What is DEX?
DEX stands for decentralized exchange. It is an online service that allows peer-to-peer or direct transactions between two crypto-related parties. Decentralized crypto exchanges are built to combat the imminent problems present in centralized exchanges. Simply, DEX is a P2P crypto marketplace built right on Blockchain, which allows traders to store funds and perform trading activities right from the wallet. DEX are designed to minimize impending unfairness by eliminate human error and intrusions. The users can freely carry out transaction with one another in a direct manner, completely removing the need for a third-party mediation.
DEX is governed in two ways, automatic or by the users themselves. DLT (distributed ledger technology) provides safety for the customers’ assets. Some Blockchains are originally built to be used for DEX such as ‘Ethereum’s EtherDelta, and ‘Graphene’s CryptoBridge. There are also other blockchains such as Switcheo and Waves which are powered and supported by other cryptocurrencies.
What is the main difference between DEX and centralized exchanges?
In centralized exchanges, there is a requirement for ‘users’ identification. User’s assets (coins) are stored in the wallets controlled by the owner of the exchange. Which usually is honey pot for the hackers. Decentralized exchanges, on the other hand, work the opposite way completely. All funds are controlled by the individual users. Individual wallet itself is the account for the DEX.
Centralized exchanges are being managed by individuals or organization that are motivated by the profit. The supervising entity is responsible for keeping the ‘users’ data as well as the details of the transaction safe and privately intact. They have the absolute hand over the operations, and they can make important decisions relating to service development even without the knowledge of the users.
On the other hand, since decentralized exchanges can be managed in an automatic or semi-automatic manner, DEX gives its participants the power to take part in the decision-making process. These platforms have technical bridges that connect the users to the distributed registry. This kind of power also allows the participants to store and process almost all of their essential transaction data. Moreover, the personal data of users cannot be stored on ‘DEX’s servers. It merely acts as a platform where users who are looking to buy or sell can find matches.
What are the benefits of decentralized exchanges?
The distributed architecture is the main strength for the Decentralized Exchanges
Network Security: Since decentralized exchanges have no records of their ‘users’ assets, the loss of funds due to a total collapse or a ‘hacker’s attack is completely taken out of the picture. Hackers will have a hard time infiltrating the system because there is no sole entry point where they can obtain access to the data and assets of the users. Since centralized exchanges have a single entry point, they are often vulnerable to these kinds of attacks.
Minimal risk of manipulation: Decentralized exchanges has no central structure which is strongly associated with manipulating the price and the trading volumes inside the exchange.
Since it is not required for a user to have a personal account on DEX, a customer can carry out a transaction without the need of providing an email address and other personal data for verification. This set up makes the transactions more anonymous than those exchanges that require authentication in the pretense of KYC (know your customer) and in compliance with the anti-money laundering law.
Interference free from regulators: Centralized exchanges need to comply with a variety of regulations. So, in the event their services collapse or become limited due to several factors, the authorities have the power to block the service, either temporarily or permanently. On the other hand, decentralized exchanges have a distributive architecture, it is independent, and it can operate without any interference from regulators, local and international alike.
Accessibility for new opportunities: Decentralized exchanges not only allow users to transact using the existing cryptocurrencies, but they can also use the system to make new ones. This structure enables startup projects to save costs on liquidity since they don’t need to shoulder high placement fees on major platforms.
Drawbacks of DEX
While the distributed architecture of DEX, as well as the absolute user control, entail many benefits, this setup also comes with challenges and difficulties.
No recovery options: It is impossible to recover the private key or password in case of loss or broken. The user will not be able to stop a transaction or to restore data. A distributed registry is not compatible with refund and chargeback procedures so recovering the assets will be impossible in case the user loses the access or make mistake in transaction. All actions are irreversible. A simple operational mistake can cause loss and misplacing of a private key can easily diminish access to the account (wallet).
