Decentralized Exchanges Explained

Decentralized exchanges are peer-to-peer crypto trading platforms that work through the use of algorithms, smart contracts, and other advanced technologies. Users may trade with each other from all over the world, without ever giving up their personal information and with no 3rd party institutions in between.

To better understand decentralized exchanges, it’s helpful to first review how centralized exchanges work to learn why they post vulnerabilities.

What is a centralized currency?

A centralized currency is what most people still consider money – or fiat. As its central authority, the government issues and regulates fiat money. Another central authority manages and further controls it – a bank. The bank in turn uses various intermediaries such as payment companies and other 3rd parties when conducting the business of holding your money.

You’ve heard of a ledger before. In a bank, they have many ledgers that must balance out regularly, such as for operating expenses and customer transactions. It’s basically how they keep track of all the numbers and actions in their business. But with a bank, that ledger is centralized in a number of ways:

  • There’s one centralized server on which those ledgers reside.
  • To access the ledger, all the employees must connect to this one server when conducting business. Additionally, customers may access certain parts of the ledger to engage in online banking.
  • The Bank’s Board of Directors and executive management governs the server.
  • Some of the customer account data that goes onto the bank’s ledgers is later shared with 3rd parties. This benefits both the banks and those affiliated enterprises seeking new customers (i.e. life insurance companies).
  • Bank ledgers usually operate on a server within one geographical region. If the central server is down, no one can access it.

Vulnerabilities of Centralized Currencies

Centralization opens up traditional currencies (like the Euro or the Dollar) to the following vulnerabilities:

  • Single point of failure. If a hacker or embezzler wants to steal a bank’s money (aka the money belonging to all account holders), they have only one server to try and gain access to.
  • Control is always in the hands of a few. Decisions come without any system of consensus from the people who use and depend on this currency.
  • Since everything resides on that one server (or sometimes with international banks there are several), if the server goes down, so goes the entire system. All the employees and customers must switch to a temporary system, causing inconvenience and inefficiencies. Customers that normally access their financial information from their mobile apps or pc’s will have to wait until the system is back up.

What a decentralized currency looks like

Now let’s look and see how cryptocurrency differs from the money we use today:

  • The ledgers are distributed amongst numerous servers across the globe. That’s where the term “distributed ledgers” originated. One type of distributed ledger is a “blockchain. It’s particularly difficult to hack or manipulate a currency with the built in cryptographic and consensus functions inherent with blockchains.
  • Anyone with an internet connection, electricity and a device can access their currency. Anywhere, anytime. This includes those people in developing countries who don’t yet have access to banks, and also those unable to come up with a minimum balance to open an account.
  • The servers, which are spread broadly, are ‘ruled’ by consensus mechanisms, or algorithms that keep the currency running fairly, to benefit all users. No one server, miner, country or bank runs the show. It runs itself. It’s a community type of currency, where all the users participate and benefit.

What is stored on the blockchain

  • Only transactional data is stored on the blockchain. Your personal data is not required to own cryptocurrency. For some people, such as refugees who may have lost their official identification, they can still download a cryptocurrency wallet and transact with digital assets. It’s possible even for a family member on a distant continent to make an immediate transfer of cryptocurrency into that refugee’s wallet. Another use case is for people who regularly send part of the salary back to their family in their home country. Using crypto in this case would enable families from the poorest regions of the world to get more money, since remittance fees are notoriously exorbiant and exploitative.
  • With cryptocurrency, not only can you make a transaction almost immediately, the cost is minimal and it doesn’t matter where you are or what time it is. You can quickly send crypto to someone in the next room, or on the other side of the world. There are no boundaries or borders.
  • Only you have your “account numbers” which are referred to as private keys (or seed phrases). Unless you decide to give that information out, you are the only one with access to your cryptocurrency. We’re not just talking about keeping transactions quiet for money laundering; this is for people who believe in the right to financial privacy and financial sovereignty.

Cryptocurrencies provide a decentralized currency for everyone. Rich or poor, young or old, El Salvadorian or Nigerian, a decentralized currency brings control back to all the people while adding better security and increased efficiency. Move over banks!

What is a decentralized exchange?

A decentralized exchange is an online trading venue where people can buy, sell and trade digital assets. It has no centralized authority and enables peer-to-peer transactions in a secure and private fashion.

The challenge decentralized exchanges face

So far everything sounds great. You have a cryptocurrency that you can use, peer-to-peer, wallet to wallet, anytime and anywhere. But there’s a problem…

Blockchain technology is just getting started. Right now, MOST people are using the same old traditional currencies. Most stores, online or otherwise, do not take accept crypto. You most likely can’t pay your landlord with Bitcoin, and you certainly can’t make a big purchase like a home or car with crypto yet, unless:

You trade your crypto for fiat.

So far, we’ve talked about transactions that go directly from one person’s wallet straight to another’s. Essentially, a wallet to wallet crypto transfer happens with no intermediaries, no corresponding costs or fees, and without a wait. That is truly the beauty of crypto.

But until everybody is on board with using cryptocurrencies, we have to find ways to still use both decentralized and centralized currencies.

This is where cryptocurrency exchanges come in. Most crypto exchanges want to be decentralized because they recognize the importance. But right now, it’s extremely difficult to have completely decentralized exchanges because:

  • Until mass adoption of cryptocurrency takes place, you need a way to connect your crypto to your bank account. (Update: Stablecoins help in this situation as they bridge the crypto world to the banking system by holding reserves of more stable assets (such as USD) back crypto coins 1:1.)
  • Whenever you are dealing with banks, you must comply with their full set of centralized policies and regulations, including full identity disclosures.

