Decentralized exchanges are crypto exchange platforms that are open source, have no central governance and enable peer-to-peer trading, or as the name itself suggests are decentralized. DEXs ensure that a user information, such as transaction details and personal data, is safely and securely stored with a guaranteed customer anonymity.
Types
Broadly speaking, there are two types of decentralized exchanges, currency centric and currency neutral. Currency centric is more of a traditional model developed on top of an existing blockchain platform, which allows the exchange of only those currencies that are built on that very blockchain platform. Conversely, the newer model, a currency-neutral exchange enables connection between a diverse group of crypto assets that are developed on the different blockchains. This type of an exchange is constructed using a smart contract technology - Atomic Swap. This technology allows for an exchange between cryptocurrencies without a need for centralized intermediaries. Atomic swap usually happens between the blockchains of different crypto assets; however, it is possible this procedure to occur off-chain.
Benefits
An absence of central authority and established a peer to peer network are the main perks of decentralized exchanges. These features eliminate the need for a third party authenticator and the users can directly interact with each other. Further, decentralization can also result in faster and cheaper transactions if the network effect of the exchange platform increases in the long run.
Decentralized nature of DEX leads to another more significant attribute — censorship resistance. Censorship resistance ensures that no governing power can inflict restrictions and regulations on the exchange users or prohibit someone from using cryptocurrency of choice. This is a very significant aspect of DEX because holding crypto without an ability to trade it with the same decentralized philosophy threatens the inherent value of a cryptocurrency and starts resembling a traditional asset class and its market. Unfortunately, currently, the sovereign states remain right to abolish crypto exchanges and exert control on which cryptocurrencies will be circulating; the government can also impose taxes on crypto trading and in the best case scenario apply capital gains taxes to crypto related income. (for more information about crypto regulations and taxes see our infographics).
Another benefit of DEX is advanced cybersecurity efforts. The centralization feature of centralized exchanges creates a single point of failure. Conversely, decentralized exchanges by their very nature are able to avoid such adversities, as each user practices private control over his/her assets. This way, the decentralized architecture of DEXs eradicates vulnerabilities associated with a central point of attack and reduces the theft and account hacking. Along with increased security, decentralized exchanges maximize user’s privacy by not requiring identity verification and know your customer related practices. This could be seen as one of the advantages of DEX from a user’s perspective who is looking for a higher degree of privacy, as this feature eliminates interventions, control and monitorization conducted by centralized governments and other authorities upon the accounts and account holders on the exchange platform. On another hand, exactly this feature of DEXs is highly disliked by the governmental institutions, and righteously so, as it disallows them to track or control any accounts for illegal activities such as money laundering or terrorist financing. This way, privacy properties of DEXs can be labeled as a controversial topic, as of today.
Another merit of DEX is its ability to filter out fake volumes. Trading volume inflations, practiced by market leaders has flawed traditional centralized exchange platforms for a long time. Ability to solve this problem gives DEX an edge over competitors and enables it to become a preferred trading platform due to its transparency and fairness.
Finally, DEX facilitates transactions between users by taking advantage of smart contracts(link to smart contract infographics). It is extremely important the contracts be highly protected to enforce cryptographically secure peer to peer transactions and avoid troubles orchestrated by malicious parties. With highly secure smart contracts DEX automatically becomes a secure platform for a trading execution. As some contracts might lack all appropriate security measures in place it has been proposed to launch a smart contract auditing practices, which will ensure the validity of the contract code and eliminate any loopholes that might pose threat to the transaction security and account holder’s privacy.
Issues
Along with the advantages, DEX also suffers from some drawbacks such a currently low trading volume and vague regulatory framework.
High liquidity is always desirable especially in crypto space and currently illiquid state of DEXs poses a major threat to its mass adoption. Unfortunately, traders looking for higher degrees of liquidity are pushed away to the centralized exchanges that offer more liquid trading platforms but at the same time are more expensive, with poorer security and privacy measures.
However, the traders have been willing to take on these risks because centralized platforms allow them to avoid price slippage (price variation caused due to a delay between the trade order and execution) which has been a major fear in the volatile crypto market. Some exchanges have been trying to solve a market liquidity issue by introducing stable coin — fiat backed cryptocurrencies. However, this problem can be easily solved with higher demand and bigger masses utilizing cryptocurrencies and decentralized exchanges.
Even if DEXs becomes more liquid and attractive for crypto users, regulatory compliance with different jurisdiction still poses a threat to its adoption. Thus, the unclear regulatory ecosystem of crypto has affected the decentralized exchanges too, as non-compliance with some jurisdictions make the platform less favorable over well established and legal centralized platforms. Down the road, as legislation are clarified and appropriate laws are passed, it will be easier for the crypto folks to jump on the decentralized exchanges.
Finally, the decentralized exchanges also suffer from poor user interfaces and consequently unsatisfied customers. Most of the exchanges are hard to navigate on and are also much slower in comparison with their centralized substitutes. Slower trade execution and imperfect interface further discourage users to switch to DEXs and take advantage of a trading platform without intermediaries.
Conclusion
Decentralized exchanges represent another important step towards a fully decentralized financial ecosystem. The DEXs just like crypto are in their nascent phase, which means that more exciting and disruptive things still lay ahead of us. Despite current disadvantages, as the project develops and becomes more advanced severity of these drawbacks will also fade. As of now, considering the value of such evolutionary projects that hold the capacity to entirely wipe out the centralized system behind investing, leaves us wondering what is next.
Summary Tables:
Source: Etherscan.io
Source: https://masterthecrypto.com/decentralized-exchanges-guide-popular-dex/
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2018