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What Is a Decentralized Exchange?

What Is a Decentralized Exchange?

December 2, 2021

What is a Decentralized Exchange? 

A decentralized exchange (DEX) is a platform in the cryptocurrency market that allows traders to securely carry out their transactions without an intermediary. The transactions are conducted on a peer-to-peer network, so the trading process involves only the sender and the receiver. It means the sender does not need to transfer their assets from their wallet into their exchange wallet to make the transfer. Through this direct transfer, the risk of price manipulation or wash trading (i.e. the situation where a trader simultaneously sells and buys an asset to manipulate its supply and demand) is eliminated. However, DEX still has some centralized characteristics. For instance, traders still have to place their orders on a platform that is being controlled by a central authority which can freeze customers’ funds. In this article we will elaborate on the function of DEXs, and draw a comparison between DEXs and CEXs.

How does Decentralized Exchange work? 

The number of decentralized exchanges has been expanding thanks to their increasing popularity; CoinMarketCap lists 78 DEXs, with UniSwap and PancakeSwap having the most volume and market share. The first generation of DEXs worked like centralized exchanges (CEXs). They used order books that contained all open buy and sell orders. The spread of the orders specified the market depth and the price of a particular asset. But recent DEXs have obtained specialized financial instruments and trading models. For example, UniSwap (version 3) uses Automated Liquidity Protocol (ALP) model, which allows users to become liquidity providers. In other words, various traders pool their money to create the fund needed to execute the orders of a specific asset.

The diversity of DEXs may cause price slippage, which happens especially for sizable orders and results in paying more for buying a particular asset than was formerly expected. If slippage is eliminated, the trader can buy the asset for the best possible price, using their available capital. DEX aggregators are developed to address this issue. For example, 1inch Exchange aggregates liquidity across different DEXs, or DeversiFi aggregates the liquidity both from DEXs and CEXs, which will, in turn, accelerate the required time for the order to be executed.

DEX vs CEX.

Transaction Fees in Decentralized Exchange

One of the first things that attracts traders’ attention is the transaction fee. CEXs charge a percentage of every transaction conducted on their platforms besides the transaction fee of the blockchain network. Binance CEX, for example, charges a 0.5% fee for instant buy/sell for one Bitcoin, which with its current market price (30.000$ on 21/07/2021) would cost the trader 150 dollars. DEXs, on the other hand, charge only a gas fee (0.05 to 1$) for confirmation of every transaction on the blockchain network.

Account Verification in Decentralized Exchange

CEXs require users to verify their identity and restrict the withdrawal amount for the accounts that are not verified. This policy is referred to as Know Your Customer (KYC). Such policies are liable to overnight changes; a CEX may announce that it would no longer provide service for users from a given country or that an asset will be removed from the exchange asset list and would no longer be supported. 

Technical Issues in Decentralized Exchange

They also apply a login policy that permits only a limited IP range for user logins, creating an obstacle for users who do not have access to a static IP address. CEXs obtain such policies to prevent money laundering. On the contrary, DEXs are more anonymous, and users can start trading basically by signing in to their accounts. The role of a central authority is also minimalized, and there is no third party involved in the transactions, and the trading process would be pretty autonomous. 

 Safety and Security in Decentralized Exchange

The presence of a third party with a central authoritative server also increases the risk of the safety of traders’ assets. That is, a hacker attack on a CEX server can cause an enormous loss of users’ capital. In contrast, on DEX platforms, since the transactions directly reside on the blockchain network and there are no medium central servers, the risk of a hacker attack is almost eliminated. Moreover, server failures or frequent upgrades, which are familiar issues for CEX users and may cost them a great financial opportunity, will not be a problem for DEX users.

Convenience in Decentralized Exchange

User interface (UI) is the factor that puts DEXs at a disadvantage compared to CEXs. CEXs benefit from a user-friendly interface that simplifies the trading process for users, helping beginners to find their way around the platform. There are also various built-in components that facilitate order placing in CEXs. The features allow users to set sell/buy limits, Stop Loss (SL), take profit (TP), alarms, etc. Also, popular CEXs have a 24/7 support team that guides their users if there is something wrong with their accounts. Contrarily, DEXs are not decorated with graphical designs, and the UI might be confusing for beginners. The features available on a CEX may not be accessible in a DEX. As a result, working with such UIs can be demanding. Of course, this is because of the relative novelty of DEXs, and future improvements are bound to improve the trading experience on these platforms.

Conclusion 

 Decentralized exchanges have a bright future since their shortcomings (such as lower liquidity and slower execution time compared to centralized exchanges) are being made up for new protocols and trading models. You should see which one suits you better. If you are new to the cryptocurrency market and want to set foot on solid ground, you had better start with centralized exchanges and test the market. Then, as your knowledge and experience broaden, you can move to decentralized exchanges. Nevertheless, if a CEX of your choice does not list your desired asset or has a strict policy on membership from your region, you can directly go DEXs. And in case you are already familiar with the market and have some trading experience, you can skip the third-party commissions and enjoy a real-time peer-to-peer experience.

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