A cryptocurrency exchange, also known as a digital currency exchange, is a platform where investors can convert fiat currency into cryptocurrency tokens and vice versa. The exchanges also allow for the conversion of various cryptocurrency tokens. They play an important role in the cryptocurrency industry, and trading and using crypto tokens would be nearly impossible without them.
A cryptocurrency exchange’s architecture is currently very similar to that of a bank. Both are institutions that act as middlemen, holding people’s funds in order to keep them safe, liquid, and easily transferable from one location to another.
The majority of cryptocurrency exchanges, like banks, are centralized. This means that there is a centralized, trusted authority in charge of the platform’s safety and control.
Investors, like banks, give centralized crypto exchanges access to their wallets. By doing so, investors give a third-party access to their wallets and give up the burden of having complete control over their money.
This is beneficial to investors because it provides them with a level of protection and peace of mind that they would not have if they remained independent. There have been reports and rumors of people losing millions of dollars in cryptocurrency because they misplaced their private keys. This is prevented by exchanges.
Crypto exchanges offer traders security in the form of easy access to their funds. If users forget or lose their password, the exchange can help them regain access to their accounts after the necessary verification. This is similar to banks, where if you lose your debit card, you can simply request a replacement after verification.
Centralized exchanges also provide market stability by allowing investors to buy and sell assets at a consistent price. This is due to the large volume of tokens they hold, which aids in market stabilization and allows investors to trade their tokens with relative ease.
So, why do decentralized exchanges exist?
Centralized exchanges appear to have everything. So, why is it necessary to establish a decentralized exchange? The answer lies in their centralized nature, which provides them with all of their advantages, but also brings with it a couple of important drawbacks.
The following are the major constraints of centralized exchanges:
- Centralized exchanges collect user data and store it on a centralized server. Users typically gain access to their funds via an email and password combination, which is saved on the server. As a result, centralized exchanges are a popular target for hackers looking to make a quick buck. A few exchanges have already suffered as a result of this, losing millions of dollars in investments. Some exchanges reimbursed investors’ funds out of their own pockets, but not everyone was so fortunate.
- Another significant constraint of centralized exchanges is censorship. Cryptocurrencies are appealing because they are decentralized and cannot be controlled by government institutions. For example, the government can intervene and restrict access to someone’s bank account. This problem also affects centralized exchanges, where government regulations and seizures can limit the investor’s ability to access their money.
To address these concerns, decentralized cryptocurrency exchanges have been established. Decentralized exchanges, like cryptocurrency tokens, are peer-to-peer and use automated algorithms for transaction verification.
How decentralized exchanges function
A decentralized cryptocurrency exchange does not use a central controlling server (or cluster of servers) to control user data. As a result, there is no need for a third-party escrow to hold investors’ funds while they conduct transactions.
The main distinctions between centralized and decentralized exchanges are as follows:
- Control
During a transaction on a centralized exchange, the server holds the order books and the funds. However, there is no need for a central server in the case of decentralized exchanges. Transactions are carried out directly between peers, without the use of central servers. As a result, the transaction participants control the funds of the users.
- Anonymity
The regulatory environment surrounding exchanges is becoming more stringent, making it difficult for centralized exchanges to maintain user anonymity. Users are unhappy about sharing information with exchanges because anonymity of transactions is a major point in the philosophy that underpinned the advent of cryptocurrencies.
Decentralized exchanges, on the other hand, are analogous to the distributed blockchain, in which every transaction is anonymous and encrypted. This protects users’ privacy and shields them from government intrusion.
Why are decentralized exchanges better?
Let us now discuss how decentralized exchanges are or can be improved. The following are some of the obvious advantages of this new type of exchange.
- Faster and less expensive transactions
Because there is no third-party involved in the transaction, decentralized exchanges can complete transactions faster and with lower fees. Because the transactions are peer-to-peer, the typical lag that occurs when processing transactions will be greatly reduced.
- Secure
In the previous section, we discussed how centralized exchanges can be hacked and their users’ information stolen. Because user information is not stored on a central server, the relative likelihood of decentralized exchanges being hacked is much lower. If a hacker gains access to a user’s information, the attack remains localized, and accessing the entire network is nearly impossible, as with blockchains.
- Hardware wallet integration
Another intriguing feature of a decentralized exchange is its ability to integrate directly with hardware wallets such as Trezor and Ledger Nano S. To transfer tokens from a wallet to a centralized exchange, users must enter their private keys. This opens the door to a keylogging attack. Users can directly transfer funds from their hardware wallets to the smart contracts provided by decentralized exchanges.
- Funds are controlled by users.
The best thing about decentralized exchanges is that the funds remain in the hands of the users rather than a centralized authority. Because the platform is built on peer-to-peer network architecture, users always have control over their funds, even during transactions. The private keys are not shared with the exchange and remain under the user’s control.
DEX’ limitations
Okay, decentralized exchanges are great, but they have limitations. Some of the major drawbacks of decentralized exchanges are as follows:
- Functionality is reduced.
Decentralized exchanges, in contrast to centralized exchanges, lack a number of useful features such as stop loss, margin trading, and so on. These characteristics can be a significant impediment to a trader’s performance. These features have yet to be added by decentralized exchanges, but centralized exchanges already offer them.
- Difficulty in application
Centralized exchanges dominate the market because they are extremely simple to use and offer a lot of assistance to users. That is not the case with decentralized exchanges, where users must navigate dozens of smart contracts. Even experienced users may find this difficult. While dealing with the latter, users must also be concerned about remembering their private keys. Decentralized exchanges are not user-friendly for these reasons.
Below are the highest-ranked decentralized cryptocurrency exchanges, according to traffic, liquidity, and trading volumes:
- Uniswap (v3)
- dYdX
- Curve Finance
- Kine Protocol
- PancakeSwap (v2)
- DODO (Ethereum)
- Sun.io
- ApolloX DEX
- Uniswap (V2)
- Perpetual Protocol
