Similar to foreign exchange markets, where currencies are traded continuously, cryptocurrencies need their own markets for users to buy, sell and trade cryptocurrencies. However, as decentralization is a key aspect of cryptocurrency trading there was a need - trading without the cost or manipulation of a third party, for exchanges without a centralized point of authority, welcome Decentralized Exchanges (DEX).
What are Decentralized Exchanges (DEX)
Decentralized exchanges are cryptocurrency exchanges focusing on peer-to-peer trade without the need for a middleman. Being peer-to-peer, they are not legally based in any country or jurisdiction.
A great way to understand how decentralized exchanges function is the image above. Notice how in the centralized model all assets are a direct connection to the middle man, not each other. Decentralized exchanges are mere platforms for investors to buy, sell and trade their crypto assets anonymously and securely.
Decentralized Exchanges use Automated Market Maker protocols to configure the price of each cryptocurrency, to reduce potential cryptocurrency arbitrage.
How do Users Interact with a DEX?
Unlike centralized exchanges, there are no accounts, Know Your Customer checks, or specific rules surrounding who can use a DEX. They are trustless and permissionless, allowing anyone with access to a cryptocurrency wallet and funds to use them.
Users, therefore, cannot store any cryptocurrency on a decentralized exchange so must connect through a variety of cold or hot wallets, such as MetaMask which is a non-custodial browser wallet. Once a wallet is connected, the user can then anonymously trade any cryptocurrency stored on the wallet or access dApps and their protocols from inside the Decentralised Exchange, making them a gateway into DeFi (Decentralized Finance).
Main Features and Differences of Decentralized Exchanges
Many newcomers to the crypto space may be confused about the differences between Decentralized Exchanges, especially if they are used to traditional banking systems, and rightfully so. Here are some of the main features and differences which Decentralized Exchanges have when comparing them to Centralized Exchanges and even non-crypto platforms like banks.
Security is of even more importance in the crypto-world and is one of the main incentives for using a Decentralized Exchange. Wallets that connect to DEXs, like MetaMask, are called non-custodial wallets which is a fancy way of saying only the owner of the wallet has access to the cryptocurrency inside. Wallets like these provide users with ‘keys’ that only they have access to, which is where the phrase ‘not your keys not your coins’ comes from. Cryptocurrency on centralized exchanges is stored in custodial wallets.
Furthermore, as wallets are only connected, not stored, on Decentralized Exchanges only the user ever has access to their cryptocurrency with the DEX simply being an interface allowing the movement of funds. This means your cryptocurrency cannot be ‘hacked’ from a DEX as they were never stored there in the first place.
No personal information is required to trade on a DEX, making it trustless and permissionless. Centralized Exchanges will require KYC protocols before you can deposit cryptocurrency or fiat to utilize their services. The anonymity this provides to DEX users is another big drawing point for many as their wallet address is not connected to their name or identity which may also be useful for those living in countries without progressive cryptocurrency regulation , such as China.
Also, this allows absolutely anyone in the world with an internet connection to access a DEX, removing the limitations of developing countries banking infrastructure or backward ruling, and giving everyone complete rights to their own finances. This anonymity has been heightened by recent events in Canada for example, where assets were simply frozen by the government, illustrating to many Canadians and cryptocurrency investors worldwide that ‘not your keys, not your coins’ and the amazing lack of control one has over their fiat currency when stored in traditional banking.
Anyone using peer-to-peer trading on Decentralized Exchanges can only trade with cryptocurrencies. Unlike centralized exchanges, fiat has no use case in DeFi so crypto-to-crypto trades using cryptocurrency ‘pairs’ such as ETH/USDT are the only way to trade. However, stablecoins have made DeFi less volatile in recent years as seen from our ETH/USDT pair, you are essentially trading fiat using a stablecoin tethered to the value of a singular US dollar.
- Transaction Storage
Centralized Exchanges will often keep transaction data for up to six months for security and tax implications. However, Decentralized Exchange transactions are visible directly on the blockchain, making each transaction completely transparent. Although wallet addresses are anonymous, the blockchain allows for all transactions to be visible to anyone with access.
