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What is a Decentralized Exchange?
For the longest time, the world was founded on fiat currencies like the US Dollar as the main way of operating in the financial sector. While that’s still true, the creation of Bitcoin in 2009 and the crypto revolution that followed certainly shook things up and this gave way to innovations such as the decentralized exchange.
So, what exactly is it and what is the significance? Let’s dive into the Exchange – Rates world and explore what these exchanges are all about, as well as some auxiliary things that are important to know. This will also include what DEXs are according to Rates, a closer look at functionality, as well as anything you’re likely to expect once in it. With more interest going into this specific area, it’s at least worth a look!
DEXs as they’re also called are p2p platforms that allow interested parties to trade crypto and assets in a decentralized manner that lacks the traditional middleman of your typical exchange. This is accomplished via the use of smart contracts that are facilitated by the public ledger known as the blockchain. Because of this mode of operation, DEXs typically don’t face the following:
- Transparency issues and counterparty risks
- Hacking risks due to the lack of a central location or platform
- Limited liquidity if we compare to centralized exchanges
- Security risks as users have full control of funds
- Centralized requirements, identity verification and other similar processes
- Trading restrictions or limitations published by centralized banks
- Location restrictions (that allow users participate worldwide)
- Privacy and anonymity for their users and traders
- Integration with DeFi protocols and services and much more
With cryptocurrencies becoming continually more common, it should come as no surprise that several trading platforms have presented themselves. The following are just some of the most notable ones out there:
Note that, unlike centralized exchanges, DEXs are exclusively tied to crypto, which means one can swap Bitcoin for Ethereum, platform-created coins, and even NFTs. In short, fiat exchanges are out of the question.
How does it function?
Understanding how a DEX operates requires you to know some key things beforehand. One of these keys is the knowledge that platforms of this kind come in one of two forms, which are the automated market maker or AMM and the order book.
The AMM Path
These are bots that simplify crypto trading by allowing users to trade easily by providing liquidity for assets where there’s little to no. This is done by trading among the market maker’s accounts and making a profit. With liquidity secured, trades of greater magnitude have a lessened impact.
They are the most widely used of the two types mainly because they operate with the use of smart contracts, which set the exchange rate. These DEXs are constantly quoting users’ prices and it’s this that allows instant access to liquidity pools.
Speaking of liquidity pools, an emphasis on accessible ones is rather heavy, as trades happen instantly and without outside allowance. This is, of course, only possible provided that said pools are sufficient. As such, users are often encouraged to also play the role of liquidity provider, which gets them a share of trading fees, while still paying for using the network.
Most DEXs available in the sphere are of this kind because of the ease of use. Uniswap, for example, has just around 30 million users and counting.
The order book path
This more traditional route matches buy and sell orders that depend on a particular platform’s set electronic conditions. It isn’t as used because, for the most part, it’s quite cumbersome, demanding that every order be put up on the Blockchain.
This does make them less secure and far more reliant on centralized systems, defeating their entire purpose. Though not as utilized as their counterpart, there’s still use for this path as shown in the existence of exchanges such as dYdX.
As you would imagine, overseeing any of this would be quite a hassle. In response, decentralized autonomous organizations, or DAOs, have been put in place to monitor the scene and make key decisions when necessary.
Why use them?
The use of blockchain technology and smart contracts has given DEXs several advantages, some of which have been listed above, but need to be expanded on. For starters, the lack of third parties found in centralized platforms makes transparency far more possible.
Because decentralization comes with some user anonymity, hacking is quite difficult. This opposes traditional platforms where targeting the main intermediary leaves all other participants open.
Chief among the advantages, however, is the fact that it’s quite accessible. All that’s necessary to get involved is an appropriate wallet and Wi-Fi. Afterwards signing up for platforms is an easy feat.
Are there any risks involved?
Beneficial as DEXs are, all things in business are risky, which means you’ll have to think of a few things before getting involved. When it comes to DEXs the following are some of the most prominent risks:
- Smart contracts are only as good as their developers
- Poor liquidity is more than a possibility and isn’t at all helpful
- Blockchain technology is still developing, which means full decentralization isn’t always possible
- False tokens can run rampant
- Too much traffic in these networks can slow things down significantly
The crypto sphere is gaining a lot of traction, even being incorporated into payment systems such as Mastercard and its millions of the USA users. As such just about anyone from rural Mississippi to Miami, Florida will start to gain access to DEXs and all they have to offer. That said, we are quite a ways away from that since centralized systems and their fiat connections are still more desirable currently.
This is further compounded by the fact that most insurance companies, like Allstate, for example, don’t cover crypto, or are at least hesitant. As time progresses, however, things are likely to change, so it’s wise of you to get a head start if possible.