Cryptocurrency exchanges, also known as EXs, are a means for consumers to buy and sell tokens. They bring buyers and sellers together on a proven platform to trade cryptocurrency and thus help determine the market price for a given token. Many cryptocurrency exchanges have been centralized so far. That is, they are created and managed by a central authority. Exchanges such as Binance, Kraken, Coinbase, and Gemini are all centrally managed crypto exchanges with significant user bases.
However, a newer form of cryptocurrency exchange has hit the market and seems to be gaining popularity by the month: decentralized exchanges. A decentralized exchange (DEX) has the same or very similar function as a centralized cryptocurrency exchange, but it is not centrally managed. Instead, a decentralized exchange can largely function as the result of smart contracts that execute transactions based on programmed code. The idea is to get the middle person – the managers of a particular exchange – out of the trade. Achieving this goal can have multiple functions.
How do decentralized exchanges work?
The mechanisms of a decentralized exchange are best illustrated by comparing them to those of a centralized crypto exchange. So how do centralized crypto exchanges work? First, a person who wants to buy cryptocurrency chooses an exchange. They complete all the necessary sign up or sign up processes and then deposit their dollars, euros or other fiat currency of their choice in exchange for some form of cryptocurrency. One can also deposit their own cryptocurrency to be traded on the exchange.
There are some known benefits of centralized exchanges. Since assets are held by the exchange, transactions do not necessarily need to be facilitated by underlying blockchains. While blockchains have several advantages, speed is generally not considered one of them. Therefore, centralized exchanges can provide transaction speeds that are faster than decentralized alternatives. When a user places a buy or sell order, it can be processed almost immediately by the mechanisms that govern a particular exchange.
In essence, a centralized cryptocurrency exchange functions in the same way as an app Robin Hood does: you deposit money on the platform, make transactions and can withdraw money whenever you wish (with certain legal restrictions). With centralized exchanges, you ultimately trust that the exchange managers will return your money when you request it, and that they will not misappropriate your deposited money in any way. You can also pay those managers a discount on each transaction. While decentralized exchanges have the same basic function as centralized exchanges, they are much less dependent on the integrity and actions of human managers.
What is the purpose of a decentralized exchange?
The purpose of a decentralized exchange is generally the same as a centralized cryptocurrency exchange: to facilitate the purchase and sale of cryptocurrency and other crypto-adjacent assets. With this basic goal in mind, both centralized and decentralized exchanges can allow investors to participate in a number of different transaction types, from simple cryptocurrency purchases to options placing and futures betting.
Perhaps the more relevant question is what is the purpose of decentralizing exchanges. As mentioned earlier, a decentralized exchange is one in which there is no centralized authority between two or more individuals involved in a transaction. Or, at least, no man authority does.
In theory, cryptocurrency purchases and sales are issued through decentralized exchanges carried out by smart contracts. Rather than the human stock market administrators raising and paying out money to buyers and sellers, they run themselves smart contracts handling each transaction.
From the simplest of points of view, the benefits of a decentralized exchange can include:
- A lesser need to trust a central authority to act ethically
- Lower management costs
- Democratic participation in exchange-related management decisions by participants in an exchange
- More flexibility in terms of offering, buying and selling less common tokens, such as explains the Stanford Journal of Blockchain Law & Policy
However, there are some risks associated with these potential benefits.
What are the drawbacks of decentralized exchanges?
Recent history has shown that there is the ideal of decentralized exchanges (to decentralize, decentralize, and then decentralize some more), and then there are more practical alternatives.
Full decentralization means:
- No central authority
- Confirming every transaction through every node in a blockchain
- Increased security through distributed hosting
- Keeping a comprehensive, permanent ledger of transactions on a blockchain
The main downside to this ideal is that transactions can get both slow and expensive.
To minimize these drawbacks of full decentralization, hybrid models of decentralized exchanges have emerged. Decentralized exchanges with off-chain order books are an example of how DEXs can outsource elements of their exchange outside the blockchain in the name of efficiency.
Exchanges with off-chain order books can still use smart contracts to some extent to ensure the integrity of a transaction. However, they can also rely on people outside the chain to fulfill certain orders manually. The purpose of this is to prevent a particular blockchain pipeline from clogging with too many orders on it. The downside is the addition of third parties, which generally puts any blockchain-linked system further away from the ideal of true decentralization. This balance of uber decentralization and scalability is one that every decentralized exchange must achieve in its own unique way.
What is the current state of decentralized exchanges?
Decentralized exchanges have fallen in line with the broader trend in decentralized financing (DeFi): growth. The general uncertainty that defined 2020 has further accelerated investment in decentralized exchanges. CoinTelegraph notes that a specific brand of algorithm-driven decentralized exchange known as automated market makers (SMPs) is particularly popular right now.
While the big question seems to be proof of the value of decentralized exchanges, some concerns remain. One concern is the scalability of blockchains as the number of transactions in a given chain increases. This concern strikes another problem: the relative slowness of transactions on decentralized exchanges compared to centralized alternatives.
As decentralized exchanges continue to feel the right mix of centralized speed and decentralized security, the hope is that products will continue to evolve to meet the high demand for decentralized exchanges.