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Given the emergence of blockchain technology and cryptocurrencies – which may offer a far more secure, trustless, and enticing future compared to fiat currency – it has become somewhat ironic that decentralized currencies have relied on centralized exchanges to facilitate transfers and trading requests.
In recent months and years, however, a new form of cryptocurrency exchange has offered a new solution for traders seeking to conduct transactions trustlessly and in privacy. Colloquially, these are called ‘decentralized exchanges’.
Remind me – what is a ‘traditional’ cryptocurrency exchange?
Cryptocurrency exchanges usually operate similarly to traditional stock exchanges where buyers and sellers trade based on the current market price of cryptocurrencies.
Trading on such platforms typically involve fees, and some allow fiat-to-cryptocurrency trades. There are many online exchanges available in different regions around the world that accept a host of different currencies. Typically, cryptocurrency exchanges are regulated by governments and have to adhere to two sets of important requirements called “anti-money laundering (AML)” laws (which prevents the products of criminal activity from appearing as legitimate money) and “know your customer (KYC)” laws, which ensure that traders have to register their identities on services as proof of involvement.
Despite the fact that centralized exchanges can be prone to hacking attempts, manipulation by individuals with oversight, or can be shut down by governments, such services have typically seen a welcome adoption by traders as well as a high trade volume thanks to their ease-of-use.
So what is a ‘decentralized’ cryptocurrency exchange?
Decentralized exchanges have emerged in recent months and years as an alternative to their centralized or ‘traditional’ counterparts.
Put simply, a decentralized exchange is an exchange market that does not rely on a service to hold a user’s funds. Trades instead are facilitated peer-to-peer (or customer-to-customer) and are conducted through an automated process.
Decentralized exchanges leverage blockchain technology to creating a trustless and secure way to exchange cryptocurrencies without the need for a central ‘broker’. Principally, decentralized exchanges serve only as a matching and routing layer for trade orders.
On a decentralized exchange, trading is completed utilizing smart contracts on cryptocurrency platforms – many of which run on Ethereum.
When using a decentralized exchange, users leverage a proxy token (many of which are Ethereum-complaint) to facilitate an exchange of value.
Essentially, users deposit their funds on decentralized exchanges, and are offered an ‘IOU’ in the form of a token which can be traded freely. When a user is prepared to withdraw their funds, these tokens are restored to the cryptocurrency they represent and are returned to customers.
What are the benefits of a decentralized exchange?
Decentralized exchanges offer several enticing benefits over their ‘traditional’ counterparts – chief of which may be the trustless nature of such services.
Users of decentralized exchanges do not need to trust the honesty nor security of a facilitator or ‘broker’, given that contracts and agreements are executed autonomously.
Further, while users on centralized exchanges sacrifice some of their privacy in compliance with KYC and AML regulation, users of decentralized exchanges do not need to disclose their identity to anyone unless the exchange in question relies on bank transfers.
Given that decentralized exchanges are distributed through network nodes all around the world, they are not likely to suffer from server downtime that might disrupt the operations of a centralized exchange.
What are the weaknesses of a decentralized exchange?
In the same manner in which a ‘traditional’ cryptocurrency exchange can be vulnerable to hacking attempts (and the theft of cryptocurrencies), traders place their faith in smart contracts – which can be similarly manipulated, poorly constructed, or otherwise prone to failure – potentially resulting in a loss of funds.
Newer decentralized exchanges have promulgated the concept of “cross-chain atomic swapping”, which could allow cryptocurrencies on different blockchains to be traded seamlessly. This, however, is still a new concept and has not been widely adopted by a large number of cryptocurrency projects.
While decentralized exchanges may be far less prone to manipulation or hacking attempts than traditional exchanges, their complexity and relative novelty typically mean that such platforms can expect far lower trade volumes when compared to their centralized counterparts.