Decentralized exchanges (or DEX) are a way through which we can conduct peer-to-peer cryptocurrency transactions. By following the decentralized exchange method, the common third-party entities are put aside, and instead, blockchain or distributed ledger appears.
There is a lot to say about the decentralized exchange, yet, beforehand to comprehend the concepts well, we shall take a trip and look at some other basic concepts that lead us to the method of the decentralized exchange. So do not miss the rest of the article.
A cryptocurrency exchange is comparable to a stock exchange; however, it focuses on cryptocurrency tokens rather than stock exchanges. A cryptocurrency exchange, in essence, provides a platform for consumers wanting to buy and sell cryptocurrency assets, to swap digital tokens in values based on current market pricing.
Different Types of Crypto-Currency Exchange
There are three different types of cryptocurrency exchanges:
1. Centralized Exchange (CEX)
The most typical way for centralized exchanges to allow trades between users is to keep an order book, which is a collection of buy and sell orders issued by individual traders. Orders are demands to buy or sell a particular quantity of a cryptocurrency at a fixed price.
CEXs collect orders from its users and then arrange and implement the buy and sell orders using sophisticated software.
Users of CEX do not trade crypto or fiat currency with one another. Rather, when they deposit funds on an exchange, the latter assumes custody of those assets and provides the trader with a comparable number of IOUs. The exchange takes care of each user's IOUs as they pass through trades and only changes them into real cash when the user withdraws funds.
CEXs will be the most common method of operation for cryptocurrency exchanges by 2021. They're a handy place for day traders and crypto investors to buy and sell crypto because of the speed and cost-effectiveness of transactions processed by a single point of authority.
The reliance of CEXs on a central institution, on the other hand, has several drawbacks. Users have little access to centralized exchanges' internal processes, resulting in a lack of integrity that allows for harmful actions like wash trading and price manipulation.
Because they maintain custody of customers' money, centralized exchanges are a tempting target for attackers both inside and outside the company: in 2019, only the 12 biggest CEX breaches resulted in the loss of over $292 million in client cash.
Technical faults or concerted attacks can cause CEX services to be unavailable for extended periods of time, resulting in lost trade opportunities for its clients. Finally, centralized exchanges are an obvious target for government censorship, since they allow regulators to freeze and/or take user cash, as well as oblige the exchanges' parent businesses to expose their users' personal information.
2. Decentralized Exchange (DEX)
Decentralized exchanges (DEX) are a sort of cryptocurrency exchange that offers fully safe online peer-to-peer cryptocurrency transactions without the use of an intermediary.
The conventional third-party entities that would ordinarily monitor the security and transfer of funds (e.g. banks, stockbrokers, online payment portals, state officials, etc.) are substituted by a blockchain or distributed ledger in transactions done through decentralized exchanges. Smart contracts and order book relaying, are two prominent means of functioning, although there are many additional possibilities with varying degrees of decentralization.
Decentralized exchanges lessen the danger of theft from exchange hacking since users do not need to transmit their assets to the exchange. Decentralized exchanges can also eliminate price manipulation and faked trade volume through wash trading, and they are more anonymous than centralized exchanges with KYC requirements.
Different Types of DEX
Decentralized crypto exchanges and DeFi solutions have evolved over time. Order books, like centralized exchanges, are used by the initial generation of decentralized exchanges.
1. Order Books model
A record of all open purchase and sell orders for a certain asset is kept in order books. The depth of the order book and the current market price are determined by the spread between these values. This information is frequently maintained on-chain during transactions on DEXs with order books, while your money stays off-chain in your wallet. like dYdX, Idex and Lumenswap OBM client
2. AMM model
Order books are not used to facilitate trades or determine prices on the next generation of decentralized exchanges. To calculate asset price, these platforms often use liquidity pool methods. These exchanges, which are peer-to-peer in nature, quickly execute deals between users' wallets, a process is known as a swap. The total value locked (TVL), or the value of assets held in the protocol's smart contracts, is used to rank the DEXs in this area. like Uniswap, Balancer and Lumenswap AMM client.
3. Aggregators of Decentralized Exchanges
A variety of protocols and techniques are used in decentralized exchanges. Although this dynamic increases security and autonomy, it also causes liquidity to be disconnected between platforms. For institutional investors or rich individual traders looking to buy a certain crypto asset in significant quantities, the lack of liquidity might be a disincentive. DEX aggregators have created methods to deepen asset liquidity pools across centralized and decentralized crypto exchanges to solve this issue, like 1inch.
Advantages of Decentralized Exchange (DeX)
When the entire sector is predicated on the notion of disintermediating intermediaries, it's a bit of a contradiction to rely on centralized companies to trade crypto. Aside from the ideological motivation, decentralized exchanges provide tangible benefits to their users.
Safety and security
If you've been paying attention to the news recently, you've probably heard a lot about centralized exchanges getting hacked or losing large sums of money from customers. To mention a few major occurrences, there was the $72 million Bitfinex hack, the legendary $472 million Mt. Gox security breach, and this year's record-breaking $530 million Coincheck robberies.
While the motives for each hack differ, there is a fundamental issue that can be linked to all of them. Every centralized exchange today is custodial, which means it holds the funds of its users. With so much crypto concentrated in one place, it's no surprise that centralized exchanges are a hot target for black-hat hackers.
Because decentralized exchanges do not keep funds, they are not a target for hostile actors attempting to commit a large-scale robbery. Because the custody is dispersed over the whole user base, assaults are far more expensive and less profitable.
The majority of decentralized exchanges do not require any sort of registration and hence do not gather any of your personal information. There is no intermediary that qualifies as a money transmitter because these exchanges are DApps that function without a central body, hence there are no KYC/AML procedures to comply with government rules and prohibitions.
It's unclear if the present regulatory system will adapt to this new type of trade, particularly if damages arise as a consequence of a badly drafted smart contract or a security breach. However, for the time being, it is feasible to trade anonymously on decentralized exchanges.
Individual users having entire control over their assets not only increases security against hackers but also provides traders with entire independence and authority over their cash. Problems like exchanges blocking clients' accounts and delaying or even refusing withdrawals are no longer an issue. Users interact directly with their peers on decentralized exchanges, eliminating the need for a centralized platform with order books and custody.
Although centralized exchanges account for the great bulk of market activity, the emergence of DeFi has made a place for the creation of decentralized crypto exchange protocols and aggregation tools, because they provide security, regulatory supervision, and even insurance.