An Introduction To Decentralized Exchanges
By: Shaun Newsum
Tags: Insights, Cryptocurrency, Bitcoin, Blockchain

There are many cryptocurrency exchanges in the market today. By now, you’ve probably used at least one cryptocurrency in order to buy or sell cryptocurrency. Maybe you’re just starting out and you’ve only used Coinbase to buy Bitcoin, or perhaps you’ve tried your hand at trading altcoins on Binance.

Nobody can deny that exchanges are incredibly important to facilitate cryptocurrencies — after all, they are the mechanism that allows people to buy and sell cryptocurrencies and tokens to each other. Just like most things within the cryptocurrency industry, there have been significant innovations made with cryptocurrency exchanges within the past two years. The main innovation that this article will focus on is the creation of decentralized exchanges.

More specifically, this article will provide the following information:

What decentralized exchanges are

Why decentralized exchanges matter

Four decentralized exchanges that you can use today

Limits and downsides of decentralized exchanges

What are decentralized exchanges?

To understand what decentralized exchanges are, it’s important to first understand what it means for an exchange to be centralized. A centralized exchange is one in which a central entity figure manage’s a person’s capital and private keys, and facilitates trading between users.

Centralized exchanges have more volume than decentralized exchanges because:

Decentralized exchanges are still new, and so they are still fixing some “growing pains” (which I’ll focus on later). Meanwhile, many centralized exchanges have had time to fix their issues. With centralized exchanges it is not necessary to understand what a private key is in order to trade tokens on the centralized exchange, or to send tokens. Decentralized exchanges require users to be aware of MetaMask and private keys.

Examples of popular centralized exchanges include Coinbase, Binance, and Poloniex.

A decentralized exchange (DEX), on the other hand, provides users with the ability to trade cryptocurrency on a distributed ledger — all while allowing the users to control their private keys and funds. There is no middleman/intermediary, and the smart contracts for the DEX are open source so they can be reviewed and verified. There is not a single or central entity that controls users’ funds. This puts the power back into the hands of the users of the exchange, not the owners of the DEX.

Examples of decentralized exchanges include IDEX, Waves, and Kyber.

Why are decentralized exchanges important?

By now you might be asking yourself, “who cares about decentralized exchanges?” They might appear at first to be making things more complicated for users of the exchange, requiring technical knowledge about MetaMask, private keys, and so on.

The truth is that decentralized exchanges provide a number of significant benefits, not only to the people who create the exchanges but also to the exchange’s users.

One main benefit that decentralized exchanges provide to users is removing the need to trust a centralized entity to secure the users’ funds. With a centralized exchange like Binance or Bittrex, users are trusting that:

The centralized exchange will keep the private keys of their users safe from hackers The centralized exchange will prevent hackers from getting access to users’ accounts by getting their login info The centralized exchange will not exit scam (i.e. run away with users’ funds).

With decentralized exchanges, these concerns do not exist for users. The smart contracts that the decentralized exchanges use manage funds for users. Because of this, the companies that created the DEX have zero ability to move around users’ tokens.

No need for KYC/AML

Another advantage that decentralized exchanges provide is that there is no need to have login information for the exchange. This also means that there is zero need for users to go through a KYC/AML process, such as a user submitting their driver’s license or state-issued ID.

Usually, all users need to trade through a DEX is having access to their Ethereum wallet through MetaMask. Once they do, they can connect their MetaMask to the DEX to start trading.

Ability to invest in the exchange’s success

Another massive advantage of decentralized exchanges is that they provide users with the ability to stake some money in the success of the DEX through a token. Many centralized exchanges do not have a token that is connected specifically to the exchange (except Binance with its BNB token).

There are several examples of this. IDEX has an AURA token which enables people to stake the token to not only secure the decentralized network, but also earn a share of fees generated by IDEX. If an investor believes that IDEX will get significantly more volume in the future (and thus generate more fees), they have the ability to invest in that success by putting some money into AURA.

Minimal fees

Unlike centralized exchanges, decentralized exchanges have significantly lower (if not zero) fees to use the DEX except for paying for gas. This means that users don’t have to worry about racking up a significant amount of fees when depositing or withdrawing tokens onto the DEX, or when trading a significant amount during the day.

Protection from hacks/exit scams

Another great advantage that a DEX provides is that it removes many of the security worries that users of a centralized exchange might have. For example, a DEX does not control a user’s private keys — the users do.

There is also the possibility that a centralized exchange might exit scam — that means that the exchange steals their users’ tokens and shuts down their website.

With a DEX, there is no possibility that the owners of the DEX can steal their users’ tokens because they do not own the users’ private keys. Furthermore, let’s assume that a DEX (such as IDEX) were to suddenly shut down one day and people were no longer able to access the website. Even if this were to occur, users of IDEX can still retrieve their tokens because IDEX’s smart contract is designed in such a way that users can retrieve their tokens directly from the smart contract.

