Whether a true decentralized existence exists depends on the practice. In the basic sense, the crypto exchange operates on two main systems- the centralized and decentralized system. When you trade digital currencies on a platform with a middleman, it is a centralized system. On the other hand, a decentralized system cuts out the middleman and allows users to take ownership and control of their funds and private keys.
Features of a centralized system
A centralized exchange is much more popular and accounts for the highest users. The likes of Binance coinbase use the centralized exchange are perfect examples of that. Just like the way banks operate, centralized exchanges have the following features-
Centralized systems control all of the funds deposited by their users. Say you want to buy some bitcoins, you go to an exchange and sign up. You provide your details and deposit them into the database. All transactions occur in the exchange’s database. It’s like you’re entrusting your private keys to a custodian. In other words, to be centralized means you trust someone else to handle your money.
Ease of use for newcomers
If you’re starting in the world of digital currency transactions, you will find centralized exchange much easier. There isn’t a need for peer-to-peer transactions. The presence of an app and website makes it comfortable to use.
Features of Decentralized System
For a system to be called Decentralized Cryptocurrency Exchange, it must meet at least four of these requirements.
- Unlike a centralized exchange, DEXs must be non-custodial.
- A DEX must require no permission.
- It must be both a cross-chain and on-chain protocol
- It must allow direct trading between two listed assets
Unlike a centralized system, decentralized cryptocurrency exchanges allow users to operate peer-to-peer transactions. All transactions are carried out based on smart contracts and atomic swaps.
The main difference between a centralized and decentralized cryptocurrency exchange is whether or not there is an intermediary.
So, are DEXs truly decentralized?
Considering the centralized cryptocurrency exchange features discussed above, having a truly decentralized cryptocurrency exchange is possible as long as there is no intermediary. However, many exchanges calling themselves decentralized are not decentralized.
In a truly decentralized system, users do not seek permission. Instead, you will have your custody. Other features of the decentralized system include:
- Transparency- This is possible because you run your wallet
- Fewer Security Vulnerabilities- Since you run your wallet say for Diminutive Coin, there is less risk of security issues commonly seen in the centralized cryptocurrency exchange.
- You don’t need to deposit or withdraw funds to trade on a truly decentralized cryptocurrency exchange.
Degree of Decentralization
Some decentralized cryptocurrency exchanges can still have centralized components. This is a case whereby there exists a central authority that controls the exchange. As seen in IDEX, it blocked New York state users from placing an order on the platform. Bancor, a supposedly decentralized exchange, was hacked and suffered a loss of $13.5 M in assets. A decentralized exchange, through and through,
Other well-known cryptocurrency exchanges like Binance launched their decentralized cryptocurrency exchange. But they are considered quasi-decentralized exchanges because the same compliance principles apply. For example, they follow the regulatory standards seen in a centralized exchange, such as Know Your Customers (KYC), which shouldn’t be so in a decentralized exchange.
Not all decentralized exchanges operate the same way in practice. They range from quasi-decentralized to fully decentralized cryptocurrency exchanges.
Bitcoin is the leading blockchain in decentralization. Those who verify transactions in the bitcoin networks are called Miners. The more independent network miners get, the more evenly distributed the mining power is, and the more decentralized the network becomes.
How does a decentralized exchange work?
If you want to trade on a decentralized exchange, this is how it works:
- You place an order specifying the number of units, the cost of the token and set the bid for the asset.
- Once this is done, other buyers would submit their bids.
- You then use your wallet address to sign in to a decentralized exchange.
- Submit a buy or sell request
- The smart system transfers the asset
Types of Decentralized Exchanges
There are three various types of DEXs. These include:
DEXs that use ON-Chin Order Books have network nodes that keep the records of all orders. It also has miners that verify all transactions.
In this type of system, all transactions are hosted by a centralized system. Exchanges that use this system are known as quasi-decentralized. This is because they employ relayers to manage the order books.
This system does not require order books. Instead, it uses smart contracts that perform all the transactions based on some parameters.
Advantages of Decentralized Cryptocurrency Exchange
The centralized cryptocurrency exchange is designed in a way that the funds of the users are kept on the platform. Hence, making it susceptible to hacking.
DEXs are less susceptible to this type of risk since users can freely trade from their wallets.
Unlike CEXs, most DEXs do not require the Know Your Customer systems. This allows them privacy when trading on DEXs.
Since DEXs does not have a central authority involved, it is possible to access the tools and trade anonymously on DEXs.
- Complete Control and sovereignty
Since DEXs are non-custodial, they allow users to have full control of their funds and private keys. All transactions are self-executed by the user.
There is also no interference from either local or international authorities.
Some Drawbacks Of DEXs
Despite the numerous advantages offered by DEXs, it is still not without its downsides. This is why it is important to consider the pros and cons of each exchange system to know which one perfectly fits your plan. The disadvantages of DEXs include:
In DEXs, when a person carries out a transaction, a trading call is broadcasted to the network and confirmed by a miner before processing it. This, however, can be slow.
Liquidity in DEXs depends on the number of active users on the platform. Low active users mean low liquidity. They also do not have access to any other fund to facilitate trading.
It is important to know that the degree of decentralization of blockchain networks varies. This implies that decentralization is a spectrum and not an actual state. In other words, blockchain networks would have both centralized and decentralized exchanges embedded in their system.
To run a fully decentralized exchange would involve fewer profits for the owners. This is because the market is yet to acquire a massive influx of traders.