1. What is a decentralized exchange?
A decentralized exchange (DEX, decentralized exchange) is an exchange that operates on the basis of a distributed registry, does not store user funds and personal data on its servers and acts only as a platform for matching bids to buy or sell user assets. Trading on such platforms takes place directly between participants (peer-to-peer) without any financial intermediaries.
However, most of the existing exchanges, which call themselves decentralized, in fact, are not completely decentralized: they use their own servers to store the data on trades and orders to buy or sell users’ assets, but the private keys are kept by the users themselves.
2. How are decentralized exchanges different from centralized exchanges?
Centralized exchanges are managed by a specific company or person who is profit-oriented. Managers of exchanges are responsible for protection of user data and information on trades, fully control the operation of the platform and make decisions important to the development of the project on their own.
Decentralized exchanges are managed automatically or semi-automatically with the involvement of platform participants in the process of making important decisions. Such platforms provide the technical possibility of direct interaction between the participants and use a distributed registry (blockchain) to store and process all (or almost all) data.
3. Which decentralized exchanges are already in operation?
Here are a few representatives that are already in operation:
- IDEX – a decentralized exchange on Ethereum with real-time trading and the ability to trade directly from a hardware wallet;
- Waves Dex – a multiplatform decentralized exchange with the ability to exchange cryptocurrencies for fiat money from the Waves project. Representatives of the project claim that at the moment the trading volume on the platform is more than 25% of the total trading volume on all decentralized exchanges;
- Bancor Network – a decentralized exchange with an automatic pricing mechanism and, therefore, with no dispersion between the prices of buying and selling tokens;
- Switcheo Network – a decentralized multi-chain exchange based on the NEO blockchain with zero commissions.
Today there are more than two hundred fully working decentralized exchanges, but now it is hard to compare this number with the number of their centralized counterparts, which, in all likelihood, can exceed several thousands.
4. What are the main advantages of decentralized exchanges?
Most of the strengths of decentralized exchanges derive from their distributed architecture and the lack of a single control center. Here are a few key advantages:
- Decentralized exchanges provide complete anonymity to the user;
- A decentralized exchange does not store user assets, so there is no risk of losing money through hacking or a complete collapse of the exchange itself, which radically distinguishes them from centralized exchanges, which are hacked quite regularly, including large exchanges such as ShapeShift and Bitfinex;
- A decentralized exchange does not have a single entry point through which all assets and data can be accessed, which makes it difficult for hackers and makes the attack itself pointless;
- The decentralized exchange does not have any personal accounts, does not require verification, and does not even need to specify an email, so no one can use or steal personal user data;
- a decentralized exchange has no management with an interest in manipulating prices within the exchange;
- Because the exchange has a distributed architecture, the authorities can not close it or freeze your account.
Thus, decentralized exchanges leave users with full control over their funds, bids, and data, and at the same time full responsibility for their actions.
5. What are the main disadvantages of decentralized exchanges?
The same architecture of decentralized exchanges and the full control of users over their own funds entail a number of difficulties:
- many options for traders, such as stop loss, margin trading or banding, are not available to users of most decentralized exchanges;
- decentralized exchanges typically have a smaller liquidity pool compared to centralized venues;
- a decentralized exchange, by definition, may not have a help desk capable of affecting transactions or user accounts;
- since many decentralized exchanges are managed by smart contracts, cryptocurrencies that do not support interaction with smart contracts cannot be traded on them.
Based on the complexities described above, decentralized exchanges are much more reliable and secure than centralized exchanges, but are more suitable for experienced users who are willing to take full responsibility for their actions without the ability to contact support and demand a refund. In addition, some decentralized exchanges, such as Bancor, have vulnerabilities, which also allow for unauthorized withdrawals.
6. How are decentralized exchanges regulated?
In the U.S. regulators are trying to apply the existing legal framework, and in Singapore the authorities are trying to create a new regulatory framework for the operation of such exchanges. Nevertheless, there is no unambiguous position on decentralized exchanges in these countries, and in other countries decentralized exchanges are not regulated at all.
One of the main difficulties related to the regulation of decentralized exchanges is that in most cases such exchanges are not controlled by specific legal entities or individuals.
This leads to problems in determining who is responsible in case of any violation, difficulties in checking trading activity and identifying possible violations. For the same reason, some already existing rules applicable to centralized exchanges cannot be applied to decentralized exchanges.
7. How will the concept of a decentralized exchange develop?
It is believed that centralized exchanges will gradually introduce the functionality of decentralized exchanges, and therefore the future of online exchanges lies somewhere in the middle, offering the user the advantages of both types of exchanges. In general, decentralized exchanges are considered the most successful solution for serving the broad masses of cryptocurrency users.
Nevertheless, the problems of blockchain scaling as well as the mass adoption of cryptocurrency remain unresolved. In addition, to attract more users, decentralized exchanges will first need to solve the problem of user interface complexity (and some have already done so). Until all these problems are solved, decentralized exchanges are likely to remain a purely niche product.