If you want to spend some of your crypto, there are only a few places where you can do so directly. Otherwise, for all your purchases, bills and other expenditures, you’ve got to have access to a traditional currency like the dollar.

The varying levels of decentralization

The many crypto exchanges that are now operating internationally actually have varying levels of decentralization. Some are even considered hybrids, a cross between centralized and decentralized. Overall, the more centralized an exchange is, the more vulnerable it is to the manipulation, control and inferior security of fiat currencies.

But a true decentralized exchange has no central authoritative entity. No one person or company is controlling it; instead, it runs on consensus algorithms using smart contracts to handle peer-to-peer payments.

When using a decentralized exchange you can do the following:

  • Make buys, sells and trades of major cryptocurrencies and altcoins, in privacy and safety.
  • Borrow or lend cryptocurrencies.
  • Join a liquidity pool to earn crypto tokens
  • Stake tokens to earn interest
  • Know that you own your money. Your digital assets, as long as you hold the keys, is yours. No central authority can manipulate, garnish, steal or forcefully tax that money.
  • Your coins are safer than fiat in many cases. Digital assets run on distributed systems that incentivize users to be good actors and keep the system running. Though there is no central authority figure, the algorithmic protocol and consensus mechanisms that involve all users keep it running. Layers of encryption have the potential to make trading cryptocurrencies more secure than bank transactions.

Decentralized exchanges cannot provide governments or other central authorities with user information upon request, even if they were required to by law. They don’t require identifying data from their users (unless those users want to transact in fiat there), and thus it is not stored anywhere.

So why isn’t everybody using decentralized exchanges?

It’s early 2019 at this time of writing, and cryptocurrencies are only in their infancy stage. As of now, most people depend on centralized fiat currencies to manage their finances. For those wanting to invest in cryptos, they need a system that allows them to use their fiat money to buy and cash in their cryptocurrencies.

To do so on a crypto exchange, most people are subject to KYC (Know your Customer) and AML (Anti-money laundering) policies. But once that happens, you are out of decentralized territory.

People can trade crypto to crypto using dozens if not hundreds of wallets and exchanges that are available. But when we talk about using fiat in any way, centralization creeps back. As more infrastructure and new innovations emerge in the blockchain space, we get closer to bringing global adoption of cryptocurrencies. Only then will we see the surge of businesses begin taking cryptocurrencies directly.

Coinbase – A wannabe dex?

A good example of a centralized cryptocurrency exchange is Coinbase. At the current time, US investors (and many others) can only use fiat money to purchase or make trades with Coinbase if they go through the complete (and bank-derived) KYC/AML procedures.

Coinbase holds your cryptographic keys as well. So one central entity is holding all the account information and the actual digital assets. Similar to a bank, only Coinbase states that they have a very secure system of cold storage. But there’s still a centralized point of failure. This means in the case of a hypothetical hack at Coinbase, all users are vulnerable.

In an nutshell, if you don’t own the keys to your wallets, you don’t own that crypto. Nor to you reap the benefits of decentralization.

List of decentralized exchanges

WAVES

On the Waves Decentralized Exchange (Waves DEX), it’s decentralized even if you are from the US or Canada, meaning once you have a Waves wallet, you can trade crypto to crypto.

But if you are from those countries, you are simply not eligible to trade, buy or sell in fiat currencies. One way you can spend your dollars on Waves is to pay someone you know in an eligible country, and they can purchase the crypto you want and send it right to your Waves wallet. Without the fiat function, for instance, Americans basically must get crypto sent directly into the wallet to get started and don’t have the option to buy or sell anything with fiat.

But you can use this decentralized exchange to trade cryptos in this way without going through the KYC process. As a result, Waves does not hold any of your personal information. Unless of course you want to deal in fiat, then, as you can see in the “Fiat Gateway” image below, you are required to identify yourself.

In summary, on decentralized exchanges, if you can get someone to send crypto directly to your wallet, then you can use that exchange in full decentral mode to trade, buy and sell crypto. It is only when users need to cash in their digital assets for fiat that they lose some of the benefits of decentralization.

IDEX

Idex is another example of a decentralized exchange, but it services primarily Ethereum-based cryptocurrencies, like HedgeTrade’s token, HEDG.

When you create your cryptocurrency wallet on IDEX to start trading, you’ll find a reminder like the one above. A major decentralized aspect to crypto exchanges is that you hold your account keys and the password for encrypting your keys. If you lose them, there is no account recovery, because that would entail a 3rd party holding that information. And there isn’t one. On decentralized exchanges like Waves and IDEX, there is no such intermediary.

On the other hand, if you used fiat to purchase some cryptocurrency, that bank and any of their intermediaries will keep that information on centralized servers. Later, they may allow 3rd party agencies to access parts of that data.

Update July 2021: Waves and IDEX were a few of the first decentralized exchanges to gain traction. Today , CoinMarketCap lists over 75 DEXes with the top ten by by 24-hour volume looks something like this:

Best decentralized exchanges by volume (2021)

  • Uniswap (v3)
  • Pancakeswap (v2)
  • MDEX
  • MDEX (BSC)
  • 1Inch Liquidity Protocol
  • Uniswap v2
  • Sushiswap
  • 1Inch Exchange
  • QuickSwap
  • Synthetix

Not only are decentralized exchanges booming as far as volume and trading activity, but they have largely solved their earlier struggles with liquidity through liquidity provider (LP) tokens and DEX aggregators that pool the orderbooks of numerous decentralized exchanges. what are DEX

Conclusion

We hope this has helped you gain an understanding of decentralized exchanges and how they are operating in the current market. By using blockchain technology, we’re creating a more fair system of money. One without costly intermediaries and with a higher level of trust and security.