Why Decentralized Exchanges Matter
Centralized cryptocurrency exchanges have a notorious history of being hacked, manipulated, and bureaucratic. From the historic Mt. Gox hack to the more recent issues surrounding Tether, crypto exchanges have had a turbulent past to say the least. Not to mention the often terrible UI and ridiculous fees they charge to get in and out of cryptocurrency. Nevertheless, there have been advancements in the security and usability of crypto exchanges. However, these improvements come at a cost. The funneling of users into the best exchanges is causing a major centralization of digital assets, hindering the decentralized nature of many of them. In other words, if only a few reliable and regulated exchanges are controlling the entry and exit points of digital assets, they yield a huge amount of power over user’s assets and financial information, something many cryptocurrencies seek to avoid. This is the dilemma decentralized exchanges seek to avoid.
What do decentralized exchanges look like?
Most projects with the goal of creating a “decentralized exchange” are trying to build exchange systems where buyers and sellers become their own order book, or at least decide the exact terms of their trades. Users broadcast what they are willing to trade for their assets to a network, and then other users with trading terms that match those of the original proposed trade are automatically matched up. Users are then free to transact the assets directly, rather than through an exchange. Many projects aim to create exchanges where smart contracts facilitate these peer to peer transactions automatically, without fees being paid to a company deciding the terms of the trade. This is not to say that there aren’t fees, but they are split between each trader and are only as much as it costs to facilitate the trade. The vision is a system where assets flow effortlessly from blockchain to blockchain, or an internet of money, where value is as fluid as data. This vision means that decentralized exchanges act more like a new protocol than a website.
Some of the more popular decentralized exchange projects are 0x and AirSwap. 0x is a new protocol that anyone can use to exchange digital assets. When many users use this protocol to trade it creates a decentralized network of exchanges, similar to HTTPS (an adaptation of the Hypertext Transfer Protocol) is used to exchange data on the internet. 0x hosts its own portal where people can exchange digital assets, however the protocol can be used by anyone to, in essence, play host to their own trades. Users host their own order book, with the option of making it public or private. This means developers can build their own custom exchanges on top of the 0x protocol, which is what truly makes the 0x project unique. Finally, it’s worth noting that the 0x tokens are used by both buyers and sellers to pay the fees in each exchange of assets.
AirSwap is another similar project working to facilitate decentralized exchanges between ERC20 tokens (tokens built using the ethereum blockchain), with notable differences from 0x. One main difference is that instead of paying for each exchange of assets, users simply pay a fee in AirSwap tokens to enter the network where they’re able to exchange. Also, AirSwap first matches buyer and sellers, and once this is done, they work out the terms of the exchange before it’s published on the blockchain. This is considered “off-chain” whereas, 0x transactions happen mostly on the blockchain, or “on-chain.”
What do decentralized exchanges specifically stand to gain over centralized ones?
Decentralized exchanges cut out the broker in an exchange, making them significantly cheaper. The specifics about how each decentralized exchange actually does this vary, but for example 0x uses its off-chain protocol to automatically match buyers and execute trades with smart contracts. Users pay the exchanges fees using ZRX, and the transaction is recorded on each of the transacted assets’ blockchains. Ultimately, decentralized exchanges function like a community instead of a business, resulting in significantly cheaper fees.
Privacy is also a major advantage of decentralized exchanges. Many government-regulated exchanges are required to gather a lot of personal information about their users, such as their names, addresses, and SSN, or even photos of their driver’s license when users start transacting larger amounts. With decentralized exchanges there’s none of this. There’s no withdraw limits, reporting personal information, etc. This means that it’s also easier for the unbanked to gain access to cryptocurrencies through these exchanges, because there’s far less documentation required. In sum, users have more control over their money.
The decentralized nature of these exchanges also makes them nearly impossible for governments to shut down, just like cryptocurrencies in general. This means that users don’t have to worry about their funds being seized by the government. In countries where exchanges have been banned, like in China, decentralized exchanges will thrive.
Finally, because there’s no regulation on what coins are listed on the exchange, users can exchange whatever digital assets they have. Decentralized exchanges often tap into untouched liquidity in certain assets, because often times, if exchanges will not list an asset, users of that coin have no means of transacting. It’s often difficult to get an asset listed on exchanges. For these assets, decentralized exchanges are vital. Plus, with the large number of separate, yet popular exchanges, liquidity is heavily segmented in the cryptocurrency market, but if everyone and every asset adopted a single decentralized exchange, there would be unprecedented liquidity and efficiency in the market.
Unfortunately, many of the most promising projects for this outcome haven’t come out yet or have very small user bases, leading to the opposite problem: a lack of liquidity. Also, among the major issues that plague decentralized exchanges right now are a lack of fiat to crypto exchangeability and exchangeability within only one type of blockchain (mainly ethereum blockchains). However, these issues will improve with time, and I’m optimistic about the future of decentralized exchanges.
Sources:
https://hackernoon.com/decentralized-cryptocurrency-exchanges-93039613eeb7
