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What is a DEX?
Blockchain technology has paved the way for some unique use cases, including DEXs. A decentralized exchange is a peer-to-peer cryptocurrency marketplace; these exchanges require no third party, and users can directly trade with each other. DEXs exist as decentralized apps (DApps) and use smart contracts to facilitate trading. However, unlike the case with centralized exchanges, DEX users have complete control over their coins.
DEXs do not merely facilitate the trading of cryptocurrencies, although they are primarily known for this. Another popular use case of blockchain technology is the tokenization of assets, making it easy to trade them on decentralized exchanges. Through tokenization, DEX users can invest in some of their popular assets, including stocks. Tokenization also makes it possible for such individuals to invest in fractions as they would with regard to digital currencies. Also, DEXs facilitate the 24/7 trading of tokenized assets, which is not possible in stock exchanges.
How Do DEXs Work?
Smart contracts facilitate trading on decentralized exchanges in three ways: through an on-chain order book, by using an off-chain order book, and through an automated market maker. An on-chain order book records all transactions on the blockchain; it includes the requests to buy or sell tokens as well as the actual trade. Recording all this data makes DEXs that use on-chain order books more expensive and slower. Meanwhile, off-chain order books store all of the data in other places. Only the final transaction is recorded on the blockchain. Moreover, these order books are susceptible to security issues in the same way centralized exchanges are. Nonetheless, they are not as expensive or slow as on-chain order books.
Most decentralized exchanges use automated market makers (AMM). AMMs introduce algorithms to set prices and facilitate trades on the blockchain, and users play a crucial role in trading by pooling their resources to create liquidity pools that facilitate trading.
Decentralized vs Centralized Exchanges: What is the Difference?
Like any other viable DeFi project, DEXs try to address the blockchain trilemma. The primary difference between centralized and decentralized exchanges lies in how they run. Unlike DEXs, central authorities govern centralized exchanges (CEXs) and facilitate transactions; consequently, the decentralized nature of their counterpart causes significant differences between the two types of exchange.
A major difference is in how these exchanges handle market making. DEXs use an automated market maker protocol, and a group of investors in the marketplace provide the needed liquidity by pooling their digital tokens together. In return, they get rewards as their compensation. On the other hand, CEXs use order books when settling transactions. Furthermore, centralized systems require active participation to provide the liquidity needed and can also handle bigger trade volumes.
DEX transactions remain anonymous, even though each of them appears on a public ledger. Each transaction is encrypted to protect user information. However, CEXs gather all user information as required by law through KYC checks. The anonymity feature and the fact that DEX users have complete control over their private keys makes these exchanges more secure than their centralized counterparts. DEXs do not store user data in a central server, which is the case with centralized exchanges. As such, they are at a lower risk of security hacks. Finally, CEXs feature interfaces that are more user-friendly than decentralized exchanges.
Pros and Cons of Decentralized Exchanges
The Advantages
● Reduced risk of hacking and manipulation: DEX users have complete control over their private keys. All the funds on the exchange are not stored in a central wallet, making it difficult for hackers to access it. Additionally, the absence of a central authority reduces the chances of price manipulation and falsified trade volumes.
● Maintains anonymity: Most popular DEXs do not require users to enter private information to use the platform. Although recent regulations require KYC and AML checks, user data on DEXs remains anonymous. However, the blockchain keeps a ledger of all transactions, which is traceable, should the need to access this information arise.
● Diverse options: Decentralized exchanges give easier access to limitless tokens. While you can use the marketplaces to access existing digital assets, DeFi also allows you to develop new tokens. Moreover, DEXs also facilitate asset tokenization, making it easier for ordinary users to invest in fractions of popular assets and commodities, such as stocks and commodities.
● Utility: Decentralized exchanges are a significant part of developing economies because of their numerous advantages. The anonymity, speed, and cheapness of transactions as well as their decentralized nature make these marketplaces ideal for anyone with a smartphone and internet connection.
The Disadvantages
● Complex: Most decentralized exchanges have complex user interfaces. As such, getting started with these platforms requires some prior knowledge. Unlike centralized exchanges that are more straightforward, using DEXs may be a bit complicated for new users.
● No customer service: Because these exchanges do not have a central authority governing them, no customer support is available. Therefore, users have to rely on the available documentation to figure out the solution in case of any issue.
● Low liquidity: DEXs have lower liquidity than centralized exchanges, since they do not store user funds. The liquidity on these platforms depends on token availability that is determined by increased individual participation in the marketplace.
● Smart contract vulnerability: Just like any other DeFi project, decentralized exchanges are as secure as the smart contract that powers them; therefore, bugs in the smart-contract source code compromise the platform’s security.
● No fiat trading pairs: DEX users cannot trade fiat currencies or even make fiat deposits. Users must either purchase cryptocurrencies or have existing ones in their wallets to use these platforms.
