Since the origins of Bitcoin and the subsequent emergence of other cryptocurrencies, exchanges have played a fundamental role in the global blockchain universe. You have probably heard of or used these digital exchanges, where you can exchange cryptocurrencies and tokens for fiat money or other cryptocurrencies. In exchanges, the value of cryptocurrencies is determined by the supply and demand of cryptoassets in the market. Without the existence of these platforms, we could not have a system to agree on the correct price of the assets. What is a decentralized exchange (DEX)?
Centralized exchanges have dominated this arena. However, thanks to the availability of rapidly evolving technology, a growing number of decentralized trading tools have emerged and are gaining more and more traction. So, what is a decentralized exchange (DEX)?
What is a decentralized exchange (DEX)?
A decentralized exchange – or DEX – is the technological evolution of a traditional exchange. They are digital platforms that operate like traditional exchanges but, unlike traditional exchanges, a smart contract operates at the heart of the service. This eliminates intermediaries to a large extent, making them more transparent and secure. So we can say that a decentralized exchange, or DEX, is a cryptocurrency exchange operated by smart contracts.
The most remarkable feature is that the exchange users maintain control of their assets at all times, since the trust and management of the funds does not fall on a central figure. This adds a high level of privacy, security and even anonymity when operating. What is a decentralized exchange (DEX)?
Types of exchanges
Since the creation of the first cryptocurrency exchange, the platforms have evolved a lot until today. This evolution has created three distinct types of exchanges or generations:
- First generation: Traditional exchanges are centralized and there is a third party that controls your cryptoassets. These types of platforms are often referred to as first generation.
- Second generation: The most basic decentralized exchanges are called second generation. These work with a smart contract that is in charge of operating and by its nature, everyone can see how it works. In these smart contracts you must send your cryptocurrencies, losing possession of them during the time you want to make the exchanges.
- Third generation: A new generation of decentralized exchanges update this last point, so that you do not need to send your cryptocurrencies anywhere, although you can open exchange orders with them. They are called third generation exchanges. They act through a smart contract like the previous ones, but allow the user to keep the cryptocurrencies in your wallet at all times. If those tokens generate dividends, you will be able to do so until the last millisecond of the exchange.
Blockchain technologies for DEX
While Ethereum is the most widely used platform for this type of developments, due to the large number of tokens and DApps being developed on it, there are other blockchains that also allow this. Stellar is one of the best examples of blockchains that allow the creation of decentralized trading platforms.
That said, we can analyze the various advantages and disadvantages of DEXs to get a better understanding of the topic.
Advantages of DEX:
No client funds are retained, therefore no user funds will be put at risk and no confidential personal information will be exposed.
Smart contracts are implemented in DEXs as a protection against scams and fraud. Thus, by establishing a contract with certain conditions to be met, the parties involved must obey these conditions for the transaction to be executed. In the event of non-compliance with the conditions, the contract expires and is not executed. Once programmed, these contracts are executed automatically and decentralized.
DEX does not operate with a single server, so there is little or no chance of a crash.
Tokens that are not listed on centralized exchanges can be traded freely on DEX, as long as there is supply and demand.
Disadvantages of DEX
DEX platforms can be confusing to start with and if you are not knowledgeable, they are not as easy to use as traditional exchanges. Often it takes the guidance or instruction of a more experienced user to understand them and start trading on them. CEXs – centralized exchanges – provide a slightly simpler user experience. If you forget your password, you can simply reset it; if you lose your seed phrase, your funds are irretrievably lost.
The volume traded on CEX still far exceeds that of DEX, which remains relatively niche.
For this same reason of trading volumes, CEXs tend to have higher liquidity than DEXs. Liquidity is a measure of the ease with which you can buy or sell assets at a reasonable price. In a highly liquid market, bids and offers have little price difference. Conversely, in an illiquid market, you will find it more difficult to find someone willing to trade the asset for a reasonable price. It is likely that you will not be able to find the trading pairs you want or that these assets will not trade at a fair price.
As in DEXs operations occur within the blockchain itself, their process is considerably slower than in a centralized exchange. This implies that a DEX cannot handle high frequency.
Several DEXs have emerged over the years, each building on previous attempts to optimize the user experience. As with cryptocurrencies, users are not necessarily dependent on a third party and thus the idea of self-sovereignty is reinforced. With the rise of DeFi, there are more and more decentralized exchanges based on Ethereum, and these in turn are experiencing a massive increase in usage. If this momentum continues and builds, we are likely to witness even greater technological innovation in the industry.