What is a Decentralized Exchange and Why Should You Care?
The main differentiator for a decentralized exchange is that you are trading crypto for crypto on the same blockchain. On DEX, you have to already belong to the ecosystem (Crypto users, Blockchain users) in other to participate in trading.
The four core functions of any exchange are:
- Capital deposits
- Order Books
- Order matching
- Asset Exchange
In order to create a Decentralized Exchange (DEX), each of these functions must be decentralized. Typically, on cryptocurrency exchanges, the assets exchange part is decentralized by default as the assets are cryptocurrencies. The other three functions, and especially deposits, are usually centralized. Due to “know your customer” and “anti-money laundering” regulations exchanges are required to seek user identities for any capital deposits which is stored on a centralized server that holds your information and exchange with any form of centralized databases or servers allowing you to access the cryptocurrency market.
A decentralized exchange cannot shut anyone out. Any application built on a decentralized blockchain can’t be shut down unless the entire chain is shut down. If your access point to the crypto world is a centralized exchange, then your ability to access cryptocurrency is no more free or independent than your ability to access regular currency. A Government could still seize your assets, shut down your trading, or come after you personally.
Decentralized exchanges mitigate much of these risks. It also requires the user to be 💯% responsible and in control of their funds. For some other people, this might be a negative. Not everyone wants to be in charge of the safety of their assets. By shouldering the responsibility on your own, your funds are as secure as you want them to be. Several million dollars of cryptocurrencies have been stolen from users when the centralized exchange that they used was hacked.
Traditional Exchange vs Decentralized Exchange
Traditional exchanges have been run by centralized companies who are responsible for all the aspects of how the platform operates. Normally entities known as market makers form the backbone of all trading on a platform by providing the majority of the liquidity. This is usually from the reserve that the exchange itself is holding or from major players operating on the exchange. By placing orders on the buy and sell sides of the order book, they make it possible for other traders called market takers to be able to execute their own trades with maximum efficiency. Decentralized exchanges however handle all of this with pure code, meaning there's no central authority that has any power over the system which is made possible by smart contracts that act as the automatic market markers.
DEXes can offer virtually all the functionality of a centralized exchange with notably lower fees, know your customer requirements, which is attractive to a variety of users.
DEX’s can facilitate faster and cheaper transactions as code does all the validation. There's no middleman paying employees to verify every trade and take huge cuts off of every transaction. The code does the work and you get the best value as well as the most control in your trading.
It’s not an easy undertaking to decentralize every aspect of an exchange marketplace, and while some have nailed down the basic functionalities of swapping coins with other users.
There are some issues for you to consider in DEX like:
- Slippage: Slippage means the difference between the expected price of trade vs the actual price that gets executed. This can happen because the market moves just as an order is going through or when liquidity is too low, the trade itself can actually move the market sometimes quite a bit. They are usually some safety nets that have to be in place because if the user is not careful, they can end up paying more or receiving less than they originally anticipated.
This is best combated by paying attention to how much liquidity is available for the asset you are trying to exchange and staying away from smaller volume pools. Services like Uniswap offer the ability to set slippage tolerances that will cancel a trade if it's going to move the prices past a certain percentage, which can help to at least mitigate some mistakes.
One important thing to watch out for are scam tokens. Since everything is user-run and unregulated, anyone can deploy a new asset to the ecosystem. While this gives freedom and flexibility to project developers, it also paves the way for scammers to make virtually identical copies of existing tokens all in the hope of confusing users who are trying to purchase the real assets. The name and icon can be exactly the same, the only obvious difference will be the address of the smart contract you’re interacting with. This is why you should always follow official links from the developer's website when looking to trade new tokens on decentralized exchanges.
By sticking only to verified links, you should be able to avoid scams.
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