Decentralized Exchange-A Comprehensive Guide

Introduction

A peer-to-peer market for exchanges where cryptocurrency traders can conduct transactions without entrusting their cash to a third party is how we define Decentralised exchanges or DEXs. Self-executing agreements expressed in code or Smart contracts are used to make these transactions possible. Conversion of different cryptocurrency tokens can also be serviced on the exchanges. Trading and using crypto tokens would be almost impossible without the exchanges and that is why they’re crucial to the cryptocurrency sector.

Providing a solution for anyone who does not want to entrust their money to a third party  DEXs, or decentralized exchanges, are booming and thriving nowadays.  

For all our readers and visitors CryptoGoldie is presenting the new comprehensive guide and overview of decentralized exchanges. Without further ado let’s take a closer detailed look and understand what are DEXs, and how they work.

Decentralized Exchange 1
What is a Decentralized Exchange?

A system that eliminates intermediaries and enables traders to exchange cryptocurrencies straight with each other is defined as a decentralized exchange. Traders have complete control over the funds throughout the transaction which is ensured by the DEX.

The possibility of hacking is almost impossible due to the distributed network of nodes, that the decentralized exchanges use. The server downtime which users suffer when trading is also solved with the DEX.

Allowing anyone to trade cryptocurrency, they provide an open and transparent network that represents and establishes the standards for online cryptographic exchanges. With this, users are now able to trade cryptocurrency and certain decentralized exchanges are operational today.

What are DEXs and how do they work?

Because decentralized exchanges are built on top of blockchain networks that support smart contracts and where users keep custody of their assets, every trade incurs a transaction cost in addition to the trading fee. Traders need to engage with smart contracts on the blockchain to use DEXs,

The three basic forms of decentralized exchanges are

-Automated market makers,

-Order books,

-DEX aggregators.

Smart contracts are used for all of them which allow users to trade directly with one another. Order books comparable to those used by centralized exchanges were employed in the initial decentralized exchange.

All decentralized exchanges go through 5 stages and work pretty much in the same way. 

Stage 1: The user deposits a sum (in BTC or ETH) into the exchange’s network, where it is kept as proxy tokens.

Stage 2: To equal the genuine coins on the exchange the deposited coins are then used as collateral.

Stage 3: The customer places a sell order with the exchange and in this way finalizes a transaction.

Stage 4: Finally, the proxy tokens are exchanged between the two parties.

Stage 5: Once both parties have acquired tokens, they can exchange them for real money through the same or a different trading channel.

Automated market makers (AMMs)

A smart contract-based automated market maker (AMM) system was necessary to be developed which allowed overcoming the liquidity issue. Vitalik Buterin’s paper on decentralized exchanges, the Ethereum co-founder partly inspired this approach, which explains how to perform trades on the blockchain via token-holding contracts.

Blockchain oracles decide the price of traded assets, which are blockchain-based services that would provide information from exchange and other platforms. Rather than meeting buys and sell orders, these decentralized exchanges’ smart contracts use pre-funded pools of assets called liquidity pools.

Pools get funded by other users, and they are then entitled to the protocol’s transaction fees for completing transactions on that pair. These liquidity providers must deposit an equal amount of each commodity in the trading pair to earn income on their cryptocurrency holdings. This practice is known as liquidity mining. The pool’s smart contract cancels the transaction if one of the traders tries to deposit more of one property than the other.

This is one of the dangers that liquidity providers face. It is known as impermanent loss, which is a direct outcome of depositing two assets for a specific trading pair. Trading on the exchange can help to reduce the risk of one of these assets being more unstable than the other.

Order book DEXs

Keeping track of all open purchase and sell orders for certain asset pairs is what Order books do. A trader’s willingness to buy or bid for an asset at a certain price is what buy orders are built for to determine. Hence, sell orders indicate a trader’s willingness to sell or ask for the asset in question at a specific price. The depth of the order book and the market price on the exchange is determined by the difference between these values.

The two forms of order book DEXs are on-chain order books and off-chain order books. Users’ funds stay in their wallets while only the specific information is frequently held on-chain by DEXs that use order books. By borrowing funds from these exchanges traders may be able to leverage their bets.

To give traders the benefits of centralized exchanges DEX platforms retain their trade books of the blockchain, but on the other side, only resolve transactions on the blockchain. To ensure that deals are performed at the prices that consumers want, exchanges can save money and time by using off-chain order books.

