Decentralized Exchanges, or DEX, are sites where individuals can trade cryptocurrencies without the assistance of a third party. To fully comprehend what a decentralized exchange is, it’s necessary to first grasp how centralized exchanges operate.
Centralized Exchanges, such as Binance or Coinbase, are websites or mobile applications that allow users to purchase, sell, and trade cryptocurrencies and tokens listed on the exchange.
Assume you wish to purchase some Bitcoin.
You can visit an exchange, register by giving banking and identification information, and make a cash deposit. (This procedure can take many days, which is one disadvantage of centralized exchanges over DEXs.) The exchange will inform you of the price. It is determined by a “order book” of people buying and selling at various prices.
The exchange will display those Bitcoins in your account, which you can then swap for other tokens. However, you do not truly own them because you are entrusting the exchange to function as your custodian. Any trading you conduct, like exchanging Bitcoin for Ethereum, takes place within the exchange’s database, not on the blockchain.
Exchanges pool users’ cryptocurrencies in exchange-controlled wallets. Your private keys are managed by the exchange.
According to DEX proponents, the attractiveness of decentralised exchanges is security. A centralized exchange can restrict your access to your cryptocurrency, restrict or eliminate your ability to trade it, and potentially expose you to hackers.
On the other hand, centralized exchanges are typically much easier to use for newbies and can frequently offer faster trading speeds due to their independence from blockchain technology. This has been Coinbase’s greatest achievement: establishing itself as a household name in the United States for crypto-curious individuals interested in buying cryptocurrency but intimidated by the procedure. Allowing Coinbase (or any other centralised exchange) to function as custodian of their funds is perfectly acceptable for those individuals.
What Are Decentralized Exchanges and How They Work?
A decentralised exchange facilitates trade between individuals by utilising smart contracts (automatically executed protocols), but does not take ownership of their currency.
DEXs accomplish this in one of three ways: through an on-chain order book, through an off-chain order book, or through an automated market maker.
Each transaction in an on-chain order book is recorded on the blockchain. This includes not just the purchase itself, but also any request to purchase or cancel an item. It is the pinnacle of decentralisation, yet the requirement to centralise everything
All of this occurs off-chain through off-chain order books, with the final transaction being resolved on the blockchain. Due to the fact that orders are not stored on-chain, this method may encounter some of the security concerns associated with centralized exchanges but is not as slow or expensive as on-chain order books.
AMMs, or automated market makers, do not use order books. With order books, if you have Chainlink tokens and wish to purchase Compound, you must first find someone who has Compound and is prepared to trade for Chainlink at an agreed-upon price. AMMs eliminate counter-parties and replace them with algorithms that determine the price, allowing you to trade Chainlink for Compound independent of who is on the other end of the exchange. They often accomplish this through the use of “liquidity pools,” which essentially compensate users for storing a portion of their assets in a smart contract that can subsequently be tapped for trades. As a result, individual users play a critical role in enabling exchanges.
The Benefits of DEXs
Decentralized exchanges are not required to collect private information from American people, such as social security numbers or addresses, as centralised exchanges are required to do under the Bank Secrecy Act. Until now, because DEXs do not exercise control over assets, they have been exempt from such regulations.
Anyone can build a token pair using DEXs like as Uniswap. You can quickly create a new token and begin exchanging it for a friend’s token. Thus, DEXs enable individuals to possess tokens for use in decentralised finance (DeFi), which enables individuals to save, borrow, lend, or trade without going through a bank or other financial institution.
Because your coins are not stored on a centralised exchange but rather in a wallet that you control, you are resistant to hacks. And, while centralised exchanges may go offline for maintenance, a DEX allows you to continue trading.
Aspects of DEXs that are disadvantageous
There is no connection to bank cards.
Decentralized exchanges only work with cryptocurrency assets, not fiat currency (such as USD), because enabling crypto-to-fiat conversion would require bank involvement. (Unlike blockchain-based transactions, dollar transactions do not settle quickly.) As a result, you must already own cryptocurrency to use a decentralised exchange.
Uniswap, along with a slew of other DEXs, is built on the Ethereum network. Any tokens traded there must also be Ethereum-based. This means that Bitcoin and a large number of other popular currencies from competing blockchains will be unavailable. Indeed, this technically implies the absence of ETH. Instead, users must convert their ETH to “Wrapped Ether” (WETH), which is priced similarly.
There is no Customer Service.
Centralized exchanges operate similarly to banks. They have consumers whom they mostly wish to retain. However, in a genuinely decentralised exchange, there is no counterparty. The protocol’s creators do not share the same relationship with users. While entire communities of DEX users exist, you are ultimately responsible for your own money.
To know more about other fascinating concepts of Web3, check out the Crypto101 series by Coin Crunch India.
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