A cryptocurrency exchange or a digital currency exchange is a platform that allows investors to convert fiat currency into cryptocurrency tokens and vice versa. The exchanges also allow the conversion between different cryptocurrency tokens. They play an integral role in the cryptocurrency industry, and without them, it would be nearly impossible to trade and use crypto tokens.
Contemporarily, a cryptocurrency exchange’s architecture is pretty similar to that of a bank. Both are institutions that act as middlemen and hold people’s funds to keep them safe, liquid, and allow their easy transfer from one location to another.
Like banks, the majority of the crypto exchanges are also centralized. What this means is that there is a central, trusted authority that is responsible for the safety and control of the platform.
Just like a bank, investors provide centralized crypto exchanges with the control of their wallets. By doing so, investors give access to their wallets to a third party and lose the burden of having 100% control over their money.
This is good for the investors as they are provided with a degree of protection, and peace of mind which they don’t have if they stay independent. There has been news and rumors of people losing cryptocurrencies worth millions because they lost their private keys. Exchanges prevent this from happening.
Crypto exchanges provide the investors with protection in the form of ease of access to their funds. If they forget or lose their password, then, after the necessary verification, the exchange can help them regain access to their accounts. This is just like the banks, where if you lose your debit card you can simply ask for a new one after verification.
Centralized exchanges also provide stability to the market and allow investors to buy and sell their assets at a stable price. This is because the large volume of tokens they hold helps them stabilize the market and allows investors to trade their tokens with relative ease.
Then why Decentralized Exchanges?
Centralized exchanges seem to have it all. So, why is there a need to create a decentralized exchange? The answer to that question also lies in its centralized nature, which provides it with all of the benefits.
The following are the major limitations that are found in centralized exchanges:
- Centralized exchanges gather the data of their users and store it in a centralized server. Usually, the users gain access to their funds through an email and password combination, and this information is stored on the server. This makes centralized exchanges a prime target for hackers, looking to get rich quick. A few exchanges have already suffered from this and lost investments worth millions. Some of the exchanges reimbursed the investors funds from their own pockets, but not everyone was so lucky.
- Censorship is another major constraint of centralized exchanges. The motivating factor behind cryptocurrencies is that they are decentralized and cannot be controlled by government institutions. For example, government can intervene and control access to someone’s funds at their bank. Centralized exchanges also suffer from this problem, where government regulations and seizures can restrict the investor’s money.
Decentralized cryptocurrency exchanges have been created to resolve these issues. Just like the cryptocurrency tokens, the decentralized exchanges are also peer to peer and use automated algorithms for the verification of transactions.
How Decentralized Exchanges Work
A decentralized cryptocurrency exchange does not use a central controlling server or a bundle of servers to control the data of the users. Consequently, there is no requirement for a third-party escrow to hold investors funds while they perform transactions.
The following are the main differences between centralized and decentralized exchanges:
In centralized exchanges, the server holds the order-books and the funds while a transaction takes place. However, in the case of decentralized exchanges, there is no need for a central server. The transactions are carried out directly with peers without the central servers. Therefore, the funds of the users are controlled by the participants of the transaction.
The regulatory environment surrounding exchanges is getting tougher, which makes it difficult for centralized exchanges to keep their users anonymous. Since anonymity of the transactions is the major point in cryptocurrencies, users are unhappy about sharing information with the exchanges.
On the other hand, decentralized exchanges are equivalent to the distributed blockchain, where every transaction is anonymous and encrypted. This ensures the privacy of the users and protects it from government intervention.
How Decentralized Exchanges are Better
Now, let’s talk about how decentralized exchanges are, or can be, better. The following are some of the evident benefits of the new kind of exchanges.
- Faster and Cheaper Transactions
The removal of a third-party in the transaction process means that decentralized exchanges are able to perform faster transactions, with greatly reduced fees. Since the transactions are peer-to-peer the lag that is usually found while processing transactions will be greatly reduced.
In the last section, we discussed how centralized exchanges are vulnerable to being hacked and the information of its users being stolen. There is a much lower relative probability of decentralized exchanges being hacked because the user information is not stored on a central server. If a hacker does gain access to a user’s information the attack remains localized and accessing the whole network will be next to impossible, just as with blockchains.
