In the world of cryptocurrency, there are two main types of exchanges: centralized and decentralized exchanges.
Centralized exchanges are the more traditional type, where users deposit their funds into the exchange and then trade with other users on the platform.
Decentralized exchanges, on the other hand, are powered by blockchain technology and allow users to trade directly with each other without the need for a central authority.
What is a Decentralized Exchange?
Decentralized exchanges (DEXes) are cryptocurrency exchanges that do not rely on third parties to hold customers’ funds. Instead, trades occur directly between users (peer-to-peer) through an automated process. This type of exchange is often favored by privacy-minded users and those seeking increased security.
DEXes are a relatively new phenomenon in the cryptocurrency space and are constantly evolving. The most popular decentralized exchange in operation today is EtherDelta, which facilitates trades of Ethereum (ETH) and ERC20 tokens. Other decentralized exchanges include Waves DEX, IDEX, and Radar Relay.
This type of exchange is often lauded for its increased security, as third parties are not needed to hold onto users’ funds. Additionally, decentralized exchanges are often seen as more private, as they do not require Know-Your-Customer (KYC) or Anti-Money-Laundering (AML) requirements that centralized exchanges do.
Though they come with a number of advantages, decentralized exchanges also have a few disadvantages. Let’s explore the working and the pros and cons of DEXes.
How do Decentralized Exchanges Work?
On a decentralized exchange, trades are facilitated by smart contracts on a blockchain. This means that a decentralized exchange is much less likely to be hacked, as there is no central point of attack.
DEXes work in a similar way to traditional exchanges, in that they allow users to buy and sell cryptocurrencies. But, there are a few key differences.
- Less regulated than traditional exchanges. This can be seen as an advantage or a disadvantage, depending on your point of view.
- Lower fees than traditional exchanges. This is because there are no middlemen involved in the process.
- Faster than traditional exchanges with transaction processing. This is because there is no need for approval from a third party before a trade can be made.
The steps to trade cryptocurrencies on a DEX are similar to a centralized exchange, the process involves additional upfront steps.
Step 1: Connect an existing wallet to the exchange
In order to trade on a decentralized exchange, you will need to connect your cryptocurrency wallet to the exchange. This can be done by entering your wallet address into the exchange interface.
Step 2: Choose the currency pairs that you want to trade
Once your wallet is connected, you will need to choose the currency pairs that you want to trade. Decentralized exchanges may offer a smaller selection of cryptocurrency pairs, so you can find an exchange that deals in the tokens you’re interested in.
Step 3: Place your buy or sell orders
Once you have chosen the currency pairs that you want to trade, you will need to place your buy or sell orders. You can do this by entering the amount of currency that you want to buy or sell, and the price that you are willing to pay or accept.
Step 4: Your order will be matched with another order and the trade will be executed
Once you have placed your order, it will be matched with another order from another user. If the orders are compatible, the trade will be executed and the coins will be transferred to the respective wallets.
Step 5: The trade will be recorded on the blockchain
The trade will be complete once it is recorded on the blockchain. This decentralized system ensures that all trades are transparent and secure. It also allows you to view the trade history of any particular currency pair.
Let’s now look at some of the pros and cons of a decentralized exchange.
Advantages of decentralized exchanges
There are a few key benefits of using a decentralized exchange, which we outline below.
One of the biggest benefits of using a decentralized exchange is that it is often seen as more secure than a centralized exchange. This is because decentralized exchanges do not require a third party to hold onto users’ funds.
Additionally, decentralized exchanges are often built on top of blockchain technology, which adds an additional layer of security. With a decentralized exchange, users can be sure that their funds are safe and secure.
Another benefit of using a decentralized exchange is that they are often more private than centralized exchanges. This is because decentralized exchanges do not require Know-Your-Customer (KYC) or Anti-Money-Laundering (AML) requirements that centralized exchanges do.
As such, users can trade on a decentralized exchange without having to go through a lengthy verification process. Additionally, users can remain anonymous on a decentralized exchange, which is not possible on a centralized exchange.
Another advantage of decentralized exchanges is that they are censorship-resistant. This means that no single entity can control or shut down a decentralized exchange.
This is in contrast to centralized exchanges, which can be shut down by governments or financial institutions. For example, in 2017, the Chinese government shut down all of the country’s cryptocurrency exchanges.
Disadvantages of decentralized exchanges
Though they come with a number of advantages, decentralized exchanges also have a few disadvantages. Below, we outline a few of the biggest disadvantages of using a decentralized exchange.
One of the biggest disadvantages of using a decentralized exchanges is that they are often less user-friendly than centralized exchanges. This is because decentralized exchanges can be difficult to use for those who are not familiar with the process.
Additionally, decentralized exchanges often have complex user interfaces that can be difficult to navigate. As such, it can be difficult for newcomers to trade on a decentralized exchange.
Another disadvantage of using a decentralized exchange is that they generally have lower liquidity than centralized exchanges. This is because there are fewer users trading on them.
As such, it can be difficult to find someone to take the other side of a trade on a decentralized exchange. This can make it difficult to buy or sell certain tokens, as there may not be enough buyers or sellers.
Limited payment options
Another downside of using a decentralized exchange is that they often have limited payment options. This is because decentralized exchanges only support cryptocurrency payments.
As such, users cannot use fiat currency (e.g. USD, EUR, GBP) to buy or sell tokens on a decentralized exchange. This can be a problem for those who do not own any cryptocurrency, as they will need to first purchase cryptocurrency before they can trade on a decentralized exchange.
Decentralized exchanges offer several advantages over centralized exchanges, including increased security, privacy, and censorship resistance. However, they also come with some risks, such as lower liquidity and complexity. Whether or not a decentralized exchange is right for you will depend on your needs and preferences.