What Is a Decentralised Exchange?

 

Decentralised exchanges began gaining popularity around 2014. Over the years, they have only become more popular. So, what’s so exciting about decentralised exchanges? 

 

KEY TAKEAWAYS

• Traditionally, a centralised exchange is a platform where transactions are overseen by an intermediary such as a central bank.

• It was around 2014 that decentralised exchanges first appeared and later evolved over time, now occupying a central role in the trustless crypto economy.

• A decentralised crypto exchange is a digital exchange that allows P2P transactions, without relying on central intermediaries such as brokerages, exchanges, or banks.

In the Web 3.0 economy, a decentralised exchange is the definitive element of asset trading. A new entrant to the market, the existence of such an exchange ensures that the traders can purchase and sell cryptocurrencies and virtual tokens effortlessly and keep their funds safe and secure.

Decentralised exchanges make a departure from centralised exchanges in that the former lie outside the purview of any government approved intermediary such as a central bank or a broker. Since these exchanges lie outside the control of any central authority, they give the traders more control over their assets. In this blog, we will take a closer look at the category of what are decentralised exchanges and their emerging role in the burgeoning crypto economy.

What Are Decentralised Exchanges?

Decentralised exchanges (DEXs) are digital exchanges that allow peer-to-peer (P2P) transactions within their marketplaces. Here, users can trade cryptocurrencies and other digital assets such as non-fungible tokens (NFTs) without the interference or dependence of a central authority.

You don’t need to rely on intermediaries such as brokerages, exchanges, or central banks. These exchanges allow users to trade digital assets, speculate on their price movements, offer liquidity, and stake tokens to earn interest.

In a DEX, you yourself are responsible for the security of your funds and assets because it’s you who owns the private tokens. So, if you transfer funds from your wallet to an incorrect or wrong address, the DEX is not liable for the loss of your funds. It's autonomy that underlines every feature of DEXs.

How Do Decentralised Exchanges Work?

In terms of software architecture, a DEX is a type of a decentralised application (dApp). A decentralised application is an open software application that is distributed and runs on a peer-to-peer blockchain network. DEXs deploy immutable smart contracts, built on blockchain networks, to automatically handle and carry out transactions. DEXs empower users to trade directly from their digital wallets, providing them greater custody of their funds.

A DEX is built on a permissionless, trustless smart contract platform that is not dependent on any intermediary such as a central bank. The protocol is managed by a network of nodes spread across the globe, with no central role assigned to anyone. This is why there is no possibility of a complete collapse due to failure at a central point. Since the operation is spread across a global group of members, it is a decentralised operation.

DEXs operate by establishing a decentralised network of nodes that confirm and validate transactions over smart contracts. By doing this, it minimises the chances of hacks or manipulation which are often associated with centralised changes. With DEXs, users control their private keys and digital assets throughout the flow transactions. Users need to pay two kinds of fees—gas and trading fees.

While the former is asked for executing on-chain transactions, the latter is asked for maintaining the smart contract platform. Primarily, there are three types of decentralised exchanges-

• Automated Market Maker: An automated market maker (AMMs) is a protocol that imports information from crypto exchanges and other trading platforms to set the price of traded assets. They rely on liquidity pools instead of buy-and-sell orders.

   

• Order Book: An order book is a protocol that puts a record of all the open orders to buy and sell specific cryptocurrencies. It is maintained by traders who place the orders themselves. Please note that order book DEXs often face liquidity crisis.

   

• Aggregator: A DEX aggregator is a protocol that aggregates liquidity from different DEXs. It can thus offer the best possible price for a specific cryptocurrency in the shortest possible time. Such DEX aggregators offer the traders the twin benefits of resistance against price volatility and failed crypto transactions.

Such advanced and innovative protocols form the infrastructure of DEXs, making them very lucrative to traders willing to participate in the burgeoning crypto economy. Now, the question is: Do DEXs offer an alternative to CEXs that dominate the markets in terms of trading volume and user base?