DEX aggregators

DEX aggregators employ a variety of protocols and techniques in order to deal with liquidity issues. To minimize slippage on big orders, lower swap costs, and token prices, and give traders the lowest price in the smallest period these platforms pool availability from multiple DEXs.

Protecting consumers from the pricing effect and reducing the possibility of unsuccessful transactions are other major goals of DEX aggregators. To give a better user experience some DEX aggregators additionally employ liquidity from centralized platforms, all while staying non-custodial through the usage of particular centralized exchange integrations.

DEX vs centralized exchange – differences

In the case of centralized exchanges while a transaction is taking place the funds and order books are held by the server. On the other hand, decentralized exchanges do not require the use of a central server. This is possible because transaction participants have power over the users’ money.

Keeping users anonymous is challenging in centralized exchanges. On the contrary, in the case of decentralized exchanges, all transactions are anonymous and encrypted. Individuals in this way can maintain their privacy without giving all of their personal information.

The decentralized exchanges reduce the danger of hacking and server outages due to the distributed architecture of the network. In comparison to centralized exchanges, DEXs costs charged are dramatically lower.

Benefits of DEX

Cheaper and Faster Transactions: Since they do not require the assistance of a third party Decentralized exchanges can complete transactions more quickly. This approach also contributes to the decrease of overall fees.

Secure: Decentralized exchanges are safer than centralized exchanges because user information is not stored on a central server.  Even if the attack happens it will remain localized no matter if the hacker has access to the user’s information or the entire network.

Hardware Wallet Integration: Trezor and Ledger Nano S are an example of hardware wallets that the decentralized exchange allows users to connect directly and use the services of the exchange. In this way, users can send money straight from their hardware wallets to the decentralized exchanges’ smart contracts.

Users Control Funds: Users control the funds when it comes to decentralized exchanges which is a total contrast to the central authority established with the centralized exchanges. Because it uses a peer-to-peer network topology the control of funds is always in the hands of users. The user’s private keys are not shared with the exchange as they are kept private.

Token availability: Centralized exchanges have to personally evaluate tokens and guarantee that they adhere to local rules before listing them. Any token generated on the blockchain can be listed on the decentralized exchanges, suggesting that new projects will likely publish on these exchanges earlier than their centralized counterpart.

Anonymity: When they swap one cryptocurrency for another on DEXs, users’ identity is always preserved and not revealed or leaked. Knowing Your Customers Users (KYC), a conventional identification process required on centralized exchanges is not the practice with DEXs. Gathering personal information from traders, such as their full legal name and a photo of their government-issued ID is what KYC procedures entail.

Permission-less:  Regardless of their pay, race, culture, wealth, or geographic area DeFi welcomes everybody to the financial system. A mobile phone or computer with internet access is all that is required from every single user.

Globally, there are countless unbanked individuals. The World Bank estimated in 2018 that 20% of the total population of the world lack access to banking administrations. One evidence for this is that the vast majority of the unbanked need genuinely necessary know-your-customer (KYC) documents like state-issued I.D. cards.

Users can have access without any of this at a few DeFi stages. With no ID or credit score assessment, users can take out a maker loan, for example.

Interoperability: Developers can freely expand on top of existing protocols, customize interfaces, and integrate third-party apps with decentralized accounts.

Decentralized Exchange conventions are often known as ‘Money Legos especially because of this sort of adaptability. By consolidating other DeFi products new decentralized money applications can be built. For instance, to frame completely new and significantly more progressed decentralized finance market size and centers, Stablecoins, decentralized trades, and forecast markets can be joined.

 Transparency: Openness and accessibility have a more prominent degree with Decentralized Exchange. All exercises are available to the general population since most DeFi protocols are based on the blockchain (the encrypted digital public ledger). All users receive updates on all transactions. These records are not attached to individual users directly as is the case with traditional banks. On top of all of this, all accounts are pseudo-anonymous, posting only numerical addresses. DeFi DeFi products’ source code is open-source making it easily accessible for users with programming information and allowing the opportunity to review or build upon the source code/product.

On account of local area connection, open-source codes are safer and have better built and quality than proprietary software as it is constantly improved.

Finance control: With DeFi you stay in charge of your funds and finances. Certainly, you need to store your assets into the platform, but what happens to them is your decision only. A smart agreement completely substitutes a confiding in human intermediaries to qualify you for a loan and how to deal with your investments.

Nobody can prohibit you from a DeFi protocol. Working indiscriminately, the underlying smart contract is a law.