Top decentralized exchanges you can use today

So now that you’ve learned the benefits of decentralized exchanges, you’re probably wondering about a DEX that you can use today to start taking control of your funds while trading. Here are four decentralized exchanges that you can start using today:

IDEX

Kyber Network

Waves DEX

Changelly

Although this article will not go into excessive detail about each of these exchanges (that’s for a future time!), note that each of these exchanges have different user experiences, user interfaces, 24 hour volume, etc. A particular decentralized exchange might be of more use than another exchange if that particular exchange has more volume for a specific token that you want to trade.

Limits and downsides of decentralized exchanges

So far I’ve covered what a DEX is, the advantages that a DEX provides, and some decentralized exchanges that you can use today. If decentralized exchanges seem incredibly innovative and useful, it’s because they are.

But at this point you might think to yourself, “Decentralized exchanges seem really useful. Why doesn’t everybody use one?”. The truth is that a DEX is not a panacea to every single problem for users and creators of an exchange. Although a DEX represents a significant advance in exchanges and provides several distinct advantages, it also provides several distinct disadvantages that a centralized exchange wouldn’t usually face.

So what are the limits/downsides of a DEX? I’ll get into each of these points in more detail, but here’s a quick overview:

Decentralized exchanges generally have lower volume than centralized exchanges

Lack of KYC/AML compliance

Requires users to understand how to use MetaMask and store their private keys safely

Users must trust the smart contract code powering the DEX

Decentralized exchanges can face growing pains as they are still (relatively) new

Lower Volume

Decentralized Exchanges generally have lower volume than centralized exchanges do. For example, IDEX has 24 hour trading volume of $20 million according to CoinMarketCap. Popular centralized exchanges (like Bittrex/GDAX/Poloniex) have a daily trading volume of >$100 million. This is because:

Decentralized exchanges are newer and so less people know about them

Decentralized exchanges require knowing how to use MetaMask.

UI/UX of a DEX might be more confusing than a centralized exchange

All these factors cause decentralized exchanges to have lower volume. This can lead to some difficulties for users if they’re attempting to trade a specific token that does not have much volume on the DEX. As a result, users who cannot buy/sell tokens as a result of low volume might be discouraged from using a DEX.

Lack of KYC/AML Compliance

As stated before, a DEX does not require users to have login information in order to trade their tokens. All it requires is connecting the DEX to a MetaMask wallet. Because of this, users do not need to submit information such as their email, state-issued ID, or driver’s license.

As a result of this lack of a KYC/AML process, decentralized exchanges might face increased scrutiny from regulators. A DEX allows a person to trade massive amounts of cryptocurrency anonymously (as long as volume for the DEX exists). This could cause decentralized exchanges to become prime targets of hackers and scammers who know their personal information won’t be connected to their illegal trading.

It should be interesting to see the response of the SEC and other regulatory bodies as more people realize that they can use these exchanges completely anonymously. Will they require decentralized exchanges to add a KYC/AML process? Or will they allow decentralized exchanges to continue as they are? Only time will tell.

Requires users to understand MetaMask/Private Keys

In order to interact with decentralized exchanges like Kyber Network or IDEX, users must connect to their MetaMask wallet. This requires some technical experience of installing MetaMask and understanding the need to keep private keys and seed phrases safe.

While this is incredibly empowering to users because it allows them to completely control their funds, it also puts the responsibility of keeping the private keys safe to users. If a person does not practice proper security measures, a hacker could acquire their private key or wallet seed phrase and use that to take control of the user’s funds.

Unlike a centralized exchange, trades on a DEX cannot be reversed because of the immutable nature of the blockchain. The need to reverse trades has happened before — Binance, for example, was able to reverse irregular trades on their exchange. A DEX would not be able to reverse illegitimate trades made by a hacker who obtained access to a user’s digital wallet.

Users must trust the smart contract code powering the DEX

One advantage that a DEX provides to users is that users no longer have to trust the creators of the DEX because the smart contract code is managing the funds and not the exchange.

However, what this does is shift trust from trusting the central entity (i.e. the creators of the exchange) to trusting that the smart contract code was written properly without any bugs. There’s the possibility that the smart contract code was written in such a way that there is a hidden bug that allows a person to exploit the smart contract and withdraw all funds within the smart contract.

While this is usually not an issue (as the smart contract code is open-source and can be reviewed), what this means is that the smart contract code should have gone through a diligent auditing process beforehand. If you are unsure whether an exchange’s smart contract has gone through a stringent auditing process, you can usually reach out to a team member of the exchange to ask.

Decentralized exchanges face growing pains

Because decentralized exchanges are still relatively new in the cryptocurrency space, they are still facing some roadblocks and growing pains as they fix issues that they’re running into and as they continue to scale.

For example, IDEX has recently run into performance issues and even had to shut down for a few days to fix these issues. While IDEX has taken steps to address these issues for the future, it’s important to realize that all decentralized exchanges are still nascent technologies and they might continue to face some more roadblocks before they become widely adopted.