Cryptocurrency exchanges, also known as EXs, allow consumers to buy and sell tokens. They bring buyers and sellers together on a proven cryptocurrency trading platform and, in doing so, help establish the market price for a specific ticket. So far many cryptocurrency exchanges have been centralized. That is, they are created and controlled by a central authority. Exchanges like Binance, Kraken, Coinbase, and Gemini are all centrally managed crypto exchanges with significant user bases.
However, a newer type of cryptocurrency exchange has entered the market, and seems to be gaining traction by the month: decentralized exchanges. A decentralized exchange (DEX) serves the same or very similar function as a centralized cryptocurrency exchange, yet is not centrally managed. Instead, a decentralized exchange can operate primarily as a result of smart contracts that operate trades based on programmed code. The idea is to pull the middle person – the managers of a particular exchange – out of the transaction. Achieving this goal can serve multiple functions.
How Do Devolved Exchanges Work?
Decentralized exchange mechanisms can best be demonstrated by comparing them with central crypto exchange mechanisms. So how do central crypto exchanges work? First, a person who wants to buy cryptocurrency chooses an exchange. They complete any necessary registration or login processes, and then deposit their dollars, Euros, or other fiat currency of choice in exchange for some form of cryptocurrency. One may also deposit his or her own cryptocurrency for trading on the exchange.
There are some obvious advantages of central exchanges. Because assets are held by the exchange, transactions do not necessarily have to be facilitated by underlying blockchains. Although there are many benefits to blockchains, speed is not generally considered one of them. Thus, centralized exchanges can offer faster transaction speeds than decentralized alternatives. When a consumer issues a purchase or sale order, it can be processed almost instantly by the mechanisms governing a particular exchange.
In essence, a cryptocurrency central exchange operates much in the same way an app likes it Robinhood do that: you deposit money into the platform, conduct trades, and can withdraw cash when you want (with some legal restrictions). With centralized swaps, you ultimately trust that the exchange’s managers will return your funds when you ask for them, and that they will not abuse your deposited funds in any way. You can also pay those managers a break from each transaction. Although decentralized exchanges share the same basic function as central exchanges, they rely much less on the integrity and actions of human rulers.
What is the Purpose of a Devolved Exchange?
Generally, the purpose of a decentralized exchange is the same as a centralized cryptocurrency exchange: to facilitate the purchase and sale of cryptocurrency and other assets adjacent to crypto. With this fundamental purpose in mind, centralized and decentralized swaps can allow investors to engage in many different types of transactions, from simple cryptocurrency purchases to option options and betting on futures.
Perhaps more relevant is the purpose of decentralizing exchanges. As stated previously, a decentralized exchange is one in which no central authority stands between two or more individuals involved in a transaction. Or, at least, no human authority does.
At least in theory, cryptocurrency purchases and sales issued through decentralized exchanges are operated by smart contracts. Instead of human exchange managers collect and pay money to buyers and sellers, self-operate smart contracts handle all transactions.
From the simplest perspectives, the benefits of a devolved exchange can include:
- Less need to trust a central authority to act ethically
- Lower management fees
- Democratic participation in exchange-related management decisions by participants in an exchange
- Greater flexibility in listing, buying and selling less mainstream tickets, such as explains the Stanford Journal of Blockchain Law & Policy
However, these potential benefits come with some risks.
What are the Disadvantages of Devolved Exchanges?
Recent history has shown that the ideal of decentralized exchanges (to devolve, decentralize, and then devolve some more), and then there are more practical alternatives.
Complete devolution means:
- No central authority
- Confirm each transaction through each node in blockchain
- Higher security through distributed hosting
- Maintain a comprehensive, permanent ledger of transactions on blockchain
The main disadvantages of this ideal are that transactions can become slow and costly.
To reduce these disadvantages of full decentralization, hybrid models of decentralized exchanges have emerged. Decentralized exchanges with off-chain order books are one example of how DEXs can outsource elements of their exchange away from the blockchain in the name of efficiency.
Exchanges with off-chain order books may continue to use smart contracts in some way to ensure the accuracy of a transaction. However, they can also rely on off-chain human beings to carry out certain orders manually. This is intended to prevent clogging of a particular blockchain pipeline with too many orders on it. The disadvantage is the addition of third parties, which generally moves any blockchain-related system further away from the ideal of true devolution. This balance between uber decentralization and scalability is one that every decentralized exchange must strike in their own unique way.
What is the Current State of Devolved Exchanges?
Devolved exchanges have fallen in line with the broader trend in devolved funding (DeFi): growth. The general uncertainty that has defined 2020 has further accelerated investment in decentralized exchanges. Cointelegraph notes that a particular brand of decentralized exchange governed by an algorithm called automated market makers (AMMs) is particularly hot right now.
While high demand may appear to be a test of value for decentralized exchanges, some concerns remain. One concern is the scalability of blockchains as the number of transactions on a particular chain increases. This concern raises another issue: relative slowness of transactions on decentralized exchanges compared to centralized alternatives.
As devolved exchanges continue to feel out the appropriate combination of central speed and decentralized security, it is hoped that products will continue to evolve to accommodate high demand for decentralized exchanges.