Decentralized Exchanges In Plain English – The Basics, Pros & Cons!

This is a comprehensive post on Decentralized exchanges (DEXs).

You are probably used to crypto exchanges, where you sign up with your email, verify your account, and start trading crypto.

DEXs are a bit different. You still get to trade crypto but you are not bothered with sign ups.

Though they are just gaining popularity, decentralized exchanges are doing very well in the market.

This post will help you understand DEXs and how they work.

Let’s jump right in!


Post Summary

  1. What Are Decentralized Exchanges?
  2. What Do Decentralized Exchanges Require To Operate?
  3. How Decentralized Exchanges Work & The Different Forms
  4. Pros & Cons Of Decentralized Exchanges
  5. Comparison Between Centralized and Decentralized Exchanges
  6. Conclusion

Click on any subheading above to read its details immediately.

Happy reading!


1. What Are Decentralized Exchanges?

Decentralized exchanges

A decentralized exchange is a cryptocurrency exchange that operates without a central authority.

Here, signing up is not a big deal as is the case with traditional crypto exchanges.

You simply log on to the exchange and perform your transactions. There is little or no interference of a third party.

Buyers and sellers talk directly with each other thereby eliminating the need for middleman fees.

Also, the exchange does not take custody of your funds. You are in charge of your funds and private keys.

DEXs are launched on blockchains. They form a part of the DeFi revolution.

And they are doing fairly well. As of August 2020, Decentralized exchanges were trading over $2.4 billion in a week. Impressive, huh?

For DEXs to operate effectively, there are certain things required.

Join me in the next section to see what these requirements are.


2. What Do Decentralized Exchanges Require To Operate?

A DEX requires the following to operate:

i. A base decentralized exchange protocol – this defines the format for a trade order, the reward for the order, and the method of trade completion e.g 0x.

ii. A database order book – an electronic list of buy and sell orders. It provides information on price, availability, depth of trade, and who initiates transactions. 3 parts of the order book are buy orders, sell orders and order history.

iii. A graphical user interface (GUI) – where users can interact with the exchange and make transactions.

iv. Application programming interfaces (APIs) – needed to help the exchange function optimally. It sends the user’s request to the exchange and delivers the feedback from the exchange to the user.

Next, we will look at the different forms a DEX can take and how they work.

Keep reading!


3. How Decentralized Exchanges Work & The Different Forms

Generally, a decentralized exchange works by giving users total control of their funds and publishing trades on the blockchain where all and sundry can see it.

There are three different forms a DEX can take namely;

  • On-chain order books
  • Off-chain order books
  • Automated market makers

a. On-chain Order Books

For decentralized exchanges that take the form of on-chain order books, all activities happen on a blockchain.

So, users do not need a third party to relay the orders to them. Everyone sees the orders.

However, users will have to pay a fee for every node on the network to record their orders.

Also, they will exercise some patience for miners to add their orders to the blockchain.

One challenge that this form of DEX may have is this:

An insider can know about a pending transaction and then go ahead to place the trade before the transaction is processed.

This is called front running and it is illegal because the front runner is taking advantage of information that is not known to the public.

But because everything gets published on a global ledger, it may be difficult to front-run.

What then happens is that miners try to publish their own trades before adding the pending trades of others to the blockchain

Examples of DEXs that take the on-chain order book form include the Stellar and Bitshares DEXs.

b. Off-chain order books

In this form of DEX, orders are not posted on a blockchain.

Rather, a centralized entity is placed in charge of the order book.

A good example is the 0x protocol for ERC-20 on the Ethereum blockchain.

It has a connection of parties known as “relayers” that manage off-chain order books.

They use 0x smart contracts to relay orders between users. When the parties are matched, the trade is then posted on the blockchain.

(Just like what happens in bitcoin mining)

Transactions are processed faster here since they do not depend so much on the blockchain.

However, there is a sad possibility of front running or misrepresentation of orders by the centralized entity.

But users still benefit from non-custodial storage as they are in charge of their funds and private keys.

Some examples of DEXs that take the off-chain order book form are Binance DEX, IDEX, and EtherDelta.

c. Automated Market Makers (AMM)

For this last form of DEX, order books do not come to play.

What we find instead, is an effective use of smart contracts and liquid pools to facilitate trades. But trades are still settled on a blockchain.

