What is a Decentralized Exchange
Most exchanges are Centralized Exchanges (CEX). Users of centralized exchanges transfer their crypto funds into the exchange’s account who then become the custodians of the users’ funds. As a result, centralized exchanges do not allow users to control the private keys of their own crypto funds and the exchange stores private keys in a centralized server or database. Therefore, this is a single point of failure and hackers target these firms to steal the private keys of the exchanges to steal users’ crypto funds. For example, approximately USD470M was stolen from Mt Gox as the centralized hot wallet of the exchange was targeted by hackersC
FOUR FUNCTIONS OF A DEX
Exchanges perform four functions:
- Fund deposits
- Order books
- Order matching
- Asset exchange
Most exchanges only decentralize the asset exchange function, since cryptocurrencies are recorded on the blockchain that is not centrally administered. Fund deposits are centralized, and exchanges require user identities for fund deposits. This creates a centralized record-collection and data-storage of personal information. A true Decentralized Exchange (DEX) decentralizes all four functions of the exchange.
WHY USE A DEX?
- True to the philosophy of decentralization. It is “impure” to use a decentralized currency/asset in a centralized environment. Not controlled by a single or group of companies.
- Negates censorship and control. Cannot be shut down by a government or company.
- Freedom to control your own crypto funds. No need to hand over your custodianship of your funds.
- Honors the privacy of users. No need to perform KYCs and perform registration to trade.
- No downtime. Exchange is hosted by a network of machines.
- Liquidity for all cryptocurrencies & tokens. As many centralized exchanges have onerous rules/regulations/costs, it is difficult and expense to raise money via an ICO/IEO.
TWO TYPES OF DEXs
At present, there are two types of DEXs, namely blockchain-centric & blockchain-neutral.
These are designed to connect across different blockchains. “Atomic swaps” are used to facilitate peer-to-peer trades between blockchains. An atomic swap is when a trade is done in a single operation (i.e., atomic) where smart contracts function as a trustless escrow to hold on to one cryptocurrency until the counterparty sends their counterparty over, and then both cryptocurrencies are released. Once other cross-chain technologies (e.g., PolkaDot, Cosmos) are building tools and protocols that can perform these operations across different blockchains more efficiently.
The choice of using a DEX or a CEX comes down to your specific use-case. If privacy and anonymity are more important than user-friendliness, liquidity and trading features then use a DEX. Otherwisem a CEX is appropriate.
An Honorary Senior Fellow at the University of Queensland with professional experience as a quantitative researcher for BlackRock and Bank of America Merrill Lynch in New York, USA. He led research teams in the development of capital models, securitized products and factor models in both equities and fixed income asset classes. Rand has several academic publications in cryptocurrency, portfolio management, systemic risk & quantitative trading