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What is a Decentralized Exchange (DEX)?



SUMMARY


A decentralised exchange (DEX) is a peer-to-peer (P2P) marketplace that connects buyers and sellers of cryptocurrencies. Unlike centralised exchanges (CEXs), decentralised platforms are not pledged, meaning a user retains control of their private keys when transacting on a DEX platform. In the absence of a central authority, DEXs use smart contracts that self-execute under certain conditions and record each transaction on the blockchain. These trustless, secure transactions represent a growing segment of the digital asset market and are leading the way for new financial products.



CONTENT


  • What is a decentralized exchange?

  • Advantages of DEXs

  • Disadvantages of DEXs

  • Exchanges of the future


WHAT IS DECENTRALIZED EXCHANGE?


Traditional stock and fiat exchanges bring buyers and sellers together in one place, making it relatively easy for traders to enter and exit positions by providing liquidity to the market. Greater liquidity increases the likelihood that there will be someone on the other side of a trade who is willing to trade with a buyer or seller. While cryptocurrency exchanges (CEXs) facilitate trading in blockchain-based digital assets, the platforms themselves can be centralised or decentralised. Centralised exchanges act as trusted intermediaries in trading and often act as custodians, storing and protecting your private keys and therefore your money.


Leading centralised crypto exchanges facilitate every aspect of trading digital assets: from security to fair market prices to regulatory compliance, consumer protection and access to the latest digital assets. Most CEXs require you to deposit fiat or cryptocurrencies into an exchange-managed crypto wallet before you can trade. You can transfer money from your exchange wallet to an external crypto wallet. You can also exchange cryptocurrency for fiat and transfer money to your bank account. As of September 2020, CEXs accounted for around 95% of all crypto trading volume.


On the other hand, decentralised exchanges (DEXs) have emerged as an alternative to CEX platforms, offering peer-to-peer (P2P) trading and access to the emerging decentralised finance (DeFi) sector. There are now more than 35 decentralised exchange options. Platforms such as Uniswap, Kyber and Bancor have established themselves as decentralised alternatives to centralised exchanges. In January 2019, DEX platforms accounted for only 0.11% of global trading volume, but this figure has since risen to 6% in August 2020. The monthly trading volume on decentralised exchanges was $20 billion in October 2020.


DEX platforms take a different approach to facilitating the buying and selling of digital assets. Instead of using an intermediary organisation to process transactions, DEXs use the functionality of self-executing smart contracts. Because there are no middlemen, DEXs have a non-custodial framework where you retain control over your private keys and cryptocurrency funds. Most DEXs have no counterparty risk, meaning they have no credit default risk and do not follow KYC (Know Your Customer) or AML (Anti-Money Laundering) protocols.



ADVANTAGES OF DEXS


Even in the earliest stages of development, decentralised crypto exchanges offer advantages that impact the custody and diversity of digital assets, transaction confidence, trading fees and investor privacy.


Custody:

DEXs do not require custody, meaning traders do not have to give up control of their private keys to conduct transactions. Instead, external wallets interact with DEXs and trades are executed by smart contracts themselves. Centralised exchanges, on the other hand, play the role of custodian of your funds by controlling your private keys. This requires you to give up control of your private keys, but centralised exchanges offer trust and security.


Diversity:

As of October 2020, there were over 7,400 cryptocurrencies on the market. CEXs control which cryptocurrencies they list and usually only list those with sufficient trading activity, distribution and effective security standards to ensure profitability and legal compliance. Many altcoins are only accessible through DEXs, where P2P transactions can take place without high trading volumes. This enables broader engagement in digital assets and promotes financial inclusion.


Trustless transactions:

On CEXs, every transaction is monitored and recorded by a central authority, the exchange itself. Using smart contracts, DEXs execute and record trades on the blockchain, enabling trustless transactions. And because DEXs do not hold funds, they are less vulnerable to hacking.


Lower fees:

Decentralised exchanges work by using self-executing smart contracts. Since there is no intermediary, DEXs use the same "gas" fee structure as the Ethereum blockchain they are built on. DEXs charge a low fee, around 0.3% for exchanges like Uniswap. Although these fees fluctuate depending on the load of the network, they are far below the costs incurred by centralised alternatives.


Data protection:

Traders using decentralised exchanges do not have to disclose their private keys as the wallets are held externally and the DEX is not liable for the funds. For the same reason, DEXs do not usually require users to go through KYC and AML procedures. While this may be advantageous for convenience, it is potentially problematic from a legal perspective.



DISADVANTAGES OF DEXS


The disadvantages of using decentralised exchanges also present hurdles to widespread adoption. These shortcomings affect DEX scalability, user experience, market liquidity and capital mobility.


Scalability:

The scalability of the blockchain depends on the number of transactions a network can process before it reaches capacity. For example, the Bitcoin network processes 4.6 transactions per second (TPS), while Ethereum reaches 15 TPS. Decentralised exchanges work with smart contracts that live on blockchain networks. As such, DEXs are bound by the limits of their underlying network infrastructure.


User experience:

DEXs are still at an early stage of development and can be challenging for those less familiar with decentralised blockchain technology. First, users need to become familiar with external wallet platforms so they can interact with a DEX. Then they need to fund their wallet by transferring fiat or cryptocurrencies. Finally, they need to connect this wallet to the DEX interface to make a trade. With a CEX, depositing money for trading is much easier.


Liquidity:

As DEXs are still relatively new and support different trading pairs, market separation has a negative impact on market liquidity. Nevertheless, asset liquidity has increased significantly with the growth of DeFi.


On- and off-ramps:

With current DEX technology, it is not possible to buy digital assets with fiat currencies such as USD, trade with fiat currencies or make withdrawals to your bank account. While stablecoin technology is about to take over the role of fiat in the DeFi ecosystem, the lack of entry and exit options for fiat is a barrier to entry for newcomers.



EXCHANGES OF THE FUTURE


Although centralised exchanges still dominate crypto markets and meet the needs of everyday crypto traders and investors, decentralised alternatives offer an interesting alternative. Through smart contracts on the chain, DEXs offer a trusted way to connect buyers and sellers and provide new models for equitable participation and governance among stakeholders. However, these platforms are still in their infancy and further refinement of the user experience, infrastructure development, improved scaling mechanisms and increasing connections to central crypto and traditional financial institutions will be necessary to ensure future adoption.

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