All You Need to Know About A Decentralized Exchange
Decentralized Exchanges (DEXs) are one of the most promising use cases of blockchain today.
This is because blockchain plays a big role in keeping track of digital assets in a decentralized way and also deals with most of the problems brought about by centralized exchanges. We’ll delve deeper into how exactly it does this at a later stage of this decentralized crypto exchange guide.
At this time, decentralized exchanges manage roughly 1–4% of the total trading volumes, and this is expected to grow between 5–20 times more in the next 24 months assuming that the trading volumes don’t change and there is a constant correlation between the token price and the projected usage.
If you’re looking to understand what DEXs are, and how they operate in the cryptocurrency space, you’re certainly in the right place.
In this decentralized exchange review, we’ll look at:
- What are decentralized exchanges,
- The problems of centralized exchanges and how decentralized ones counter them,
- The problems faced by decentralized exchanges and,
- A few examples of DEX exchanges.
Without further ado, let’s begin!
What is a Decentralized Exchange?
Before I put it in the simplest terms possible, here’s a more detailed explanation of what a decentralized exchange is:
A decentralized exchange is a digital assets market that does not rely on any third party individuals or organizations to hold customer’s funds; instead, the platform offers a direct peer-to-peer trading mechanism that allows the users to process their transactions on an automated system.
This type of exchange runs on proxy assets (representing shares in conventional companies) or through a multi-signature escrow system or tokens (digital assets that represent certain cryptos or fiat currencies) and other solutions currently under development.
So, what exactly constitutes such an exchange?
Let’s find out!
Requirements for a Decentralized Cryptocurrency Exchange
For such an exchange to operate optimally, it is important for the following measures to be in place:
A Decent Number of Users: To ensure there is no manipulation of prices and high liquidity, an exchange needs to have a large network of buyers and sellers.
Fast Transaction Speeds: Markets are fast-paced platforms with changes in prices of assets sometimes being experienced within seconds or minutes. For this reason, traders need to be able to place transactions and have them executed in the shortest time possible.
As Few Trading Pairs as Possible: A stable crypto exchange should have a minimum number of trading pairs to ensure that the market does not open up to arbitrage as this has proven to be detrimental in the long run.
User-Friendly Interface: As much as different investors may have different requirements of what amounts to a user-friendly exchange platform, the average Tommy needs to be comfortable making a trade with lesser complications. On the other hand, a person from Wall Street will most likely prefer a deeper analysis of various assets, including charts and graphs; either way, the level of use of an exchange is to a great extent dependent on its overall interface.
Scalability: Exchanges need to have the right technology in place to be able to handle high trading volumes without unnecessarily straining its operations. In case trading volumes spike, an exchange needs to be able to handle it and not slow down or shut down its operations.
Affordability: An efficient exchange will strive to make it possible for all investors to afford to trade on their platform. And for this to happen, there’s a need for striking a balance between offering sustainable transaction fees while generating the adequate income necessary for sustaining the operations of the exchange.
Despite decentralized exchanges not being fully embraced by all sectors of the economy, there are a couple of platforms that have managed to capture the attention of traders from various factions. Let’s have a look at a few successful exchanges.
Bitsquare: This is an open-source platform that allows users to buy and sell cryptocurrencies such as Bitcoin without the need of having to involve third parties. This ensures that the transactions are executed in a direct way, between the buyer and the seller of a digital asset. The platform relies heavily on one of the common features of DEXs, which is the multi-signature escrow system to enforce transparent trading on its platform.
NXT: This is one of the first 2.0 cryptocurrency projects that enables its user to issue and trade digital assets. However, on this platform, users can only exchange assets for the NXT coin and no other cryptos.
Bitshares and Openledger: Bitshares runs its own native crypto called Bitshares and abbreviates it as BTS on exchanges. The platform allows users to trade Market Pegged Assets with BTS and User Issued Assets. Openledger, on the other hand, is a web-based replica of Bitshares, and both run on the same type of blockchain.
Benefits of a Decentralized Exchange
Low Trading Fees: Decentralized exchanges have very low operating overheads, and this makes it possible for them to keep their trading costs at bay. However, due to the continued traffic in the crypto space, some exchanges are being forced to operate on relatively higher prices due to gas prices. But still, if compared to their centralized counterparts, DEX’s rates are quite manageable.
Enhanced Security: Decentralized systems operate differently when it comes to user security. In a decentralized set-up, users do not hand over the control of their assets to a third-party. This makes it close to impossible for them to expose their data to unauthorized users since they have full control of their resources.
Easy to Manage Assets: The very logic of decentralized exchanges is to allow users to have full control over their portfolio. With this functionality, users can trade and use the funds to transact on a different platform, pay a friend, or purchase a product. This is more convenient compared to centralized exchanges that take longer periods between deposits and withdrawals. Additionally, most decentralized exchanges are e-commerce-friendly, allowing you to purchase products or services using various cryptocurrency wallets.
In addition to these benefits, here are a few downsides of centralized exchanges that are actually benefits of decentralized exchanges:
Scalability of Transactions: A typical decentralized Bitcoin exchange such as Coinbase can receive up to 250,000 sign-ups each day leading to an increase in trading volumes of an upward of 40% per day. When central exchanges are faced with similar circumstances, they end up with problems since they have a central computing system that ends up straining its operations.
Decentralized exchanges are also highly scalable to minimal barriers to entry as well as favorable trading terms. This enables these exchanges to undergo massive growths in relatively short time spans.
Security Issues: All funds collected by central exchanges are managed centrally; this increases the risk of an attack on those areas that are known to store such assets. And in case they store digital assets in such systems, hackers are likely to have a field day.
But unlike their centralized counterparts, decentralized exchanges are secured by a team of competent persons from all walks of life. This ensures that the best of the talent is used to secure exchanges using minimal resources.
The Downside of Decentralized Exchanges
Limited Exchange Pairs: A lot of times you’ll realize that an exchange doesn’t allow you to directly trade one coin for another, especially when the pair is not among the major coins such as Bitcoin and Ethereum. This sometimes forces users to buy Bitcoin first to use it to buy whatever coin they need to acquire. Acquiring BTC or ETH first and then obtaining another coin or token may lead to higher transaction fees and delayed transactions. Despite there being an effort to put in place corrective measures by some networks such as Bancor in this regard, most cryptos are yet to implement the same on their platforms.
Trade Collision: The blockchain works in a manner that it collects transactions into what seems like “blocks” and then processes them. In a way, a number of protocols take 5–10 seconds to execute transactions and when more than one command is sent out, only one gets executed at a time, and not simultaneously. This leads to a trade collision and as the crypto space continues to attract more users, the problem is likely to escalate.
Front-Running: There is still need for decentralized exchanges to develop a technique for matching buyers and sellers, whether from third-parties or from internal developments. The tech will help prevent “outsiders” finding unconfirmed orders and undercutting them to make quick profits. Ox project has been trying to explore a possible solution of providing a semi-decentralized platform. But whether that will work or not, still remains to be seen.
To make it easier for you to wrap your head around this guide, you need to understand that the most unique feature of a decentralized exchange is that users have full control over their digital assets and are free to broadcast their portfolio to potential buyers. There are no central servers and all security and privacy of transactions are controlled entirely by each user.
In the end, it makes more sense to have ultimate control over what you own – don’t you think?