Understanding Decentralized Exchanges

Cryptocurrency exchanges fall into two main types: centralized and decentralized. While all of the traditional exchanges—like the New York Stock Exchange and the NASDAQ—are centralized, some exchanges for cryptocurrencies are decentralized.

Keep reading to learn everything that you want to know about decentralized crypto exchanges.

What is a decentralized exchange?

A decentralized exchange (DEX) is a peer-to-peer crypto trading platform that functions without any involvement of a third party. All transactions on decentralized exchanges occur directly between DEX users.

DEXs enable market participants to transact directly without the involvement of any company or government. Decentralization is a core value of many in the crypto community.

Decentralized vs. centralized exchanges

Decentralized and centralized exchanges have similar offerings of digital assets. They also both charge transaction fees to users. But otherwise, DEXs operate much differently from centralized exchanges. Some of the key distinctions include:

Third party involvement: A centralized exchange is governed by a third party that acts as a custodian overseeing the trading process on the platform. Decentralized exchanges use technology to eliminate the need for third party involvement.
Registration requirements: Centralized exchanges require customers to comply with Know Your Customer regulations enforced by the U.S. Treasury, while decentralized exchanges do not require this.
Security: Centralized exchanges are more frequent targets of malicious actors, whereas the decentralized nature of DEXs makes them relatively difficult to hack.
Privacy: Decentralized exchanges do not share transaction data with any third party. DEX users also do not disclose any personal information.
Trading volume: Trading activity on centralized exchanges still far outweighs the trading volume on DEXs. Decentralized exchanges currently account for only about 5% of the global crypto trading volume.
Number of supported tokens: Decentralized exchanges support many more tokens than centralized exchanges. The only requirement for a newly minted cryptocurrency to register with a decentralized exchange is that the new token must be built on the same blockchain—such as the Ethereum blockchain—as the DEX.
Geographic availability: Decentralized exchanges are open to users in all jurisdictions, without regard to nationality.

Coinbase and Binance are two of the largest centralized exchanges. Uniswap, PancakeSwap, and Bancor are among the largest decentralized exchanges.

How do decentralized exchanges work?

DEXs use smart contracts to facilitate the trading of digital assets. While most decentralized exchanges use a protocol known as automated market maker (AMM), there are other DEXs known as order book exchanges. Let’s delve more into these two types of decentralized exchanges.

Automated market maker exchanges

The AMM protocol uses smart contracts to facilitate trades among users via liquidity pools. Some participants in the DEX contribute to the liquidity pool and are compensated, while others withdraw from the liquidity pool and pay interest. Trades using the AMM protocol are considered decentralized, but are not technically peer to peer, as the liquidity pool represents a mediating step.

Ethereum founder Vitalik Buterin introduced the concept of the AMM protocol in a 2014 whitepaper on DEXs. Uniswap, the first decentralized exchange to use the AMM protocol, launched in 2018.

Order book exchanges

Order book decentralized exchanges follow a traditional system to fulfill buy and sell orders. These types of exchanges can be categorized into two types: on-chain and off-chain. These terms denote where the exchange’s data is recorded. Let’s quickly explore both of these:

On-chain: Order book exchanges that are on-chain keep record of open “buy” and “sell” orders on the blockchain.
Off-chain: Order book exchanges that are off-chain conduct most of the trading process outside the blockchain. Generally only the trade settlement process occurs on-chain.

The Binance DEX is a popular on-chain decentralized exchange. IDEX and 0x are among the most prominent off-chain DEXs.

What’s next for decentralized exchanges?

Satoshi Nakamoto conceived of Bitcoin in part to free people globally from traditional financial constraints. For Nakamoto, decentralization was a key component of the ethos of crypto.

While decentralized exchanges offer many significant benefits over centralized exchanges, widespread adoption of DEXs is not likely to occur until DEXs become better understood and easier to use. Relatively low trading volumes on DEXs also make the markets that they support less liquid than centralized markets for the same tokens.

Technology advances over time are likely to substantially increase the use of DEXs. It is likely only a matter of time before using a decentralized exchange is a more common way to buy or sell cryptocurrency.

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