Summary

You may already know all the processes of the cryptocurrency exchange platform. Please register with your email address and set a strong password. Once your account is verified, you can start trading cryptocurrencies.

The operation of decentralized trading platforms is so simple that there is no cumbersome registration process. In most cases, there is no need to deposit or withdraw cryptocurrencies. Because transactions generally take place directly within the wallets of both users, the involvement of third parties (if any!) is limited.

While decentralized exchanges can be difficult to navigate, and they may not yet offer the assets you need, as the technology develops and user interest grows, decentralized exchanges are likely to become an integral part of the cryptocurrency space.


Table of contents

  • Introduction

  • Definition of decentralized trading platform

  • The operation process of centralized trading platform

  • Operation process of decentralized trading platform

    • On-chain order book

    • Off-chain order book

    • Automated Market Maker (AMM)

  • Advantages and Disadvantages of Decentralized Exchanges (DEX)

    • DEX Advantages

    • DEX Disadvantages

  • Summarize


Introduction

Since the early days of Bitcoin, exchanges have been the go-to place for matching buyers and sellers of cryptocurrency. Without these forums attracting a global user base, we would have far less liquidity and no consensus on the right price for assets.

Traditionally, this space has been dominated by centralized players, but with the rapid development of available technology stacks, a large number of decentralized trading tools are emerging.

In this article, we’ll take a deep dive into decentralized exchanges (DEXs), which are trading venues that do not require any intermediaries.


Definition of decentralized trading platform

In theory, any transaction between peers can constitute a decentralized transaction (atomic transaction analysis). But in this article, we are more interested in platforms that simulate the functions of centralized trading platforms. The biggest difference between them is that the backend is located on the blockchain. Others will not take over your funds, and you do not need to give the same trust to the trading platform as centralized products.


The operation process of centralized trading platform

You can deposit currency or fiat (via bank transfer or credit/debit card) or cryptocurrencies through a common centralized exchange. If you deposit cryptocurrencies, you give up control of them. But this giving up is from a technical perspective, not from a usage perspective. You can still trade or withdraw the currency, but you can't use these cryptocurrencies on the blockchain.

You no longer own the private keys to your funds, which means that when you make a withdrawal, you must ask the exchange to sign the transaction on your behalf. When you make a trade, this does not happen on-chain, instead the exchange allocates the balance to the user in its own database.

The entire workflow is super streamlined because slow blockchain speeds do not affect the success or failure of transactions, and all transactions will take place within the system of a single entity. Cryptocurrencies can be bought and sold more efficiently, and there are more tools at your disposal.

But this comes with a loss of independence: you need to put your money in the hands of the exchange and put your trust in it. As a result, you may be exposed to a range of counterparty risks. What if the team runs away with your hard-earned Bitcoin? What if a hacker attacks the system and runs away with all your funds?

For many users, this level of risk is acceptable, as they can mitigate the risk of data breaches by trusting reputable exchanges with a proven track record and preventive measures.


Operation process of decentralized trading platform

DEXs are polarizing in nature from their centralized counterparts, being very similar in some ways and very different in others. First, we can see that there are several different types of decentralized exchanges available to users. The commonality between these platforms is that orders are executed on-chain (using smart contracts) and in neither case does the user have to give up custody of their funds.

While some operations are already done in cross-chain DEXs, the most common operations revolve around assets on a single blockchain, such as Ethereum or Binance Chain.


On-chain order book

Even on some decentralized exchanges, everything is done on-chain (we’ll discuss intermixing methods shortly). Every order (and its changes and cancellations) is written to the blockchain. This is obviously a very transparent approach, as you don’t need to trust a third party to pass your order to you, and there’s no way the orders can be mixed up.

Unfortunately, this is also the least practical method. Because you have to ask every node on the network to record the order information at all times, and you will pay the fee in the end. You need to wait until the miners add your information to the blockchain, which means that the process you experience is cumbersome and complicated.

Some see front-running as a flaw in this model. Front-running occurs when an insider learns details of a pending transaction and uses that knowledge to act before the transaction actually takes place. The front-runner can therefore benefit from information that is not available to the public. This is generally illegal.

Of course, if all transactions are published on a global ledger, there is no traditional front-running opportunity. However, bad actors can still deploy an alternative attack: in this model, miners can see the details of orders while they are unconfirmed, and then they will ensure that their orders are added to the blockchain first.

On-chain order book models include decentralized exchanges such as Stellar and Bitshares.


