What are Decentralised Exchanges? Crypto DEXs vs centralised exchanges, UniSwap and more, explained in simple terms
Decentralised exchanges such as dYdX, UniSwap, PancakeSwap, and SushiSwap see hundreds of millions of dollars’ worth of transactions each day. Instead of building a database of customers, these DEXs allow users to anonymously and directly with each other’s crypto wallets. Here’s how:
For users of crypto exchanges like , , , Binance etc, it is mandatory to sign up with an email, create a password, verify the account, and perhaps even go through a KYC process.
As these crypto exchanges are centralised - just like banks, private enterprises or government bodies - they collect and store information about their users.
Decentralised Exchanges (DEXs) are fundamentally different. Instead of building a database of customers, DEXs allow users to anonymously and directly transact with each other’s crypto wallets. Some examples of DEXs are dYdX, UniSwap, PancakeSwap, and SushiSwap – which see hundreds of millions of dollars’ worth of transactions each day.
There are several other key differences between centralised and decentralised exchanges.
To understand these differences and learn about the pros and cons of DEXs, let’s first explore how centralised exchanges work:
How Centralised Exchanges work
If you use WazirX, CoinDCX, Binance, Coinbase etc, or plan to use them, you would be availing the services of a centralised company that allows you to trade crypto.
After signing up with your personal information, you would deposit money (your local currency or in crypto, if you already own some).
At that point, the exchange gets custody over your assets. While you can decide how to trade, deposit or withdraw these funds, the assets sit with the exchange, and you cannot spend them elsewhere.
The exchanges also do not provide you a private key to the funds. When you want to trade or make a transaction, the exchange signs off on it on your behalf, and based on your instructions.
When a crypto trade goes through, the exchange generally edits the balance in the accounts of the two parties to reflect the transaction.
This is similar to the process banks follow. When you send money to another customer of the same bank, the bank does not physically move any money between accounts. It simply adjusts or allocates balances to users accounts in its own database.
On centralised exchanges, crypto transactions are possible only due to the database of users and accounts created.
These exchanges usually provide a better customer experience compared to DEXs, since centralised exchanges can streamline their workflows to match orders in their databases.
Further, they do not perform transactions on-chain (on blockchains, which are generally slower than private databases and networks).
Centralised exchanges are prone to counterparty risk or hacks and leaks. In August this year, $97 million in crypto was stolen from Japanese exchange Liquid in a cyberattack, adding to a list of similar hacks across global exchanges.
Despite this, many users prefer centralised exchanges with a strong track record and ease of use.
How Decentralised Exchanges work
Like centralised exchanges, DEXs allow users to trade crypto. But they work in a fundamentally different way.
On many DEXs, transactions are executed on-chain. This means transactions occur on a single blockchain, like Ethereum, Binance Smart Chain, etc.
As blockchains are open source and public, DEX transactions are transparent. There is no way to hide or modify transactions for nefarious purposes.
On a DEX, as transactions occur on-chain, there is no centralised entity making edits to the account balances on its database. Instead, users transact anonymously with each other through their crypto wallets. Consequently, there is self-custody of funds on a DEX. As users transact using their own wallets, they retain custody of their assets.
Let’s look at an example.
A user with a MetaMask or Trust Wallet can use a DEX to trade or swap Ether (ETH) stored in their wallet for a wide range of crypto tokens. The user retains full custody of the ETH stored in their wallet, as the firms making crypto wallets do not take possession of their users' funds.
When a trade is made on a DEX, the crypto received comes from the wallet of another user and the exchange takes place on the blockchain supporting the DEX.
Uniswap, for example, is built on the Ethereum blockchain and allows users to trade and swap ERC-20 tokens (an Ethereum standard) such as Shiba Inu (SHIB), Decentraland (MANA), Enjin (ENJ) and several others.
However, it does not support non-ERC-20 tokens such as Bitcoin (BTC), Dogecoin (DOGE), Cardano (ADA), etc.
As blockchains are inherently slower than private networks, DEXs are more cumbersome to use than centralised exchanges. It could take a few to several minutes (or even hours) for a transaction request to be added to the blockchain and for the transaction to be validated.
Uniswap is a Decentralised Exchange (DEX) built on the Ethereum blockchain
Pros and cons of DEXs
Pros:
Access to rare tokens
Centralised exchanges list many popular tokens like BTC, ETH, DOGE, etc, but there are several thousand cryptocurrencies in existence that aren’t listed on them. Provided there’s supply and demand (sufficient liquidity), many unlisted tokens can be traded freely on DEXs, as long as they are supported.
For instance, the trending crypto token Floki Inu (FLOKI) is not available on any centralised exchange. Users can acquire and trade FLOKI only on DEXs like Uniswap, PancakeSwap (V2), ShibaSwap, etc.
Self-custody, no counterparty risk
DEXs are becoming popular among crypto investors as they don’t hold user funds and don’t expose them to counterparty risk.
A centralised exchange is prone to shut down or hacks and leaks of sensitive information. A DEX, however, is resistant to breaches, and even in the case of an unlikely hack, doesn’t put user information or funds at risk.
No KYC
Centralised exchanges have to comply with KYC and Anti-Money Laundering norms, and users have to submit personal information and identity documents to use such services.
This is seen as a privacy concern by many. On a DEX, which runs on a blockchain and is thereby permissionless, there is no requirement to share personal information. Users only require a crypto wallet, and signing up for a crypto wallet generally involves no sharing of personal information.
Cons:
Poor user experience
DEXs are typically not as user-friendly as centralised exchanges. DEXs are impacted by the block times and speeds of the blockchain, which can make trading painfully slow at times.
Further, since users have full custody of assets, there is no ‘Forgot Password’ option. If a user forgets their wallet’s seed phrase (similar to the private key), their funds become inaccessible and irretrievable. Thus, DEXs offer a less forgiving experience compared to centralised exchanges.
Low trading volumes and liquidity
Liquidity measures how easily assets can be sold or bought based on their availability in the market. Centralised exchanges generally provide markets with higher liquidity, which translates to quicker trades and low differences between buying and selling prices.
As DEXs are still in their nascent stages, trading volumes and liquidity are generally lower. In such markets, especially if there is no liquidity farming in place, it is harder to match with a trader who wants to buy or sell at a fair price.
The emerging Automated Market Makers (AMM), which string together a group of smart contracts and incentivise participation, may help address the problem.
High transaction fees
When the blockchain network supporting DEX is congested, transaction fees can be expensive.
Although this isn’t always the case, it is not uncommon for an on-chain transaction to require anywhere from a few to several hundred dollars’ worth of fees on a network like Ethereum, which is infamous for its high gas fees.
The way forward for DEXs
Over the last year, India has been rapidly adopting cryptocurrencies for investing and trading. A recent report by blockchain data platform Chainalysis ranked India second in terms of global crypto adoption in 2021, behind only Vietnam.
Industry estimates say over 1.5 crore citizens have invested in Bitcoin, Ethereum, and other cryptocurrencies across centralised Indian exchanges such as CoinDCX, WazirX, CoinSwitch Kuber, Zebpay, and others.
As these exchanges explore adding features of DEXs into their existing products in their own, unique ways, the road ahead is likely to see both types of exchanges flourish. Since centralised exchanges and decentralised exchanges each have their own pros and cons, users have the freedom to opt for either or both.
Edited by Anju Narayanan