And, DEXs of this form are protocol inclined i.e. they can only make use of the assets of a particular blockchain.

Here, liquidity pools are used to create market. Any user on the exchange can be a liquidity provider.

The deal is that a liquidity provider stakes two different coins of equal value (usually a stablecoin and a blockchain token).

Then as interested buyers demand for the stablecoins, it depletes in number while the blockchain token increases because only both coins can be exchanged in that pool.

The goal is for the provider to increase the amount of blockchain tokens in his custody.

For example;

Ada creates a liquidity pool with 1000 USDT and a matching value of Ether say 10 ETH.

If Obi comes to buy 500 USDT, he will have to pay with 5 ETH because that is the matching ratio between the 2 coins.

Ada will now have 500 USDT and 15 ETH. The liquidity pool will last until all the USDT is finished.

Meanwhile, the exchange makes profit from Ada. She will be charged some fees for staking her coins in the pool.

And what makes it possible for Ada to exchange all her USDT for ETH is the use of Smart Contract.

So, in this form of DEXs, smart contracts interact with different liquidity pools and not other users. In other words, smart contracts serve as order books.

Top examples are Uniswap and Kyber Network.

In the next section I mentioned the pros and cons of DEXs.

Tag along!


3. Pros & Cons Of Decentralized Exchanges

Pros

i. No Account Verification Hitches

DEXs do not request for personal information from users. There is no need to upload any Identity document to verify your account.

You do not even have to sign up for some DEXs. All you need is a cryptocurrency wallet and you are good to go.

This saves users the stress of searching for an identity document when they do not have one.

Also, they do not have to worry about their personal information being leaked.

ii. Non-custodial nature

Another major pro of DEXs is the fact that users are in charge of their funds.

Thus, there is no fear of loss should the exchange be hacked or any similar misfortune occurs

iii. Variety of tokens

For DEXs, a token just needs to be in demand and supply. It doesn’t matter whether the token is listed on other exchanges like Binance, Luno, Quidax, etc.

So long as you find someone who is ready to supply the token you want on the DEX, you can proceed with your transaction.

Therefore, users have variety of tokens to trade and make profit.

Cons

i. It is not user-friendly

A newbie may have a hard time performing transactions on DEXs.

Also, when users encounter problems, rectifying it is not as easy as it is in traditional exchanges.

ii. Low Trading volumes and poor liquidity

Volumes traded on DEXs are not as high as what you will find in its centralized counterparts.

Also, it is not very easy to find people who want to buy or sell at a reasonable price on DEXs.

Though many tokens can be traded on DEXs, you may not find the pair you want. And even when you find, the pricing may not be fair.

Before we call it a wrap, let’s compare centralized and decentralized exchanges.

Keep reading!


4. Comparison Between Centralized And Decentralized Exchanges

DEX vs CEX

In the table below, I compared CEXs and DEXs based on relevant parameters.

Check it out:

 DEXsCEXs
Funds &
Private Keys
Held by usersHeld by the
platform
User InterfaceNot easy to
maneuver
Quite easy to use
Transaction SpeedRelatively slowRelatively fast
LiquidityLowHigh
FeesUnstable feesStable fees
SecurityUsers don’t face
the risk of losing funds
Users face the
risk of losing funds
RegulationDoes not require a
license
Requires a license
FeaturesLimited FeaturesSeveral Features
ExamplesUniswap, IDEX,
Kyber, Bisq,
1inch.exchange,
etc.
Coinbase, Remitano,
Luno, Binance,
Quidax, etc.

5. Conclusion

The whole idea of a decentralized exchange is to grant users absolute control which is what cryptocurrency stands for in the first place.

However, there is room for improvement especially in terms of user interface, trading volumes and liquidity.

We have come to the end of our discussion on DEXs. I hope you enjoyed your read.

Now, I’d love to hear from you:

Do you intend to trade on a DEX one of these days?

Maybe you have traded on one before – Which one did you use and what was your experience?

Let me hear your thoughts in the comments section right now.

Also, share this post with your friends by hitting those icons below, thank you!


PS: 

If you want to learn how to trade cryptocurrencies profitably, then enroll in our Crypto Trading Mastery Course by going to www.ctmastery.com. You can also join our Telegram community at https://t.me/ctmastery


Chinma Udeji
Le's connect

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