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Off-chain order book

Decentralized exchanges that include an on-chain order book model still retain their decentralized nature in some ways, but they are undeniably more centralized than previous entries. All orders are no longer posted on the blockchain, but are hosted somewhere.

Where exactly? It depends. You can delegate full order book management to a centralized entity. But if that is a malicious entity, then they can manipulate the market to some extent (i.e. by front-running or tampering with orders, etc.). However, non-custodial storage is not without benefits.

The 0x protocol for ERC-20 and other tokens deployed on the Ethereum blockchain is a good example. Rather than being a single decentralized exchange, it provides a framework for “relayers” to manage off-chain order books. Using 0x smart contracts and other tools, hosts can access pools of combined liquidity and relay orders between users. Only when the parties are matched will the trade begin to execute on-chain.

From a usability perspective, these methods are superior to those that rely on on-chain order books. They are not subject to the same limitations in terms of speed because they are not as dependent on the blockchain. Trades must be settled on the blockchain, so off-chain order book models are still not as fast as centralized exchanges.

Off-chain order book implementations include Binance DEX, IDEX, and EtherDelta.


Automated Market Maker (AMM)

Tired of the term “order book”? No problem, the automated market maker (AMM) model does away with that concept entirely. There are no order makers or takers involved, just users, game theory, and some cheesy black magic.

The details of automated market makers depend on the implementation, but generally they string together a bunch of smart contracts and then provide clever incentives to ensure user participation. We won’t go into the details of these implementations, but will look at the definition of Uniswap and how it works as an example of how a Uniswap DEX works.

Available decentralized exchanges based on AMM are more user-friendly and have integrated wallets such as MetaMask or Trust Wallet. However, like other forms of DEX, transactions must be settled on-chain.

Projects involved in this include the aforementioned Uniswap and Kyber Network (both of which use the Bancor protocol), both of which facilitate the trading of ERC-20 tokens.


Advantages and Disadvantages of Decentralized Exchanges (DEX)

We have already briefly touched upon some of the pros and cons of DEX in the previous section. Now, let’s take a deeper look.


DEX Advantages

No KYC identity verification required

KYC/AML (Know Your Customer and Anti-Money Laundering) has become a routine practice for many trading platforms. For regulatory reasons, individuals must submit identity documents and proof of address.

Some people worry about privacy issues, while others worry about accessibility issues. What if you don’t have valid documents? What if the information is accidentally leaked? Since DEX is a permissionless platform, there is no need to check your identity information. All you need is a cryptocurrency wallet.

However, if a portion of a DEX is centrally managed, there are legal requirements that need to be followed. In some cases, if the order book is centralized, the host must ensure compliance.


No counterparty risk

The main appeal of decentralized cryptocurrency exchanges is that they do not hold customer funds. Therefore, even in the event of a catastrophic breach like the 2014 Mt. Gox hack, user funds would not be at risk, nor would any sensitive personal information be exposed.


Unlisted Tokens

Tokens that are not listed on a central exchange can still be traded on a DEX for free, provided there is supply and demand.


DEX Disadvantages

Availability

In reality, DEXs are not as user-friendly as traditional exchanges. Centralized platforms offer real-time trading without being affected by block times. CEXs offer a more forgiving experience for newcomers who are not familiar with non-custodial cryptocurrency wallets. If you forget your password, you can simply reset it. However, if you forget your mnemonic, your funds stored in cyberspace will be lost forever.


Volume and Liquidity

The volume of transactions on CEXs far exceeds that on DEXs. CEXs have more liquidity. Liquidity measures your ability to smoothly buy or sell an asset at a reasonable price. In a highly liquid market, the difference between the bid and ask prices is small, which means that there is a lot of competition between buyers and sellers. However, in an illiquid market, it will be difficult to find someone willing to trade your asset at a reasonable price.

DEXs are relatively niche, so there may not be enough supply or demand for the crypto asset you want to trade. You may not be able to find your ideal trading pair, and even if you do, you may not be able to trade it at a fair price.


cost

DEX fees are not always higher than their counterparts, but if your network is congested or you are using an on-chain order book, then higher fees may occur.


Summarize

In recent years, various decentralized trading platforms have emerged, and each iteration has learned from past attempts to simplify the user experience and build a more powerful trading venue. The principles that eventually emerged seem to coincide with the concept of self-sovereignty: just like cryptocurrencies, users do not need to trust other third parties.

Thanks to the rise of DeFi, Ethereum-based DEXs have seen a surge in usage. If this strong momentum continues, we are likely to witness a constant stream of technological innovation across the industry.

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