Also, DEXs are built completely on open-source code, allowing anyone to see how they truly work, with Uniswaps code being used to create ample other DEXs such as Pancakeswap.
- DeFi Access
Decentralized Exchanges offer easy access into the world of DeFi, allowing users to anonymously get funds into DeFi protocols such as staking, without going through a centralized exchange.
Decentralized Exchange Fees
Although DEX fees are often lower than centralized exchanges, most DEXs are run on the Ethereum blockchain, which means transactions, when the volume is high, will cost a lot. This is referred to as Ethereums ‘gas fee’ and can sometimes reach as high as $200 for a single transaction as the blockchain can currently only handle 15 transactions per second.
Currently, Ethereum 2.0 is in the process of going live, which will transition Ethereum from a PoW mechanism to a PoS mechanism, massively increasing the number of transactions per second possible and reducing fees for its users.
Risks of Decentralized Exchanges
- Exit Scams
Exit scams, which most commonly occur in the form of ‘rug pulls’ when founders, developers, or extremely large stakeholders in a cryptocurrency decide to simply ‘pull the rug’ from underneath its investors, leaving the coins held by the victims completely worthless.
Exit scams can also happen on centralized exchanges, they are simply less likely. The reason for a greater risk of these types of scams on Decentralized Exchange is the lack of regulation around who can list a coin and the vetting process that occurs before a cryptocurrency project is listed. Inside DeFi, there is no vetting process, anyone can list a project.
- A perfect example of what a ‘rug pull’ looks like, all liquidity is instantly removed from the project.
2. Volatility (Low Market Cap Coins)
Massive volatility will occur on both DEX and CEXs, but as mentioned before there are ample amounts of ‘shit coins’ listed on DEXs making them rife for daily or even hourly volatility spikes.
Also, as any coin is tradeable on a DEX, low liquidity is a real problem for many low market-cap coins, especially those only familiar with trading high-cap cryptos such as Ethereum and Bitcoin on centralized exchanges. If I have $1,000 worth of a cryptocurrency that no one is trading, I essentially have $0. You need liquidity in the market to secure your funds if needed.
3. Smart Contract Safety
DeFi and Decentralized Exchanges are only as secure as their smart contracts, as they have no central authority governing them. Some smart contracts can be exploited if there is a bug or problem, even with the most tested of contracts, which could lead users to lose their coins or tokens.
Remember that even though anonymity is good for individuals, it also allows hackers to ‘run free’ inside of DeFi.
4. Your Keys, Your Losses
Having complete custody over your cryptocurrency is amazing until you mess up. On Decentralized Exchanges and DeFi, there is no support hotline to ring, you are on your own. Transactions cannot be cancelled, refunds given or lost coins returned.
I Understand the Risks, How Can I Start?
Ensure you have a Metamask wallet with the required funds in, whether that be ETH or Bsc to cover transaction costs and the coin(s) you want to trade. Make sure you have saved the privacy phrase of your wallet somewhere safe.
Choosing your DEX. It's advised to choose one of the biggest DEXs to ensure maximum liquidity, such as Uniswap, Pancakeswap or Sushiswap.
Finally, understanding the risk involved with each event or protocol you participate in and how to keep your funds secure is worth the time researching and fully understanding. Mistakes made in DeFi and mistakes owned.
Will Decentralized Exchanges ever become Mainstream?
We have already seen massive adoption of DEXs with huge sums of capital, in the billions, flooding into DeFi during 2021. However, for mass adoption to occur, DEXs still must tackle a few major issues.
- Easier technical barrier to entry
- Ethereum 2.0 Proof of Stake model to reduce fees during high volume
- Interoperability between different DeFi platforms to create a seamless ecosystem of decentralized peer-to-peer trade
- Easier fiat of and on-ramps
It's important to understand the benefits and downsides of using DEXs and participating in DeFi. Most importantly, it's essential you do your own research on any protocols you plan on interacting with, ensuring you understand the risk involved, how privacy and security work such as encryption keys and making sure you keep your funds safely stored in a non-custodial wallet.