There are now two types of bitcoin exchanges: centralised (most of them) and decentralised (just a few). People are enthusiastic about decentralised exchanges, but the technology is still in its infancy. While many crypto enthusiasts feel optimistic about the decentralised exchanges’ future, it remains uncertain whether cryptocurrency trading will be entirely decentralised soon.
What is a decentralised exchange?
Decentralised exchanges, also known as DEXs, are peer-to-peer markets where crypto traders engage in direct transactions without entrusting the custody of their assets to a third party or custodian. Smart contracts are self-executing agreements written in code that simplify these transactions.
DEXs are intended to eliminate the need for oversight and authorisation of trades inside a particular exchange. Decentralised exchanges provide crypto peer-to-peer (P2P) trading. Typically, they are non-custodial, meaning users retain control of their wallet’s private keys. Users can immediately check their crypto holdings using their private key to log in to the DEX. No personal information such as names and addresses will be required, which is fantastic for folks who value privacy.
DEXs only support “same blockchain crypto-to-crypto” transactions.
Fiat-to-crypto transactions always require an off-chain operation.
Someone, either the exchange or its custodian, must ensure that customers’ funds are held and allocated to the exchange’s activities to prevent market participants from withdrawing funds from pending buy or sell orders.
For example, if trader A sells BTC to trader B in exchange for USD, trader B needs to ensure that the BTCs “exist” and will be deposited into his account. As USD is not a digital asset that enables traders’ balances to be verified on a public, decentralised, and true ledger, fiat-to-crypto transfers must go through via a centralised, trusted third party that maintains the ownership record for USDs.
This justifies why fiat-to-crypto exchanges are centralised.
However, alternatives exist in the form of dollar-equivalent stablecoins such as USDT. USDTs are tokens backed by the Tether blockchain. When 1 “actual” USD is placed into Tether’s bank account, 1 token of stable currency is generated, and when 1 USD is withdrawn, 1 token is burned.
In this instance, centralisation stems from the fact that Tether must hold the same amount of USD in a bank as stablecoins. In other words, investors must trust them to store the same amount of USD in a bank account as existing stablecoins. Any withdrawal causes the loss of USDT, while any deposit results in it being created. This is an off-chain operation, as human interaction and trust are required for the deposit and withdrawal operations.
“True” DEXs only support token transactions from the same blockchain.
For example, you cannot swap BTC for ZEC in a completely off-chain transaction. As the BTC and ZEC wallets of the buyer and seller do not interact, a centralised third party (usually exchange or OTC broker) is required to ensure that BTCs are moved from one wallet to another and ZECs are transferred in the reverse direction.
The ugly truth: decentralised exchanges can be … centralised!
What is decentralisation all about?
Simply put, decentralisation involves the absence of a central mediator. When placing an order on most decentralised exchanges, traders transmit their coins to a smart contract, which transfers the funds to the purchasers. Going via this central smart contract for clearing requires trust in the contract’s code and the exchange’s staff.
What happens if the smart contract code has an error? Recent events have demonstrated that even the best Solidity programmers, such as the Parity wallet team, may make million-dollar mistakes.
As “centralised” decentralised exchanges keep client funds while orders are pending, they are regulated as Money Transmitters in the United States and Payment Service Providers in Europe to function in a compliant and legal manner.
Actual decentralised exchanges do not utilise a centralised smart contract; instead, they enable peer-to-peer, wallet-to-wallet transactions, similar to AirSwap, which just started offering LGO tokens.
Moreover, the exchange’s technological infrastructure can be subject to breaches and hacks. This risk lies at the level of the operating corporation and demands faith in its capacity to safeguard the business. Consider the recent DNS attack of EtherDelta, which resulted in the theft of over 30 ETH.
Ultimately, a great value proposition…
The fundamental advantage of decentralised exchanges over completely centralised exchanges is the freedom for traders to handle and safeguard their funds.
This results in reduced counterparty risk and increased trust in one’s ability to trade cryptocurrencies.
As traders are recognised by their wallet address, anonymity is also a benefit, but fully regulated crypto trading would require a minimum degree of client information.
On specific platforms, peer-to-peer and trustless trading is made feasible by the blockchain’s role as a trust layer between traders on a decentralised exchange, to the degree that they do not add a level of centralisation themselves.
…That still has some shortfalls today
Currently, decentralised exchanges have obstacles that may prevent them from replacing centralised exchanges.
A completely decentralised exchange cannot list fiat-to-crypto pairs, such as BTCUSD, or cross-blockchain pairs like ETHBTC as the two asset classes that lead most trade flows. ERC20 token-to-ERC20 token trading is a limited industry, and it’s essentially the only place where one decentralised exchange can function now.
Other constraints stem from the blockchain technology behind the exchange: decentralised trading is costly!
As coins are transferred from one wallet to another, dealers must pay blockchain transaction costs besides potential exchange transaction fees.
According to BitInfoCharts, the average Ethereum blockchain transaction price was 0.53 USD on June 18 — down from more than 4 USD on January 18. This is a 53 basis point transaction charge for a $100 transaction, which is more than the industry standard of 10 to 25 basis points.
This does not highlight that the unpredictability of blockchain transaction fees exacerbates operational complications for frequent traders on decentralised exchanges.
Centralised exchanges still dominate the crypto space.
Decentralised exchanges are not a feasible alternative to centralised exchanges for institutional investors due to their limited availability of trading pairs and their relatively expensive and unpredictable transaction costs.
Their most intriguing feature, the self-custody of coins, is an excellent addition to the crypto world. Still, it doesn’t bring much value to the existing institutional market, which relies on trained custodians to keep their assets.
Conversely, CEXs come with excellent liquidity due to the significant trading volume. The exchanges can rapidly fulfil their payment commitments. Numerous buy and sell orders are ensured by the lively activity on the centralised trading platforms, which assures market-friendly trading.
CEXs are built on a centralised and individual infrastructure, which allows virtually real-time transactions. Leading exchanges’ algorithms can handle hundreds of orders per second, and traders can respond immediately to shifting market conditions.
In addition, long-established decentralised exchanges, such as CoinSpot support numerous trading pairings. It’s also a breeze to make deposits and withdrawals in fiat currencies and cryptocurrencies on these exchanges.
