The plethora of smart contracts that need to be navigated to use many of these decentralized exchanges can be dizzying even for a tech-savvy individual not to talk of someone who isn’t familiar with smart contracts. Centralized exchanges have easy to understand tabs and buttons on their websites whereas many decentralized exchanges have a confusing exchange dashboard that takes some getting used to.
2. Lack of Robust Features and Functionalities
Most decentralized exchanges only support the basic cryptocurrency exchange function. More advanced trading tools and features are conspicuously missing which isn’t the case with their centralized counterparts. The absence of margin trading, stop loss, as well as a host of other trading features is one of the reasons why they haven’t yet achieved much popularity in the wider cryptocurrency commerce environment.
A Look at a few Decentralized Cryptocurrency Exchange Platforms
0x Protocol is a decentralized exchange platform for ERC20 tokens that facilitates instant off-chain ordering relays together with on-chain settlements. The reason for the dichotomy between order and settlements in the 0x Protocol is due to the desire to cut down on ether gas fees and make decentralized exchange transactions more efficient. All non-settlement activities are essentially handled outside of the blockchain with the actual value exchange activity occurring on the blockchain.
The 0x Protocol is made of order broadcast protocols called “relayers.” The function of these relayers is to broadcast orders to the network. The broadcast orders can then be acted upon by a taker who fulfills the order and the trade/exchange is executed. The relayer earns a fee in ZRX token which is the native token of the 0x Protocol. Apart from broadcast order, point-to-point orders that are targeted at a specific taker can also be carried out in the 0x Protocol.
Kyber Network is a decentralized exchange platform that enables instant on-chain exchange of cryptocurrencies. It shares a lot of similarities with the 0x Protocol in terms of what it aims to achieve with the main distinction being that all of its activities are carried out on-chain. Kyber Network also aims to address the low liquidity problem that has affected a number of decentralized cryptocurrency exchanges which makes them unable to facilitate trading activities on the go. The project also attempts to minimize the high cost associated with maintaining the order book of a decentralized exchange on the blockchain.
One integral part of the Kyber Network ecosystem is the Dynamic Reserve Pool which is used to maintain liquidity. The network is designed such that there are always a number of entities in the pool so that centralization doesn’t occur and the exchange rates are kept competitive. Upon receiving an exchange request from a user, the smart contract protocol facilitates the exchange using the best available rate for the user.
Preventing centralization is a key aspect of the Kyber Network architecture. As a result, a number of safeguards have been put in place to prevent the occurrence of centralization within the network. The native token of the Kyber Network is called the Kyber Network Crystal (KNC) which is an ERC20 token.