What Is a Decentralized Exchange (DEX)?
In theory, DEXs seek to offer alternatives to centralized exchanges that are — true to the vision of DeFi — paradigms of equitable involvement for all stakeholders. In practice, they display both pros and cons.
A decentralized exchange (DEX) is a peer-to-peer (P2P) marketplace that connects cryptocurrency buyers and sellers. In contrast to centralized exchanges (CEXs), decentralized platforms are non-custodial, meaning a user remains in control of their private keys when transacting on a DEX platform. In the absence of a central authority, DEXs employ smart contracts that self-execute under set conditions and record each transaction to the blockchain. These trustless, secure transactions represent an accelerating segment of the digital asset market, and are pioneering new financial products.
Traditional stock and fiat exchanges consolidate buyers and sellers in one place, ensuring traders can enter and exit positions with relative ease by providing liquidity to the market. Higher liquidity increases the likelihood that there will be someone on the other side of a trade willing to transact with a buyer or seller. While cryptocurrency exchanges facilitate the trading of blockchain-based digital assets, the platforms themselves can be centralized or decentralized. Centralized exchanges (CEXs) function as trusted intermediaries in trades, and often act as custodians by storing and protecting your private keys, and therefore your funds.
Leading centralized crypto exchanges facilitate every aspect of the digital asset trading experience: from security to fair market pricing to regulatory compliance, consumer protection, and access to the latest digital assets. On most CEXs you must deposit fiat or cryptocurrency into an exchange-held crypto wallet before making trades. From your exchange wallet, you can transfer funds to an external crypto wallet. You can also exchange crypto for fiat and withdraw funds into your bank account. In September 2020, CEXs accounted for around 95% of all crypto trading volume.
On the other hand, decentralized exchanges (DEX) have emerged as an alternative to CEX platforms, offering peer-to-peer (P2P) trading and access to the emerging sector of decentralized finance (DeFi). There are now upwards of 35 decentralized exchange options. Platforms like Uniswap, Kyber, and Bancor have become widely recognized as decentralized alternatives to centralized exchanges. In January 2019, DEX platforms represented just 0.11% of global trade volume, but that number has since swelled to 6% as of August 2020. The monthly trading volume on decentralized exchanges was $20 billion as of October 2020.
DEX platforms take a different approach to facilitating the buying and selling of digital assets. Instead of employing an intermediary organization to clear transactions, DEXs leverage the functionality of self-executing smart contracts. In the absence of intermediaries, DEXs take on a non-custodial framework in which you retain control of your private keys and cryptocurrency funds. Most DEXs have no counterparty risk, meaning they don’t have a risk of credit default, and do not follow Know Your Customer (KYC) or Anti-Money Laundering (AML) protocols.
Advantages of DEXs
Even in the earliest stages of development, decentralized crypto exchanges offer advantages that impact digital asset custody and diversity, transactional trust, trading fees, and investor privacy.
Custody: DEXs are non-custodial, which means traders don't need to relinquish the control of private keys to transact. Instead, externally held wallets interact with DEXs, and trades self-execute through smart contracts. Centralized exchanges, by contrast, play the role of custodian for your funds by controlling your private key. This requires you to relinquish control of your private key, but centralized exchanges offer trust and security.
Diversity: In October 2020, there were over 7,400 cryptocurrencies on the market. CEXs exercise control over the cryptocurrencies they will list, and will generally only list those with adequate trading activity, prevalence and effective security standards to ensure profitability and legal compliance. Many altcoins are only accessible through DEXs, where P2P transactions can occur without high trading volume. This provides a wider opportunity for engagement in digital assets and enhances financial inclusion.
Trustless Transactions: On CEXs, every transaction is overseen and recorded by a central authority, the exchange itself. Through smart contracts, DEXs execute trades and record them to the blockchain, enabling trustless transactions. And since DEXs do not hold your funds, they are less likely to be targeted by hackers.
Lower Fees: Decentralized exchanges function through the use of self-executing smart contracts. In the absence of an intermediary, DEXs use the same “gas” fee structure as the Ethereum blockchain they’re built on. DEXs charge a low fee, around 0.3% for exchanges like Uniswap. Although these fees fluctuate in response to the network utilization, they remain far lower than the costs incurred on centralized alternatives.
Privacy: Traders using decentralized exchanges don’t need to disclose their private keys because wallets are held externally, and the DEX is not liable for the funds. For the same reason, users aren’t typically required to complete KYC and AML procedures when using DEXs. While this may be advantageous in regards to convenience, it is potentially problematic from a legal perspective.
Disadvantages of DEXs
The disadvantages that result from decentralized exchange use also present hurdles to widespread adoption. These shortcomings influence DEX scalability, user experience, market liquidity, and the mobility of money.
Scalability: Blockchain scalability depends on the number of transactions a network can process before reaching capacity. For instance, the Bitcoin network processes 4.6 transactions per sec (TPS), while Ethereum achieves 15 TPS. Decentralized exchanges function using smart contracts that live on blockchain networks. As such, DEXs are bound by the limits of underlying network infrastructure.
User Experience: DEXs are in early stages of development and can be challenging to use for those less familiar with decentralized blockchain technology. First, users need to familiarize themselves with external wallet platforms so they can interact with a DEX. Then, they must fund their wallet by transferring fiat or cryptocurrency. Finally, they need to link this wallet to the DEX interface to execute a trade. The process of depositing funds for trading is significantly more straightforward on a CEX.
Liquidity: Because DEXs are still relatively new and support diverse trading pairs, market segregation has a negative impact on market liquidity. Nevertheless, asset liquidity has been increasing remarkably with the growth of DeFi.
On and Off-Ramps: Current DEX technology does not facilitate the purchase of digital assets with fiat currency like USD, nor can you trade fiat or make withdrawals into your bank account. While stablecoin technology is emerging to replicate the role of fiat in the DeFi ecosystem, the lack of fiat on and off-ramps is a barrier to entry for novice users.
Exchanges of the Future
Although centralized exchanges still dominate crypto markets and serve the needs of everyday crypto traders and investors, decentralized alternatives provide an interesting alternative. Through on-chain smart contracts, DEXs provide a trustless method of connecting buyers and sellers, and are offering new models of equitable involvement and governance for stakeholders. However, these platforms are still in their infancy, and further refinement of the user experience, development of the infrastructure, scaling mechanisms, and connections to centralized crypto and legacy financial institutions will be necessary to ensure future adoption.
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