A Decentralized Exchange (DEX) is a peer-to-peer (p2p) online service that allows direct cryptocurrency transactions between two interested parties.
Decentralized cryptocurrency exchanges aim to solve the problems inherent in centralized exchanges. They create p2p markets directly on the blockchain, allowing traders to independently store and my funds. Users of these exchanges can conduct cryptocurrency transactions directly among themselves, that is, without the participation of third parties.
Decentralized exchanges are controlled automatically or by participants. Asset safety is ensured by distributed ledger technology (DLT) – as a rule, the following blockchains are mainly used for DEX: Ethereum (EtherDelta, IDEX, etc.), Graphene (BitShares, CryptoBridge, etc.) Or blockchains running on others cryptocurrencies (Waves, Switcheo, etc.).
On-Chain order books
On some decentralized exchanges, everything happens in a chain (we’ll talk about hybrid approaches soon). Every order (as well as modification and cancellation) is recorded on the blockchain. This is perhaps the most transparent approach, since you do not trust a third party to give you commands, and they cannot be hidden.
Unfortunately, this is also the least practical. Since every host saves the order forever, you end up paying a commission. You have to wait for the miner to add your message to the blockchain, which means the experience can be overwhelming as well.
Some identify direct surgery as a defect in this model. A front launch occurs in the markets when an insider becomes aware of an unfinished trade and uses that information to complete the trade before the trade is processed. In this way, the top runner benefits from information not known to the general public. Generally speaking, this is illegal.
Of course, if everything is published in the global ledger, there is no way to advance in the traditional sense. However, another type of attack can be used: one in which the miner sees the order before it is confirmed and ensures that his own order is first added to the blockchain.
Examples of chain order book models include DEX Stellar and Bitshares.
Off-Chain order books
The DEX off-chain backlog is still somewhat decentralized, but admittedly more centralized than the previous entry. Instead of each order being placed on the blockchain, they are being placed somewhere.
Or? It depends. You may have a centralized organization that is fully responsible for the order book. If this entity is malicious, then it can play in the markets to some extent (for example, filling orders or distorting them). However, you will still benefit from untouchable storage.
The 0x protocol for ERC-20 and other tokens deployed on the Ethereum blockchain is a good example. Rather than acting as a single DEX, it provides a framework for parties known as “relays” to manage off-chain order books. Taking advantage of 0x smart contracts and some other tools, hosts can connect to a pooled liquidity pool and transfer orders between users. The transaction is not executed on the chain until the parties agree.
These approaches are superior in terms of usability to those that rely on order chains. They don’t face the same speed limits as they don’t use blockchain as often. However, trading needs to be set to this, so the off-chain order book model still lags behind centralized exchanges in terms of speed.
Off-chain order book implementations include Binance DEX, IDEX, and EtherDelta.
Automated Market Makers (AMM)
Tired of reading the term “lag”? Great, because the Automated Market Maker (AMM) template completely eliminates this idea. It doesn’t need creators or hosts, only users, game theory, and a little black magic.
The specifics of AMMs are implementation-dependent – they usually bundle a set of smart contracts and offer reasonable incentives to ensure user participation. We won’t go into the details of these implementations, but let’s see what Uniswap is and how does it work? for an example of how Uniswap DEX works.
The AMM-based DEXs available today tend to be relatively user-friendly and integrate into wallets like MetaMask or Trust Wallet. However, as with other forms of DEX, a chain transaction must be executed to settle transactions.
Projects working in this direction include the aforementioned Uniswap and Kyber Network (which work with the Bancor protocol), both of which facilitate the trading of ERC-20 tokens.
Most of the strengths of decentralized exchanges are due to their distributed architecture and lack of a unified control center.
Security: Decentralized exchanges do not store user assets. Therefore, neither hacker attacks nor a total stock market crash can lead to loss of funds. The lack of a single point of entry through which to gain access to all assets and data complicates the work of hackers and makes the attack meaningless in itself, which radically distinguishes decentralized exchanges from regularly centralized exchanges. hacked.
Low risk of manipulation: Another advantage of this type of service is the minimal risk of price manipulation or falsification of transaction volumes due to the lack of a central structure that is interested in manipulating within the wallet.
