In the black-and-white world of blockchain, centralization is traditionally held as systematically evil, while decentralization is regarded as the greater means for universal good. Nevertheless, it would be next to impossible for the crypto industry to develop and preserve liquidity without the help of centralized crypto exchanges.
As a result, it doesn’t come as a surprise that centralized exchanges remain on top. They are user-friendly, they have owners and operators that you could make claims to in case something happens, and, in theory, they act in accordance with regulatory requirements.
However, the leading minds of crypto are increasingly critical of centralized exchanges.
Over $1.5 billion worth of crypto was stolen from centralized exchanges in 2018 alone, while the downfall of Mt Gox removed 6% of all bitcoins from circulation. Could decentralized exchanges address these issues and become a viable alternative?
What are decentralized exchanges (DEX) ?
The main attributes by which we can be sure that an exchange is truly decentralized is that they have no regulator or central platform. A DEX is built on top of a distributed ledger and acts only as an intermediary for matching buy and sell orders, while the trade itself is performed directly between traders, and the intermediary is not involved. No funds or personal data are stored on servers; all transactions are executed by smart contracts or via a designated protocol.
It should be noted that not all exchanges touted as decentralized are truly decentralized. Take, for instance, Bancor or IDEX: they are, at best, semi-decentralized because they can still freeze traders’ assets despite operating through smart contracts.
What are DEX advantages compared to conventional crypto exchanges?
- No middlemen. A decentralized exchange makes it possible for any two traders anywhere in the world to swap their assets. The assets are distributed directly between traders, and it takes very little time to confirm a transaction.
- Security. The funds are not stored in wallets but are locked in a smart contract that, if an exchange is truly decentralized, is virtually hack proof. No funds have been reported stolen from decentralized exchanges as of yet.
- Anonymity. Decentralized exchanges are not controlled by national or supranational regulatory authorities; they do not subject traders to complicated KYC procedures at the sign-up stage and they store no personal data. User accounts cannot be blocked or subjected to other sanctions. However, it must be mentioned that anonymity has a darker side to it – decentralized exchanges can be a haven for criminals and terrorists.
- Transparency. Running on smart contracts, DEXes are far more transparent than centralized exchanges. All data related to the day-to-day operations of an exchange, such as trading volume, historical transactions, and number of transactions, are available to everyone and cannot be forged (a nice change from centralized exchanges that, as rumor has it, sometimes provide unreliable data).
Trading volumes on decentralized exchanges: now and the future
It is quite a task to stack DEX trading volumes against centralized exchanges. The market is flooded with smaller exchanges that inflate their trading volumes artificially by using trading bots. Decentralized exchanges are much more predictable in this respect, as DEX operators don’t have wiggle room to boost volumes artificially. The DEX smart contract is coded to pay some gas per transaction on the Ethereum blockchain, so you could easily estimate the actual trading volume by the amount of gas paid. However, it must be recognized that this parameter can be tampered with, and operators can pay for additional gas to boost their trading volumes.
Decentralized exchanges currently lag behind, even if we take the inflated volumes on centralized exchanges with a grain of salt. DEX trading volumes hover around $100 million against $1 billion+ for centralized exchanges. DEX trading, however, gradually recovered after the January drop when volumes plummeted to $49 million. Reputation and trader trust are things that can only be gained over time, therefore, DEX trading volumes are expected to grow steadily as more and more users start to appreciate their advantages.
Are there any vulnerabilities to DEX trading?
Decentralized exchanges are operated through smart contracts, and these are almost impervious to hacking. In the unlikely event that a smart contract is hacked, the funds themselves will be safe, though the exchange may be down for a time. Decentralized exchanges are vulnerable to phishing attacks. For example, after the EtherDelta website came under attack, some users were tricked into entering their private keys on a fake website.
What are DEX disadvantages as compared to conventional exchanges?
- Low liquidity. Low liquidity is an issue that plagues many newcomer centralized exchanges, as they may have too many assets and few traders willing to buy them for the price. With DEX, this issue gets even worse: many DEXes trade only those currencies that are built on top of the same blockchain (mostly, Ethereum) and don’t support some popular pairs like BTC/ETH.
- Slower transactions. A trader has to lock the assets in a smart contract to trade them on a DEX. Sometimes it is a tricky and time-consuming process depending on what exactly is coded into the smart contract. Moreover, some DEXes don’t support automatic order matching.
- Marginal trading is unavailable. In general, DEXes offer fewer functions than conventional exchanges. As for margin trading, it is currently supported by a couple of low-profile DEXes. The leading decentralized exchanges (in terms of trading volume) offer only basic transactions with crypto.
Centralized exchanges by definition are vulnerable to human error and such risks as hacking. Decentralized exchanges are touted as a viable solution, however, they have to pass several milestones to really challenge conventional crypto exchanges. First of all, they will need to make transactions more accessible to average users, expand their functionality and introduce cross-chain transaction support.