Whether we are talking centralized exchanges (CEX) or decentralized exchanges (DEXs), everything has to start somewhere, an exchange. A place where crypto trader buy, sell and trade cryptocurrencies. In cryptocurrency exchanges, Bitcoin owners exchange their coins for other cryptocurrencies or fiat currencies.
So let’s look at what decentralized mean:
The word decentralized means not centralized; having no center or several centers.
To better identify what a decentralized exchange is, its important to first understand how a centralized exchange works.
How Do Centralized Exchanges Work?
A centralized exchanges, such as Binance, Kucoin, Crypto.com or Latoken are platforms or apps ( marketplace) that enable traders to buy,sell and exchange cryptocurrencies against fiat money or other cryptocurrencies. They are marketplace for tokens.
They function as trusted intermediaries in trade, and often act as a custodians by storing and protecting your funds.
Let’s say you want to buy some Bitcoin, you go to an exchange like Binance, open an account, register by providing your information.
You then deposit your money – either by fiat via bank transfer or cryptocurrencies.
When you deposit crypto, the exchange will tell you price – based on an “order book” of people buying and selling at different prices.
The Bitcoin you deposit, the exchange will show you those Bitcoins in your account, and you can trade for other tokens on the exchange. But you don’t really hold them because you cannot spend it on the blockchain.
How Do Decentralized Exchanges Works?
Decentralized exchanges – or DEXs – aim to tackle the problem of centralized exchanges by building a peer -to-peer marketplace directly on the blockchain – allowing traders to remain custodians of their funds.
Decentralized exchanges uses smart contract to carryout users transactions, but doesn’t take control of their cryptocurrencies. DEXs handle this in one of three ways: On-Chan Order Books, Off-Chain Order Books, or Automated Market Marker (AMM).
On-Chan Order Books
In an on-chain order book, every transaction ( as well as purchases and cancellation) is done on the blockchain. This is proven the best in decentralization. But the need to put everything on blockchain can make it more expensive and slower.
Examples of on-chain order books models include the stellar and Bitshares decentralized exchanges (DEXs).
Off-Chain order Book
Off-chain order books, transactions are hosted somewhere, with only the final transaction settled on the blockchain. Instead of every order being done on the blockchain, rather, hosted somewhere.
This method can run into some of the security issues of centralized exchanges, but isn’t as slow or costly as on-chain. The 0x protocol for ERC-20 and other tokens use on the Ethereum blockchain is a good example.
Automated Market Makers (AMM)
An Automated market markers, or AMMs doesn’t require marker or taker, which is order book. With order book, if for instance, you have pancakeSwap token and you want to buy DAI stablecoin, you’d need to have someone who want pancakeSwap who have DAI token and is willing to trade at an agreed-upon price.
AMMs remove (Markers and takers) and introduce algorithms to set the price, letting you trade pancakeSwap for DAI regardless of whether there’s someone on the other end of the trade. Automated market markers uses liquidity pools instead of a traditional market of buyers and sellers.
On AMMs platforms, instead of trading between buyers and sellers, users trade against a pool of token – a liquidity pool.
Liquidity refers to how easily one assets can be converted into another assets, at fiat currency without affecting it markets price. Users supply liquidity pool with tokens and the price of the tokens in the pool is determine by a mathematical formula. Anyone with an internet connection and in possession of any types of ERC-20 tokens can become a liquidity provider by supplying tokens to an AMMs liquidity pool.
Advantages of Decentralized Exchanges (DEXs)
- No KYC (Know Your Customer): Decentralized exchange don’t required personal information (Identity information) like centralized exchanges that require I.D before you can trade on the exchange. In DEXs, all you need is a DEXs wallet, such as Safepal or Math wallet.
- It Minimize Risk: Centralized exchanges can expose users personal information or lock users out. If anything goes wrong with the exchange, the exchange can short down and users will not be able to access the exchange pending till when they will come up or lost their fund if the exchange is hack like the 2014 Mt.Gox and cryptopia exchange. DEXs don’t store users fund, users tokens is in a wallet with private keys they hold.
Disadvantages of Decentralized Exchanges
- No Customer Support: One of the disadvantage of DEXs is that they don’t have customer service support which is different from centralized cryptocurrency exchanges. In centralized exchanges, customer service helps user to regain back access when they loss their password or transfer the wrong crypto token with in the exchange. While in decentralized exchanges, users are responsible for their own fund (Money).
- No Bank Payment Portal: Decentralized exchanges only work with cryptocurrencies assests, unlike CEX that enable fiat payment in their platform for users to purchase cryptocurrency with their fiat money via their bank card. DEXs doesn’t support that.