Matching buyers to sellers has always been an essential aspect of cryptocurrency. Exchanges facilitate the need for secure peer-to-peer exchange; without this, agreeing on prices within the global network would be virtually impossible.
Facilitating this transaction between unidentified parties has inspired two solutions(categories of exchanges): Decentralized Exchange (DEX) and Centralized Exchanges(CEX).
CEX
In a centralized exchange, customers do not own their cryptocurrency. It is held in the exchange’s wallet and not in the user’s wallets like Metamask. Customers can trade cryptocurrencies because the exchange guarantees they have the said asset in the exchange’s control.
Trades occurring on centralized platforms are not executed to a blockchain, but internally in the exchange’s database. New users are drawn to Centralized Exchanges because of their ease of use as transactions occur faster than they would on the blockchain. Centralized exchanges are also very liquid.
DEX
Decentralized Exchanges is an autonomous decentralized application (DApp) that permits cryptocurrency traders without relinquishing funds to a third-party entity like a CEX. Additionally, it is a trustless peer-to-peer exchange of crypto.
The purpose of the DEX was to remove the need for a third-party authority that oversees and authorizes each trade. Smart contracts achieve this level of automation without trusting any outside interference through a few methods, such as automated market makers, on-chain order books, and off-chain order books.
Automated Market Makers (AMM)
Automated Market Makers is a sophisticated smart contract that facilitates automated crypto trading by using a liquidity pool, allowing no human error during the processing of the transactions.
Smart contracts pool together funds by incentivizing their exchange users to contribute to the fund. Complex algorithms bring together buyers and sellers of cryptocurrency seamlessly. Exchanges like Uniswap fall into this category.
On-chain order books
On-chain order book transactions are added to the blockchain and confirmed by its network. Transactions are transparent: since the order book is public, anyone can submit their orders for inclusion. This network requires less trust from its users when trades are confirmed to the public blockchain. However, network fees could be costly around the high-frequency hours, and transactions may be slow to update at that time.
Off-chain order books- hosted by a third party
Off-chain order books do not post to the blockchain. They are hosted by a third party and as a result, are not as decentralized as the other options. If those in control are malicious, they could use the information they gain from filling the orders to benefit themselves.
Advantages
Privacy — KYC (Know Your Customer) for exchanges where they request users’ personal information such as an address and ID pictures. In the age of data breaches, giving up personal data to a company can be problematic. However, for some exchanges to operate in specific countries, they needed to follow the local laws. DEXs are permissionless and do not require identification checks.
Security — DEXs do not hold users’ funds or private information, hence they are not at risk of any data breaches.
Tokens — DEXs are known to have tokens that are not available in centralized exchanges. Unlisted tokens can be traded on DEXs as long as there is a market for them.
Disadvantages
Usability — trades on centralized exchanges occur very fast, as they do not interact with the blockchain. However, DEXs processing time for a trade depends on the network and its current volume.
Liquidity — DEXs might not be the most liquid of the exchanges when compared to centralized exchanges. Users might find it hard to find buyers or sellers for specific tokens at the price they want.
Fees — fees can fluctuate, but when the network is connected or busy the fees turn out to be very expensive.
Closing
One of the issues that contributed to the formation of DEXs was coming up with a method to optimize returns from your trading activity while ensuring security, convenience, and privacy.
Over the years, a slew of decentralized exchanges has sprung up, each improving on past attempts to improve the user experience and provide more robust trading platforms. In the end, the concept appears to be highly associated with the ethos of self-sovereignty: users don’t need to trust a third party.
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