What is a decentralized exchange (DEX)? All the most important

Main

• A decentralized exchange (DEX) is a crypto asset trading application in which exchange and other transactions take place using smart contracts rather than a centralized trading system.
• The fundamental difference between DEX and centralized exchanges is that they do not store user funds and do not control transactions. Funds are transferred directly from the user’s wallet, which he connects to the platform. Also, decentralized exchanges do not have a user verification procedure.
• Decentralized exchanges have become an essential element of the decentralized finance (DeFi) space. As of mid-2022, there are over 200 DEXs running on dozens of blockchains.

How do decentralized exchanges differ from centralized ones?

Cryptocurrency centralized exchanges (CEXs) such as Coinbase, Bitfinex, or Kraken are organized similarly to traditional stock exchanges. They are managed by specific legal entities that are responsible for the operation of the platform, the safety of user funds and compliance with laws.

Therefore, the administrations of centralized exchanges have access to customer funds and, if necessary, can block an individual user, a specific operation or an entire direction, such as withdrawals. In addition, each new user is required to complete the identity verification (KYC) procedure.

In turn, decentralized exchanges are not an intermediary in transactions, they do not store funds and personal data of their users. Clients are most often identified using blockchain addresses and non-custodial wallets connected to the application. Trade transactions and other actions take place with the help of smart contracts.

In addition, in many decentralized exchanges, key decisions are not made by the founding and development team, but by the community of governance token holders through voting in the DAO. However, DEX often has a key developer who creates and develops smart contracts and the application protocol. At the same time, the source code of key components is open. Decentralized exchanges are the main type of DeFi applications.

When did decentralized exchanges appear?

Initially, all cryptocurrency trading was centralized. The first decentralized exchange appeared in 2014 and was called NXT Asset Exchange. At the same time, similar projects appeared, in particular Counterparty DEX and Block DX, but they did not attract much attention.

In connection with the ICO boom in 2017-2018, thousands of new crypto assets appeared on the market. They were often traded on new DEXs such as EtherDelta, IDEX, DDex and others. Those worked mainly on the Ethereum blockchain and supported ERC-20 standard tokens. However, the standard problems of the DEX at that time were low liquidity, large spreads, slow operation and too high commissions for transactions.

The Automated Market Maker (AMM) technology has brought real popularity to decentralized exchanges. Instead of the traditional order book, it uses the so-called liquidity pools of pairs of assets, and prices are calculated using a mathematical formula based on their ratio in the pool. This allows you to create a decentralized architecture and guarantee on-chain transactions through smart contracts, which are comparable in execution speed to centralized platforms.

For the first time, AMM technology was introduced by the Bancor project. However, the Uniswap decentralized exchange, launched in 2018 on the Ethereum blockchain, has become truly popular. During the development of the project was supported by Vitalik Buterin.

What are the advantages of decentralized exchanges?

Most of the strengths of decentralized exchanges stem from their distributed architecture. Here are a few key benefits (although some of them are also disadvantages):

• extremely simple trading interface without order books and different types of orders;
• complete anonymity of clients, since registration, opening a personal account or verification (KYC) with the provision of personal data is not required to work with DEX;
• DEXs do not store user crypto assets, so neither the exchange developers nor the authorities can freeze funds on user accounts or set other restrictions;
• listing of new assets on the DEX occurs instantly when the corresponding liquidity pools are replenished;
• the possibility of passive income for users by contributing assets to liquidity pools;
• DEX users can participate in its governance by farming a governance token.

Thus, decentralized trading platforms give users full control over their funds, but at the same time full responsibility for their actions.

What are the cons of decentralized exchanges?

There are several negative features and risks of using decentralized exchanges:

1. In most modern DEXs, the exchange of crypto assets is possible only within the same blockchain. Sometimes crypto assets from different networks are added to the DEX through cross-chain bridges, but this complicates the trading process.
2. On decentralized trading platforms, the phenomenon of intermittent losses is often encountered.
3. Decentralized exchanges have limited trading functions and do not have the usual options, such as different types of orders (for example, Limit or Stop Loss) or transactions with leverage. There are no additional tools, such as a tape or order book.
4. Any trading transactions, including erroneous or fraudulent transactions, are executed automatically through the blockchain and cannot be canceled or disputed in the support service. This is often used by cybercriminals to sell stolen cryptocurrencies.
5. The speed of exchange transactions in the DEX depends on the speed of confirmation of transactions in the blockchain and ranges from several seconds to several minutes. Therefore, high-frequency trading in decentralized exchanges is not possible.
6. Decentralized exchanges tend to have less liquidity compared to centralized exchanges. Therefore, when buying or selling large positions in low-liquid pairs, users may experience the so-called price slippage, which reduces the benefit to the user;
7. Commissions for transactions in DEX are higher than in centralized exchanges. In addition, users are also forced to pay a network commission.
8. When exchanging assets and on large volumes, users can become victims of price manipulation using MEV bots.
9. Since most modern DEXs do not have a centralized asset listing system, this is used by scammers issuing fake tokens for the implementation of criminal schemes, including Pump & Dump and Rug Pull.
10. Due to the presence of vulnerabilities in the code of smart contracts or the web interface, DEXs are subject to hacker attacks and hacks. For example, on June 8, 2022, assets worth $5 million were stolen from Osmosis DEX liquidity pools. Such incidents do not threaten the funds of exchange users, but can lead to the loss of funds of liquidity providers.

Are decentralized exchanges legal?

At the moment, decentralized exchanges operate in a “grey zone”, as the legislation does not yet take into account all the nuances of the architecture of these platforms, and regulators have not found effective ways to oversee them.

One of the main difficulties associated with the regulation of decentralized exchanges is that they are often not associated with specific legal entities and do not belong to any jurisdiction. For some DEXs, even their creators do not reveal their identities, making it difficult to determine who is responsible in the event of any breach.

However, attempts to force decentralized exchanges to comply with local laws have been made repeatedly in recent years, especially in the United States. For example, in November 2018 SEC accused EtherDelta co-founder Zachary Coburn of running an unregistered national exchange. And in September 2021, the SEC launched an investigation into Uniswap Labs in connection with suspicions of selling unregistered securities and non-compliance with anti-money laundering laws.

As of 2022, regulators in the EU, the US, Singapore, Hong Kong and a number of other countries are actively developing future legislation that can locally and internationally control decentralized exchanges and the exchange of digital assets.

What are the prospects for DEX?

Decentralized exchanges with AMM technology have earned the recognition of millions of users, attracted tens of billions of dollars of investment and have become an integral part of DeFi and the cryptocurrency market in general.

In addition, a number of centralized exchanges have launched their own DEXs or implemented some of their features. In September 2020, the largest crypto exchange Binance launched the Binance Liquid Swap service based on AMM technology. This service allows users to not only exchange dozens of cryptocurrencies, but also place their assets in liquidity pools and receive a share of trading fees.

In the future, decentralized exchanges should be expected to expand the functionality for traders and improve interoperability for a simple, cheap and fast exchange of assets on various blockchains.