If you're a crypto investor, it's hard to deny that exchanges play a vital role in trading crypto assets. There are mainly two types of exchanges in the crypto world: Centralized Exchange (CEX) and Decentralized Exchange (DEX). Today, you have the opportunity to delve into what a Decentralized Exchange (DEX) is and how it differs from a Centralized Exchange (CEX). By reading the article, you will understand how a Decentralized Exchange (DEX) works, its pros and cons.
Contents:
- What is a Decentralized Exchange (DEX)?
- The Difference Between DEX and CEX
- How Does DEX Work?
- Advantages of a Decentralized Exchange
- Disadvantages of a Decentralized Exchange
What is a Decentralized Exchange (DEX)?
A Decentralized Exchange is a peer-to-peer exchange where crypto assets are transferred directly between buyers and sellers. Unlike centralized exchanges (CEX), DEX platforms do not require asset storage, allowing users to keep their private keys for wallet transactions.
Without a centralized management authority, DEX relies on self-executing smart contracts, which track each transaction and register it in the blockchain. As a result of achieving a higher level of security without centralized regulation, crypto assets have become one of the fastest-growing investment options in the world.
Not all decentralized cryptocurrency exchanges are built the same. Some platforms use the traditional order book concept, while others often use liquidity protocols.
In addition to liquidity pools, DEXs develop additional aggregation tools to address the often-occurring problems of turnover liquidity.
The Difference Between DEX and CEX Exchanges
The difference between the two types of cryptocurrency exchanges lies in the approach used. A Centralized Exchange (CEX) — is a third-party corporation that acts as a repository for your assets, regulates exchanges, and charges a fee.
On the other hand, a decentralized exchange uses self-executing smart contracts to facilitate the trading of crypto assets. Thanks to smart contracts, transactions in DEX ensure greater timeliness and cost-effectiveness.
A decentralized exchange does not store your cryptocurrency. In other words, this means that you are fully responsible for your digital assets, including your wallet and private keys.
Remember, your private key is vulnerable to theft or other damage. For the most part, this means that counterparty risk on most decentralized exchanges is possible, as DEX users are not required to comply with stricter "Know Your Customer" (KYC) and Anti-Money Laundering (AML) rules commonly encountered in traditional financial institutions.
How Does a Decentralized Crypto Exchange Work?
In the crypto space, there are three types of DEX implementations, each with a fundamentally different operating concept:
- Order Book;
- Swap;
- Decentralized Exchange Aggregator.
In the early days of decentralized exchanges, transactions were placed in the Order Book. Like traditional exchanges, it tracks all active buy and sell orders for a specific asset, with the difference between this price and the current market price determining the depth of the Order Book.
On DEX with order books, information is usually stored on the network during transactions, while your funds are stored offline in your wallet.
Decentralized exchanges today no longer use order books to facilitate transactions or determine prices for crypto assets. On the other hand, the service uses a liquidity pool protocol to evaluate the available assets.
Swap refers to a cryptocurrency exchange transaction between two parties that occurs instantly in users' wallets on the same network.
Indeed, the exchange mechanism is based on the total locked value (TVL) or the value of assets stored in the smart contract protocol.
Typically, decentralized exchanges use various protocols and operating methods. These factors negatively impact the liquidity of the network. Consequently, investors and individual traders looking to invest large volumes of specific crypto assets may be limited by the lack of liquidity in the market.
To solve this problem, DEX aggregators have been developed to increase the liquidity of assets among decentralized exchanges.
Advantages of a Decentralized Exchange
This section discusses the main advantages of decentralized exchanges.
Advantages of DEX
| Asset security level | Security is a huge advantage. It is not deprivation of freedom. Users do not need to hand over their private key to make a transaction with a decentralized exchange. Instead, smart contracts allow users to connect personal wallets to interact with DEX and trade automatically. |
| Lower fees | A decentralized exchange charges a small fee, usually around 0.01-0.3%. The fees charged by DEX are much lower than those of a centralized exchange, even if they fluctuate depending on network circumstances. |
| Privacy | Since the crypto wallet is not on the exchange, decentralized exchanges no longer need traders to disclose their private keys, and they are not responsible for the funds. When using DEX, users are not required to undergo KYC or AML procedures. |
Thanks to the use of smart contracts, a decentralized exchange allows trading without intermediaries, leading to minimal commission. In this case, DEX uses a gas fee structure, as we often hear in the Ethereum blockchain, or just a transaction fee as in the BNB Smart Chain or Polygon network.
Drawbacks of Decentralized Exchanges
Although decentralized exchanges have tremendous advantages, they also have certain limitations that users should be aware of. Below are some of the drawbacks of using a decentralized exchange:
- Liquidity Level
With a large number of trading pairs presented on DEXs, market conditions negatively affect liquidity. However, with the growth of the DeFi sector, the liquidity of assets on decentralized exchanges has significantly improved.
- Cannot Trade Fiat Money
Currently, we still cannot trade crypto assets using fiat currency on DEXs, nor trade fiat currency or directly withdraw funds to bank accounts.
The concept of stablecoin is a promising alternative to fiat currencies in the DeFi ecosystem. Nevertheless, the absence of fiat currency in buying and selling cryptocurrencies remains a barrier to entry for inexperienced traders.
- In Development Stage
Decentralized exchanges are in the early stages of their development, so users should be aware of such limitations, especially those who are less familiar with decentralized blockchain technology.
This is because users need to understand how cryptocurrency wallets function. Furthermore, users must also be able to fund their wallets by transferring a certain amount of crypto assets, as well as be able to transfer funds between blockchains using special bridges.
Finally, the user needs to connect their wallet to the DEX interface for trading, where the process of depositing funds on a CEX still seems simpler.
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