- Integration with Hardware Wallets
Another interesting benefit of a decentralized exchange is its ability to directly integrate with a hardware wallet like Trezor and Ledger Nano S. In centralized exchanges, users have to input their private keys to move their tokens from the wallet to the exchanges. This creates a risk for keylogging attack. In decentralized exchanges, users can directly transfer from their hardware wallets to the smart contracts offered by the decentralized exchanges.
- Users Control Funds
The best thing about decentralized exchanges is that the funds are still in control of the users instead of a central authority. The control of funds is always in the hands of users, even during transactions, as the whole platform uses a peer-to-peer network architecture. The private keys are not shared with the exchange and remain in control of the user.
Limitations of Decentralized Exchanges
Alright, decentralized exchanges are good and all, but they also have limitations. The following are some of the main limitations of decentralized exchanges:
- Less Functionality
Unlike centralized exchanges, the decentralized ones lack a number of useful features such as stop loss, margin trading, and others. These features can be a severe hindrance in a trader’s performance. These features are yet to be added by the decentralized exchanges, but centralized ones already boast these features.
- Difficulty in use
Centralized exchanges dominate the market because they are extremely easy to use and provide users with a lot of help. That is not the case with decentralized exchanges, where the users have to navigate through dozens of smart contracts. This can be a headache, even for the experienced users. Users also have to worry about remembering their private keys while dealing with the latter. For these reasons, decentralized exchanges are not very user-friendly.
5 Decentralized exchanges you should know
Now that we know the difference between centralized and decentralized exchanges, it’s up to you to decide which kind of exchange would be better for you. In any case, the following are some famous decentralized exchanges:
A decentralized exchange focused on trading Ethereum based ERC-20 tokens. The platform claims that it combines the speed of a centralized exchange with the security level of blockchain settlement. Overall, the exchange has a well-developed UI, and in terms of volume is amongst the top decentralized exchanges.
The main display consists of a Japanese candlesticks chart, describing the performance of any given asset. Users can check out the latest trades made on the blockchain and can easily buy or sell assets from the main screen. While registering, it is important to save your backup phrase, or you risk permanently losing access to your account.
EtherDelta is also specifically built for trading Ethereum ERC-20 tokens and Ethereum pairs. The whole exchange is powered by Ethereum based smart contracts which are responsible for managing, deposits, withdrawals, and wallet integration.
The similarity between EtherDelta and IDEX is uncanny as both boast a similar UI, with a candlesticks chart as the main screen. Like IDEX, EtherDelta also provides all the important information to the traders on the main front screen.
Traders can use the platform to buy, sell or withdraw their cryptocurrency assets. The following image shows the main screen of EtherDelta platform.
- Bancor Network
Bancor Network is a smart contract powered decentralized exchange, which solves the problem of liquidity that many decentralized exchanges face. Due to this property, Bancor has a very stable network, and the platform is less volatile and provides its investors with stable prices for tokens.
Bancor has an impressive web application with a great UI which users can use to perform the simple functions of buying and selling cryptocurrencies. Unlike IDEX and EtherDelta, Bancor’s UI is free from clutter and has neatly grouped the token assets.
- Bisq (BitSquare)
Bisq provides traders with a desktop application that they can use to trade their cryptocurrency assets anonymously. Bisq supports fiat currencies and other alternate cryptocurrencies, which have not enjoyed much fame.
Bisq boasts that unlike traditional exchanges, it does not require extensive information for registration or approval from a central authority. Traders can simply download the app and instantly start trading assets.
The system is peer-to-peer and free from a single point of failure. The main advantage of Bisq is probably its support for fiat currencies. It supports 126 cryptocurrencies but suffers from low trade volume.
- Radar Relay
The platform is another decentralized exchange focused on trading Ethereum tokens. Radar Relay allows you to trade your Ethereum tokens directly from your wallet, without the requirement of a middleman.
The platform is peer-to-peer and moves tokens between two wallets. Therefore, there is no middle service, and the tokens move directly from one client to another. Unlike contemporary wallets, Radar Relay never holds the custody of the tokens.
The platform also states that it requires no signups, deposits or withdrawals and has off-chain order books, is interoperable and is able to integrate wallets.