What Is a Decentralized Exchange (DEX)?

A decentralized exchange or DEX is a cryptocurrency exchange that operates without a central authority in the way the platform manages deposits, order books, and order matching and asset exchanges as the four core functions of an exchange.

For truly decentralized ecosystems where all the four functions are decentralized, censorship, banning of users, or prevention of trading by a central authority is a much lesser possibility compared to centralized ecosystems; and prevention of or avoidance of points of failure is a main driving forces for cryptocurrency anyway.

Why a decentralized exchange?

Decentralized exchanges have gained popularity due to their low transaction fees because they effectively cut out the middleman and the many service interactions each of which would otherwise charge some fees. Decentralized exchanges also facilitate quicker transactions compared to centralized exchanges because they tend to employ tech such as smart contracts, lightning networks, and atomic swaps and which allow for faster order matching and exchanging. However, they may still not offer more options for users trading their assets compared to centralized exchanges, such as margin trading and stop loss as well as other extended market functions. But again this is a highly evolving industry.

There are some other reasons that would make someone to use a decentralized exchange for instance heightened security. For instance a lot of centralized exchanges have faced hacks and thefts which have left users drained of their cryptoassets. In addition to using extra measures to protect user’s accounts, decentralized exchanges let users to be responsible for storing and managing their own private keys. That means the keys are stored offline on their devices for instance and are not held by the crypto exchange at any time. Centralized exchanges acted as a point of failure in that if a wallet was compromised, the rest were also easily penetrable due to a central storage or access to user’s accounts.

That’s not to mean using a DEX doesn’t have its setbacks. For example, since they apply smart contracts to facilitate transactions between users, these smart contracts can improve security. However, they may contain some vulnerabilities such as underflows and overflows, reentrancy attacks and many more which means funds may still be stolen. Plus 34000 contracts were found to have known vulnerabilities according to a study. That being said, most of them go through auditing to reveal any security breaches and back door vulnerabilities. Besides the fact that they do not offer more market options compared to centralized exchanges (for instance the previously mentioned margin trading), they may also suffer liquidity – actually most do – and also may not have as huge user bases meaning they aren’t yet truly tested on a large scale.

Do we have truly decentralized exchanges?

Most of the so called decentralized exchanges today have only the asset exchange decentralized by allowing exchange of cryptocurrencies between users. In most exchanges, therefore, the capital deposits are centralized. Centralized record collection and keeping are centralized because of the need for the company to, for instance, collect users’ identities and records before they are allowed to deposit fiat. Looking at the realities of a slim crypto industry, for now, most DEXs connect to centralized platforms such as banks and liquid providers in order to source liquidity or expand their user bases or just reach more audiences. Understandably so because centralized and decentralized ecosystems are expected to continue co-existing before blockchain and crypto can gain mass adoption.

When focusing upon currency-eccentric decentralization models, not all decentralized exchanges have fiat deposits and a good number allow only crypto-to-crypto exchanges. These may enforce true decentralized but while locking themselves out of acquiring new users who would want to purchase crypto with fiat.

DEX can employ fully permission-less ecosystems unlike other exchanges incorporating central platforms that require them to perform KYC and AML and other procedures. Some of those using permission-less ecosystems also use technologies such as atomic swaps and smart contracts in order to facilitate near-instant order matching and trading. In most cases, these orders are not broadcast to everyone on the network as would through an order book.

With programmable smart contracts, anyone is able to become a market maker and can set fees for managing the transaction (accepting an order and posting it on the order book). An example of exchange that uses this method is Kyber Network which uses smart contracts and reserves.

While most of reserves are held by Kyber, there are private reserve holders who act as a source of crypto for exchange and set their own rates. On Kyber Network, it is possible to do an instant exchange for a crypto unlike on EtherDelta where cancellation order mining happens on-chain. Order matching on the latter happens on centralized servers meaning that it can be censored.

On Ox DEX, many exchanges can collaborate to build a larger order book and share liquidity pool although order matching is done on centralized servers. On IDEX platform, it is also possible for market makers to through the AURA multi-exchange protocol and many decentralized exchanges can join via child-chains to improve liquidity.

Truly decentralized exchanges also have no centrally controlled servers with the network nodes being distributed over the network. These utilize blockchain and other DLT tech. A good example of exchanges using this architecture is Blocknet’s BlockDX. Otherwise, most of decentralized exchanges use centralized servers. Most of the new decentralized exchanges are being built on a blockchain platform and utilize their own internal tokens. In order to make it possible for near-instant transactions and order fulfillment, most of DEXs match orders off-chain and then the main chain is used for the actual trade.

When discussing BlockDEX, peer-to-peer trades are done without central escrow, using atomic swaps, in a technology called XChat. The DEX uses an interchain overlay using XBridge, which provides a DHT-based peer-to-peer network. It also implements a decentralized API through which a user can connect to over localhost without permission and therefore decentralizing trading.

Scalability, liquidity and functionality struggles

The three most important factors for a crypto exchanges and blockchain to reach mass adoption is achieving liquidity, scalability and having extended options in functionality. It is not easy to balance these three issues while at the same time ensuring decentralization of the network.

Scalability, for instance, is essential for a network that keeps on expanding to on-board more users without slowing in speed. Scalability tech is a topic on its own but many blockchain platforms use side-chains or off-chains for processing some smaller transactions at low fees. As discussed in the previous sections, one of the most feasible way for a DEX to solve liquidity concerns is by hooking to third party liquidity providers.

If you enjoyed this article, why not dig into some of the great trading posts available on the crypto blog cryptocoindude.com.

1. Top crypto exchanges for traders- https://www.cryptocoindude.com/10-best-cryptocurrency-exchanges-for-trading-cryptocurrencies/

2. Telegram crypto signals channels – https://www.cryptocoindude.com/telegram-crypto-signals-channels/

3. What is crypto margin trading? – https://www.cryptocoindude.com/crypto-margin-trading/


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