From the earliest days of cryptocurrencies, exchanges have played a fundamental role in transactions. They match buyers with sellers, with their existence responsible for the creation of liquidity in the market. Exchanges also provide a means for different parties to agree on the prices of digital assets.
Up until now, centralized exchanges have dominated the exchange space. However, there is a change coming that has many excited, and decentralized exchanges herald it. This article will look into these exchanges and how they differ from the traditional centralized ones.
The Traditional Centralized Exchange Model
We are surrounded by traditional centralized exchanges today. Basically, all the most prominent names you know are centralized. Binance, Coinbase, Kraken, etc., all operate on the centralized model.
With these exchanges, you deposit your money - either crypto or fiat. When the funds have been deposited, you lose control over them. You can still withdraw and trade the funds to control what is done with them, but you technically lose control of the funds because you can't spend them on the blockchain.
With centralized exchange, you don't owe any private keys that grant access to the funds. So, when you make a withdrawal, you're essentially asking the exchange to sign off on a transaction for you. Trades on centralized exchanges also don't occur on the blockchain. Instead, the exchange allocated balances to its users.
The benefit of centralized exchanges is that workflow is much faster. Blockchain speeds don't hamper trading, and all activities occur in a single system. You can also sell and buy cryptos easily, and most exchanges provide more tools for you to enjoy.
However, all of this convenience comes at one major cost - independence. You're essentially trusting a centralized exchange with your funds, and you expose yourself to some degree of risk as a result. We've seen cases of exchanges folding up or being scam operations, and we've seen situations where they could get hacked.
For many users, this risk is acceptable. It is effortless to swallow since most centralized exchanges have structured organizations running them and are better suited to implement the best safety infrastructure to help them. However, some users remain skeptical about this operation and would like the independence that cryptocurrencies promise to provide. This is where decentralized exchanges come in.
What is a Decentralized Exchange?
A decentralized exchange is an autonomous, decentralized platform that allows parties to a cryptocurrency transaction to communicate and trade without giving up control of their funds. There are no middlemen or asset custodians available here, marking a significant difference from the centralized operation.
Decentralized exchanges primarily came to the fold as a means of eliminating the need for any central body that looks to approve and authorize trades within an exchange. Thanks to smart contracts, these exchanges operate order books and trades, promoting exemplary peer-to-peer operation.
How the Decentralized Exchange Works
Primarily, the decentralized exchanges are broke into the following:
On-chain Order Books
A decentralized exchange that uses on-chain order books comes with network nodes that maintain and keep all order records. These exchanges also require the operation of miners who will confirm transactions.
Some popular exchanges that use on-chain order books include StellarTerm and Bitshares.
Off-chain Order Books
As opposed to the on-chain order books, these exchanges keep records on a centralized platform. These exchanges use "relayers" to manage their order books. Essentially, decentralized exchanges that use off-chain order books are only "quasi-decentralized."
Some notable examples of these exchanges include 0x and Binance DEX.
Automated Market Makers
These exchanges mainly grew in popularity in 2020 with the decentralized finance (DeFi) space's growth. They include names like SushiSwap and Uniswap.
Essentially, these exchanges don't need any order books. Instead, they use smart contracts to form liquidity pools that execute trades based on pre-laid parameters.
The Driving Forces Behind DEX Popularity
Primarily, decentralized exchanges have grown in popularity for the following reasons:
As explained earlier, centralized exchanges remain prone to security risks and hacks. Bitfinex, Mt. Gox, Coincheck, and more have witnessed devastating hacks that saw unscrupulous users siphon hundreds of millions in crypto. While some of these exchanges have managed to bounce back, there is a lingering suspicion that the next attack could be more devastating than anything we've ever seen before.
Centralized exchanges are primarily prone to hacks because they act as custodians. These exchanges keep funds on their platforms, essentially maintaining the market's liquidity. This means that they are particularly prone to large-scale attacks. These exchanges can also conduct "exit scams," virtually disappearing with user funds and never being seen again.
Decentralized exchanges are less susceptible to such risks. Users can trade on these platforms and would have to hold their assets. Basically, you control the security of your funds. Since hackers don't have much of an incentive to steal from individual crypto users, you can rest easy.
Centralized exchanges require thor customers to comply with anti-money laundering (AML) and know-your-customer (KYC) measures. This forces you to give up some of your personal data to enjoy the exchange's services.
Most decentralized exchanges don't implement any measures. No central authority controls them, so there is no need for identity verification protocols. Things could change in the future, but this is the state of the market for now.
With a decentralized exchange, you control your funds. You have full custody of your funds and can use them however you please. These exchanges also don't have concerns like frozen funds or blocked transactions.
The State of the Industry
For now, centralized exchanges rule most of the industry. Most users enjoy the feeling of being insured and having someone else hold their funds. However, the crypto industry has shown that trends could shift at any point. If they do, decentralized exchanges will become the standard.