The irreversibility and immutability in this case can be viewed as a disadvantage, however this same characteristic is the core value of the Blockchain technology. In a true Blockchain protocol, the irreversibility and absolute immutability prohibits error, corruptions and mistakes caused by human behaviors.
Limited options: Most users of decentralized exchanges do not have access to services such as margin trading and stop loss. Most DEX are under smart contracts, and it offers limited options yet. However, we are still in the infant stage of Blockchain technology. The technology continually evolves. Smart contract has unlimited potential to create convenient options to DEX platforms in the future.
Liquidity Issues: DEX haven’t gained the popularity yet. Most of the DEX platform have poor liquidity. In daily volume using the same parameters, Bitshares DEX can only get 197.8 BTC while Binance can go as high as 228,823 BTC.
This key difference in liquidity is a result of the fact that most traders choose centralized exchanges. With limited options for cryptocurrency pairs, instrument and orders, decentralized exchanges often fall into what the experts call as a vicious circle. Since DEX have lower liquidity compared to the other, users think twice because ‘it’s almost impossible to increase liquidity with a small pool of traders.
Scalability: The surge in the number of traders who want to buy and sell cryptocurrencies can ultimately cause delays and commission increase due to the large load coming into the network. Scalability not unique to DEX. It is common issues for most of Blockchain platforms. Scalability of platforms have improved considerably over a year.
Lack of support service: Users of decentralized exchanges have the sole responsibility of protecting their funds since DEX lack a support service that manages the ‘users’ accounts as well as the transactions. In the event a user lost access due to a mistake or broken password, there is no support service to rely on to.
Limited processing speed: It takes time for a blockchain to check and confirm transactions. Moreover, the speed of processing depends on the Network speed (miners and not on the exchange itself). The fact that decentralized exchanges are not as popular as centralized ones, DEX users may have to deal with more extended time in finding a match, worse, it is more difficult to bargain for a reasonable price.
Decentralized exchanges come with complicated aspects, and familiarity with technical factors is required. Many of the existing decentralized exchanges today operate as DAO (decentralized autonomous organization) or DApp (decentralized application) on ‘Ethereum’s platform. They use ETH blockchain and smart contracts. For the transaction to undergo processing, gas payment is needed. Moreover, the trader must also determine the value.
When it comes to orders’ placement, there is also a big difference between the two exchanges. In DEX, ‘there’s a system with trading mechanisms that triggers communication between these orders as per stated in the queue. The users, even without the ‘exchange’s participation, personally sign the transactions using their private keys.
Some decentralized exchanges issue tokens that have crucial roles in the system. These tokens can be used to pay a commission or to invest in a particular project. ‘Let’s take, for instance, the set up on the Waves platform. Popular cryptocurrencies such as Bitcoin, Ether, and Litecoin can be traded in pair with WAVES, the ‘platform’s internal asset.
Degree of decentralization.
Unfortunately, there are many existing DEX that claims to be fully decentralized; apparently, they are not. While ‘it’s true that most decentralized exchanges have their respective servers for keeping the data relating to a ‘user’s purchase or sale, still, only the users know their private keys.
Some centralized components of DEX make it vulnerable to a ‘government’s interference. Take IDEX exchange, for example. The government bans the resident of New York from using this platform for trading purposes.
Notably, some exchanges can be targeted by hackers, too. Simply, if an exchange can freeze or lose its ‘customers’ funds, then it is not decentralized. Last year, Bancor made headlines. On July 9, 2018, Bancor lost assets due to a ‘hacker’s attack. The value was estimated to be around $13 million.
When it comes to regulation, the fact that a particular company or individual do not govern decentralized exchanges always come into the subject. Since DEX are not required to comply with rules, it becomes difficult to determine the responsible entity should a violation or a breach arise. There are existing rules in centralized exchanges in the event of a dispute; however, it is not applicable to decentralized exchanges.
Regulators in the US are making efforts in applying for a legislative base which already exists. Meanwhile, in Singapore, the regulators are working towards the establishment of a regulatory framework for decentralized exchanges.