Difference Between Centralised And Decentralised Exchange 

DEXs seem to appear as alternatives to CEXs. While CEXs offer traders centralised finance (CeFi), DEXs let traders access decentralised finance (DeFi) markets through P2P trading. Let us have a quick look at a few crucial differences between DEXs and CEXs: 

• Unlike CEXs, DEXs don’t rely on any central intermediary to clear transactions. Instead, they employ self-executing smart contracts for this purpose. 

   

• Unlike CEXs, DEXs let you have complete control over your assets as you own both your private keys and cryptocurrency funds.

   

• DEXs are considered to be comparatively safer than CEXs as the wallets don’t have to worry about cyber-attacks that threaten centralised networks of CEXs. 

   

• CEXs generally charge you several platform fees such as trading fees, withdrawal fees, deposit fees. DEXs instead only charge you gas and transaction fees.

   

• CEXs continue to remain more popular than DEXs for the simple reason that the former is simpler to use, and the latter are more suited for technically advanced users as you need to directly interact with smart contracts.  

   

• CEXs enjoy a huge user base and astonishingly high trading volumes as a large number of users flock to them. In comparison, DEXs occupy a modest portion of the market.

Benefits and Risks

What is the Future of Decentralised Exchanges?

It was around 2014 that decentralised exchanges first appeared. They have evolved over time and now occupy a central role in the trustless crypto economy.

Existing beyond the purview of centralised agencies such as banks, these platforms are now increasingly being forced to adhere to local rules and regulations in the different jurisdictions they operate in. Let us have a close look at the trading volume of DEXs in the current year. 

Source: DefiLlama

In January 2024, the trading volume of DEXs was slightly below $150 billion but hit nearly $280 billion in March. The market has since then witnessed a consistent decline. In June, the said figure could barely hit $150 billion. 
 

Source: The Block
 

The trend is the same for centralised exchanges, but the figures for trading volume are dramatically high, compared to DEXs. In March, the trading volume of CEXs was almost $2.5 trillion. In June, the figure was only slightly above $1 trillion. It is obvious that most people prefer centralised exchanges over decentralised ones.

DEXs are not easily accessible to ordinary traders who are not very tech-savvy. It will take more time for such platforms to become scalable for future usage. CEXs offer a user-friendly interface but compromise on user autonomy. DEXs instead offer you self-sovereignty but at the cost of simplicity. We recommend that you compare the benefits and limitations of both centralised and decentralised exchanges and then decide what option is best for your crypto trading experience. 

Frequently Asked Questions (FAQs)

1. What are decentralised exchanges?

Decentralised exchanges are digital exchanges that allow P2P transactions over their marketplaces, without relying on intermediaries such as central banks or brokers.
 

2. Are decentralised exchanges legal?

The legality of decentralised exchanges varies as per the jurisdiction they are operating in. In a lot of countries such as the United States and European Union member states, these exchanges are required to register themselves with the central regulating bodies to operate freely. In some countries such as China, it is illegal for decentralised exchanges to operate. 

3. Are decentralised exchanges regulated?

The decentralised exchanges are regulated in a jurisdiction if and when it gets legalised. These exchanges are regulated by the financial or cryptocurrency-specific regulatory bodies in those regions. In the United States, it is the Securities and Exchange Commission (SEC), the federal securities regulator, that regulates these exchanges. 

4. What is the difference between a centralised and a decentralised exchange?

The difference between a centralised exchange and a decentralised exchange is the role of intermediaries such as central banks. While the flow of transactions in the former is controlled by central banks, the latter is characterised by P2P transactions without the control of any intermediaries such as banks or brokers. To put it simply, a decentralised exchange gives the user complete control over their funds. 

5. Is a centralised exchange safer than a decentralised one?

Whether it’s a decentralised exchange or a centralised exchange, it is vulnerable to cyber hacks and attacks. But a decentralised exchange gives you more control over your online wallet. However, such platforms are not user-friendly unless you are a digital native.