Innovation opportunity: DeFi services and products are easy to innovate and create because of the DeFi special-built environment that provides valid possibilities to do so. Because DeFi is an open protocol it can be considerable help for developing another age of financial solutions. The DeFi extraordinariness gathers even higher significance as it can use Ethereum and allows trailblazers to make new decentralized applications for the financial area.

Limitations

Decentralized exchanges don’t include some functionalities, like margin trading and stopping losses. The trader’s ability to perform may be hindered by the omission of these features.

Centralized exchanges are relatively simple to use whereas in the case of decentralized exchanges, however, customers must travel through several smart contracts. On the account of staying anonymous, they are less user-friendly than centralized exchanges.

Certain knowledge is required: Bitcoin wallets that support smart contracts are the access to DEXs. Moreover, how to utilize digital wallets is not the only thing users must know, but they must also comprehend the security concepts involved in keeping their assets safe.

Smart contracts vulnerabilities: Open source smart contracts on blockchain systems such as Ethereum allow for anyone to look at their code. Nevertheless, major decentralized exchanges’ smart contracts are reviewed by trustworthy firms, which helps safeguard the code.

Non- vetted token listings: To create liquidity on a decentralized exchange, anyone can create a new token and pair it with other tokens. Rug pull is one of the frauds that make investors vulnerable tricking them into thinking they’re buying a different token.

The Evolution of Decentralized Exchanges

In 2014 the first decentralized exchanges emerged. However, popularity grew as decentralized financial services, based on blockchain, gained traction and AMM technology helped alleviate the liquidity issues that DEXs had previously experienced.

What is difficult for these platforms to enforce is Know Your Customer and Anti-Money Laundering checks, because there is no central organization authenticating the type of information normally supplied to centralized platforms. However, there is still the opportunity for regulators to try to impose these controls on decentralized platforms.

What is interesting is that those that do take user deposits still need users to sign blockchain messages to progress funds off of their systems. That is why regulations that pertain to custodians would not apply to these platforms.

In the DeFi environment, users can borrow funds to strengthen their holdings, lend money to earn passive interest, or supply liquidity to earn trading fees on decentralized exchanges.

What are the DeFi Applications into the Real World?

The potential to transform the lives of everyone unbanked in the world emerges with the rising adoption of Open finance platforms and processes.

For instance, foreign workers send billions across borders to their families on the remittance market where fees that they have to pay are extortionate. Decentralized Finance nurtures trends in services with the potential to cut down these costs by more than 50%. What is expected from this as a result is not only to increase employees’ productivity but also to curate growth in economies.

By concentrating on the advantages of DeFi, loans are the other challenging area that can be addressed. The practice of today’s banks is that the unbanked can’t borrow money because of a lack of credit score or a bad history with the banking institution. To eliminate the credit check process DeFi platforms come up with a solution to connect borrowers with lenders and ease the process multifold. 

On the topic of how blockchain shapes the fintech domain, these are just two examples that are only scratching the surface of a wider story of possible application. It immediately removes inaccuracies and middlemen and brings in transparency and a lack of central control in the picture. With blockchain, the grounds are only getting prepared for the coming up with newer use cases of DeFi in every Fintech real-world application.

DeFi Challenges

Risk is present with every high return financial product. Therefore DeFi challenges must be present as well. 

Specialized knowledge and attached risk are one challenge when understanding to securely handle cryptocurrencies tools. The responsibility here is transferred to the user to take care of its key and hold and follow the process of multi-factor authentication with utmost privacy. 

Furthermore, security was a challenge for sound blockchain development companies, because there have been far too many security-related incidents, where users begged the interference of stringent security and privacy algorithms. DeFi users must keep themself updated with changed service terms between different wallets, exchanges, and other crypto projects even though the solution creators have been taking control of the task of security.  Read more about breaching the security and hacking Defi from our latest news Pnetwork-losses-12m-after-yet-another-crypto-bitcoin-hack-on-defi-protocols

Finally, investors have benchmarks and historical data to look at before taking any investment decision when it comes to the traditional currencies. This privilege, however, is not given to DeFi users. Assessment for the associated risk is impossible because the lack of historical numbers makes it difficult for them to evaluate the risks. Therefore, they must perform extensive research on their own. 

Conclusion

One of the most important aspects of a decentralized exchange is security. The funds are not vulnerable to hacking or theft because they are not held in a central reserve. To protect privacy, personal information from users is not required.

By eliminating the middleman’s role decentralized exchanges also help to reduce trading fees. For traders who enjoy keeping up with crypto market trends, decentralized exchanges are more than worth considering.

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