The decentralized exchange does not have a personal account, no verification is required, and you do not even need to provide an email address so that the personal data of users cannot be stolen. This framework makes distributed ledger services more anonymous than exchanges that require personal authentication to meet Know Your Customer (KYC) and anti-money laundering (AML) requirements.
Regulatory independence: The distributed architecture protects the exchange from interference from local or international authorities. In the case of centralized structures, compliance with the rules means that the exchange service may be completely or partially blocked, in which case the service becomes limited in terms of location or options.
Accessibility for various projects: Unlike its centralized brother, a decentralized exchange not only allows you to place orders for existing cryptocurrencies but also create new ones right in the system. This allows startups to provide minimal liquidity without having to pay high commissions for listing on major platforms.
Disadvantages of decentralized exchange
The distributed architecture of decentralized exchanges and the complete control of users over their own funds present a number of difficulties.
Inability to restore access: for example, due to the lack of a KYC process and the ability to rollback a transaction in the event of a password cracking or loss of a private key, the user cannot recover his data and recover assets. Withdrawal and refund procedures are incompatible with a distributed ledger. Users who have made an operation by mistake or lost control of their keys cannot regain their access.
A small set of options: Many options for traders like stop-loss, margin trading, or loans are not available to most DEX users. Since many decentralized exchanges are governed by smart contracts, cryptocurrencies that do not interact with smart contracts cannot trade on them.
Low liquidity: Decentralized exchanges usually have a much smaller pool of liquidity than centralized exchanges. Thus, while the daily volume of Bitshares DEX is 197 BTC, the same parameter on Binance reaches 227,123 BTC.
This difference is due to the fact that traders prefer centralized services, where the choice of instruments, currency pairs, and the orders themselves is much more important than on the DEX. As a result, the decentralized service falls into a so-called vicious circle – that is, there are few users due to low liquidity, and obtaining liquidity is impossible without a large number of traders.
Scalability Issues: The influx of large numbers of people willing to trade cryptocurrencies will almost inevitably lead to a heavy load on the network and can lead to delays, increased fees, and all other problems already known to stories from centralized exchanges.
No support desk: A decentralized exchange, by definition, cannot have a support desk capable of handling transactions or user accounts. Choosing such an exchange for exchanging digital money, the user is fully responsible for his funds, and in case of losing the private key or sending an incorrect transaction, he cannot request qualified assistance. The lack of upfront support also means that a dramatic increase in user requests can lead to scalability issues, and operator response times can increase in case of technical problems.
Limited speed: transactions take a long time to be verified and confirmed on the blockchain, and the processing time does not depend on the exchange, but on the miners. Since DEXs are less popular than their centralized counterparts, it can be difficult for users to find someone to match their buy or sell orders – or get a deal at a good price. Buying or selling a new or low volume currency can be even more challenging.
Can Decentralized exchange be completely decentralized?
Most of the existing exchanges claiming decentralization are actually not quite the case.
The fact is that many DEXs use their own servers to store trade data and applications to buy or sell custom assets, but the private keys are kept by the users themselves.
Thus, decentralized exchanges have centralized components that allow the government to control its operations. A prime example is IDEX, which prohibits New Yorkers from trading on the platform.
For the same reason, some exchanges can be hacked and attacked. Charlie Lee, the creator of Litecoin, said that an exchange cannot be decentralized if it can lose or freeze its clients’ funds. The post appeared on his Twitter after the Bancor decentralized exchange was hacked on July 9, 2018, and lost $ 13.5 million in assets.
About Handling Disputes/Complaints on Decentralized Exchange
The main problem with DEX regulation is that in most cases these exchanges are not controlled by a specific legal entity or individual.
Since DEX is not required to comply with regulatory requirements, this leads to problems in identifying who is responsible for the violation, difficulties in verifying business activities, or identifying possible violations. For the same reason, some of the pre-existing rules applicable to centralized exchanges may not apply to decentralized exchanges.
In the United States, regulators are trying to enforce existing legal frameworks, and in Singapore, the authorities are trying to create a new regulatory framework for such exchanges. However, there is no definite position regarding DEX in these countries, and in other countries, decentralized exchanges are not regulated at all.