If you are tech-savvy, then you must be interested in cryptocurrencies or blockchain. Hence, you must have heard of different exchange platforms such as Coinbase, Bittrex, or Binance. These platforms promise a complete solution for trading cryptocurrencies online. However, such centralized exchanges might carry major risks.
To address those risks, the crypto community shifted its attention towards decentralized exchanges. It has been gaining popularity since then. But to understand DEX, first, we have to understand the risks related to centralized exchanges.
Cryptocurrency exchanges are a key source of liquidity to the cryptocurrency market. It enables trading billions of dollars of cryptocurrencies daily. However, in a centralized approach, every year investors lose billions of dollars due to hacking and scams. Similarly, entrusting a third party with your assets, means you do not have full control over your assets.
The issues associated with centralized exchange led to the popularity of the decentralized exchanges. The decentralized exchange allows the trade of cryptocurrencies without an intermediary. It allows users to have control over their funds, making them solely responsible for their security. Thus, eliminating the risks involved in giving up control on their assets or involving a custodian. The transaction occurs through smart contracts with the help of blockchain technology. It is a fully automated process, which makes it truly “peer to peer”. Decentralized Exchange also results in a relatively lower cost.
The other pros of using DEX include enhanced security and privacy of users. For example, centralized exchanges are often attractive to hackers. Since all information is held in one place, it often attracts different form of scams. But decentralized approach eliminates the risk of hacking. In addition to that, most of the DEXs do not implement Know Your Customer (KYC) requirements. Hence, users can refrain from entrusting third parties with their personal information.
How does Decentralized Exchanges work?
There are three categories of Decentralized exchanges. Namely, On-Chain order books, off-chain order books, and automated market makers (AMM).
Known as the first generation of DEX, on-chain order books are solely based on blockchain technology. It writes everything, including the cancellation of transactions on the blockchain. However, with such transparency comes a price too. Though it improves security, the exchanges are often very slow and comparably expensive. Some of the famous platforms that utilize on-chain order books are Bitshare and StellarTerm.
In comparison to on-chain orderbooks, off-chain orderbooks are somewhat more centralized. Off-chain orderbooks do not write everything on the blockchain; instead host it somewhere else. These third parties, that host orderbooks are called Relayers. Hence, they host and manage the off-chain order books using 0x architecture for smart contracts.
In terms of speed, off-chain orderbooks are better than on-chain orderbooks. However, if comparing to the centralized approach, it is still slower in speed. One of the platforms that utilize off-chain orderbooks is Binance Dex.
Automated Market Makers
2020 came with a new approach named AMM that suddenly gained popularity. AMM does not require makers or relies on orderbooks. Instead of that, it works by utilizing smart contracts to create a liquidity pool. Those smart contracts help in the execution of transactions based on certain parameters. Popular platforms like Uniswap and Kyber Network utilizes AMM in their DEXs.