Introduction to Decentralized Exchanges
Until just a few years ago, apart from Bitcoin, Litecoin, Ethereum, and a few other cryptocurrencies, there were no well-known cryptocurrencies in the world of crypto. Only one or two limited and unknown exchanges provided services for buying, selling, and exchanging digital assets to enthusiasts. It was at a time when digital currencies were mostly seen as a revolutionary idea, enabling the creation of a new financial system. Over the past few years, the number of cryptocurrencies has grown from around 10 to over 5,000. Many cryptocurrencies were minted on different networks and made available to the public. Cryptocurrencies are no longer just a revolutionary idea as they now address specific issues in society and have become widely scalable.
In such circumstances, it is undoubtedly necessary to have better and more developed platforms for digital asset exchanges, buying, and selling. That’s why since 2020, large exchanges have gradually started their operations and attracted users. In this situation, exchanges have transformed into a place for cryptocurrency exchange and transactions. However, it didn’t take long for some flaws to become apparent in these new exchanges. Centralized exchanges, despite their expansion and user-friendliness, have inherent issues that many cryptocurrency industry insiders point out. These platforms, like traditional banks, hold users’ private keys to their wallets, essentially controlling their assets. This could serve as a starting point for malicious activities, theft, financial problems, and ultimately the potential loss of substantial user assets.
To support this claim, one can refer to the incident involving the centralized exchange FTX, which according to CZ, the CEO of Binance, set the digital currency technology back several years. Last year, it all started with a rumor that the FTX exchange held much less than what people had in this digital currency exchange. The Bitcoin and other digital asset balances in this exchange were far less than the expected amount, or in reality, the exchange managers had spent users’ money elsewhere instead of holding the equivalent digital currency in their wallets. Once this rumor spread, people quickly requested to withdraw their funds from the exchange, but as anticipated by many users, they were unsuccessful in doing so. In essence, users’ accounts were practically empty, and the balance in the exchange wallets was far less than expected.
The above incident highlights the importance of addressing the flaws of centralized exchanges and emphasizes the need for decentralized exchanges (DEXs) that provide users with more control over their assets and prioritize security and transparency. The growing popularity and adoption of DEXs indicate a shift towards a more decentralized and user-centric financial ecosystem. With the advancement of DEX technology and the development of innovative solutions, it is expected that DEXs will continue to evolve and offer users a safer and more reliable environment for trading digital assets.
Defining Decentralized Exchanges
A decentralized exchange (DEX) is a cryptocurrency exchange platform that operates without a centralized authority. Unlike traditional exchanges, DEXs do not rely on intermediaries to facilitate trading or hold users’ funds. Instead, transactions are directly executed between users (peer-to-peer) through an automated process facilitated by smart contracts on a blockchain.
DEXs vs. Centralized Exchanges
Centralized Exchanges (CEXs) like Coinbase, Binance, or Kraken, operate similarly to traditional banks or stock exchanges. They act as intermediaries, managing users’ funds and executing trades on their behalf. This centralized model requires users to trust the exchange with their assets and personal information, which has often led to significant security breaches and financial losses.
On the other hand, DEXs offer a trustless environment. Instead of relying on an intermediary, they use blockchain technology to facilitate direct transactions between users. This ensures users maintain control of their funds until the transaction is completed, eliminating the risk of loss due to hacking or exchange failure. It also ensures transparency, as all transactions are recorded on the blockchain, which is publicly verifiable.
Underlying Technology and Principles
Decentralized exchanges (DEXs) utilize blockchain technology and leverage smart contracts to facilitate their operations. To better understand how these exchanges work, let’s examine their different types:
Automated Market Maker (AMM) DEXs are DEXs that operate based on automated market makers. They acquire liquidity from users’ funds. To illustrate, let’s consider an example: Imagine a liquidity pool has been created, and users can only contribute two types of tokens or coins to this pool. Through the use of smart contracts and the blockchain network, it is clear how many tokens each user has in the pool. When a user enters this exchange to trade the same pair of assets, they add their token to the pool and withdraw an equivalent amount of the other token. All transactions are executed without the presence of intermediaries, peer-to-peer. It is important to note that in this scenario, the price of the asset pair and their exchange rate are managed by smart contracts and determined by their supply and demand. When a trade occurs, the smart contract recalculates the assets’ prices to maintain equilibrium.
Order Book DEXs, on the other hand, operate based on an order book. These are a type of decentralized exchange that relies on an order book system. In these exchanges, buy and sell orders are placed by users and organized in a central order book. The buy and sell orders are specified with details such as price and volume. When a buy order matches a sell order and their prices and volumes align, a trade occurs. Order book DEXs often serve as direct channels for exchange between buyers and sellers, eliminating the need for intermediaries. This type of exchange offers features such as customizable order sizes, leveraging margin trading, and increased transparency in transactions.
The third category of DEXs is DEX aggregators. A DEX aggregator is a platform or service that combines liquidity from multiple decentralized exchanges (DEXs) to provide users with better trading opportunities. Instead of relying on a single DEX, a DEX aggregator connects to several DEXs and pools their liquidity together. This allows users to access a wider range of trading pairs and potentially obtain better prices for their trades.
In summary, DEXs offer decentralized and transparent alternatives to traditional exchanges by utilizing blockchain technology and smart contracts. Whether through automated market makers, order book systems, or DEX aggregators, these exchanges empower users, promote peer-to-peer transactions, and provide enhanced trading opportunities in the cryptocurrency market.