Decentralized exchanges allow users to buy and sell cryptocurrencies through peer-to-peer transactions eradicating intermediaries. In other words, it is a departure from traditional exchanges where a third party holds the authority to transfer assets between two parties.
With a decentralized exchange, a distributed ledger Blockchain replaces the third party and eliminates system failures. So, users have control over their assets that makes trading more transparent. DEXs use blockchain smart contracts to automates transaction operations, but there are various variations for order fulfillment.
Types of Decentralized Exchanges
Achieving complete decentralized is a philosophy rather than a rule as it is not practical based on blockchain first layer scalability. Most DEXs are semi-decentralized, utilizing their servers and off-chain books to manage and store data. However, the users have the authority to maintain control over their funds through private keys.
DEXs are continuously evolving ad operates over a single blockchain. All types of decentralized exchanges execute orders through smart contracts, and they do not have custody over user funds at any point.
On-Chain Order Books
For these types of exchanges, every process takes place on a chain, including order modification and cancellation. It is the most decentralized process as a third party has no right to handle and execute the transactions. However, it is not a practical approach to execute as placing information on all the nodes may take more time.
Many blockchain experts criticize this model as it is slow. Moreover, an investor watching the prices of assets and waiting, but at the last minutes before he makes a decision the price may rise or fall.
Off-Chain Order Books
Exchanges with off-chain order books are decentralized to some extent bit more centralized as compared to on-chain ones. Despite storing data on the blockchain, off-chain orders are pushed to the centralized entity that controls the order book. Some of the ERC-20 Ethereum based tokens offer DEXs that follow the same working principle, and to achieve decentralization smart contracts are integrated.
Automated Market Makers
An Automated Market Marker uses unique algorithms that make pricing pairs in real-time. Unlike the traditional market, where firms offer an accurate price and stick to that, AMM decentralizes these operations and empowers users to build a market on the blockchain. Instead of making direct transactions, users trade through smart contracts and offer liquidity. Unfortunately, due to automatic prices algorithms, there are no order types in AMM.
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Pros of Decentralized Exchanges
There are many reasons decentralized exchanges have got popularity among crypto enthusiasts. Some of them are:
No KYC Required
DEXs preserve user-sensitive information, funds and offer top-notch privacy. Users can have access to decentralized exchange without creating an account or undergoing identity verification.
No Counterparty Risk
As users do not need to transfer their assets to the exchange, the number of risks associated with theft and fraud reduces. Moreover, DEXs prevent price manipulation, and fake trading volume and users maintain anonymity due to lack of KYC.
Versatility of Token
In the past, it was difficult for users to trade new cryptocurrencies. Now, DEXs have made it effortless for users to trade even obscure currencies. Typically, traditional exchanges offer limited options that restrict the user from several countries to participate.
Cons of a Decentralized Exchanges
No doubt, decentralized exchanges offer groundbreaking benefits, they also have some drawbacks:
Limited Trading Functionalities
Mostly DEXs execute simple operations like buying and selling. As a result, users cannot find advanced options like stop loss and margin trading that makes trading difficult.
DEXs are also undergoing the same congestion as Ethereum’s first network iteration. Tough a transformative network upgrade in 2018, DEXs are still subjected to network first layer scalability.
Decentralized exchanges are a trusted and secured solution that authorizes users to trade cryptocurrencies eradicating third-party dependencies. As full decentralization is still a debate, multiple DEXs offer varying levels of security, efficiency, and privacy from them investors can choose. As DEXs are evolving continuously, it will become more practical, and user adoption will be a focus point DEXs to look at.
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