Out of the many clashes which have emerged in the cryptocurrency ecosystem since the development of Bitcoin the topic of centralized and decentralized exchanges has been a hotly debated and innovated area of the ecosystem. With this most recent run-up in the price of cryptocurrencies including Bitcoin and Ethereum, significant focus has been applied on extending the ecosystem philosophy of decentralization, or how resilient the system or network is to one of its constituent pieces going offline, behaving fraudulently or being subject to coercive force. Bitcoin originally solved the issue of trust by removing the need for an intermediary or Trusted Third Party (TPP) by implementing a Proof-of-Work mechanism that all mining participants had to perform to extend the blockchain, thus spreading power out from a single trusted ledger to a distributed network of competitive peers which require minimal information and configuration to cooperate with one another. As bitcoin has succeeded in its original goal of making a decentralized currency, the focus of the ecosystem has since turned it’s focus on to ways of decentralizing exchange and commerce itself.
Due to exchanges using centralized order books and with ever-increasing amounts of regulatory compliance, attention focused on how this could practically disintermediated and decentralized in a peer-to-peer fashion which would free users from the growing impositions of centralized exchanges. Put simply, a decentralized exchange seeks to eliminate or minimize the ability of any third party to control the activities of users, by either matching orders on a peer-to-peer basis and executing the trade securely using the blockchain as the underlying facilitator, or by deploying a liquidity pool which participants can profit from cultivating so that users can swap crypto assets with ease.
Today there are many well known and popular centralized exchanges today, many of which who benefit from deep pools of liquidity and have built up a reputation and feature set which has been desirable to their customers, such as Binance, Kraken, Bitfinex, Coinbase and others. Users are required to create an account with these companies and often verify their identities so they can send and receive funds used in trading crypto assets. Part of what has enabled the continued success of these centralised exchanges however is less to do with mundane buying and selling, instead more to do with their other services which include lending services where people can find a return on their crypto assets by lending them out to traders. Margin trading is also another significant area of interest for customers using centralised exchanges who wish to increase their returns when betting the market will move up or down. Another such advantage of these exchanges is that they also often support a wide array of assets and trading pairs which facilitate ease of use when trading into and out of cryptocurrencies, as well as creating arbitrage opportunities when there are inefficiencies in market prices.
So why the interested in decentralized exchanges
Decentralized exchanges and DeFi more broadly shine best when examined from the perspective of privacy and protection of personal data. After scores of examples of compromised exchanges, leaked documents and exit scams, user reluctance to surrender their privacy to vulnerable and popular targets has led many to move away from centralized towards decentralized exchanges and protocols, even though they may not be as fully featured or carry as deep liquidity as some of their centralized peers. With no intermediaries, DEXs operate in a non-custodial fashion meaning that custody of cryptocurrencies remains in the hands of individual users with all the associated wallets and private keys. This has the benefit of increased user control over funds but can come at the cost of being more cumbersome and difficult to manage for inexperienced users compared to centralized exchanges which have recovery methods if exchange logins are lost or forgotten.
Another benefit of the lack of intermediaries is that DEXs have lower counterparty risk as trades do not settle until they are settled by a blockchain as a token swap. This is considered to be another advantage as users do not have to concern themselves with the integrity of exchanges and performance when trade volume is high and price movements become volatile.
Due to the lack of intermediation also DEXs do not follow Know-Your-Customer (KYC) or Anti-Money-Laundering regulations as trades occur peer to peer and only between crypto-assets or cryptoized assets such as USDT or USDC.
Stacked up against each other the most common areas of interest when comparing the two different architectures of centralized and decentralized exchanges are mainly privacy, security, liquidity, whether or not usage and token listing is permissionless, who has custody of the funds when trading and whether or not they are “censorship-resistant” or resistant to the crackdown by authoritarian countries with strong capital controls.
Not private – KYC required
Breaches are common
Less & Fragmented
Custody of funds
When it comes to privacy, decentralized exchanges are highly regarded as a very minimal amount of information is required to complete trades. Orders are matched or trades are catered to with liquidity pools and little to no user information is required. Compared to centralized exchanges this is very minimalist compared to burdensome KYC and AML requirements imposed by popular centralized exchanges which can jeopardize user privacy whenever exchange breaches and leaks occur. Security is similar bugbear for users and another category in which decentralized exchanges excel in since funds are never deposited in centrally controlled exchange wallets which can be compromised by security breaches or even at times from ownership of the exchange itself.
These benefits do come with a cost however, with DEXs often having far less liquidity than their centralized competitors and are often less fully featured. Due to the higher technical barrier to entry of decentralized exchanges, issues of fragmented liquidity and low volume can sometimes burden traders who may more at home with centralized exchanges which can easily fill large buy and sell orders.
However, when it comes to the political philosophy of the ecosystem, decentralized exchanges shine through again as being by and from the ecosystem by embracing the high value placed upon permissionless technology. Just as Satoshi asked no one permission to release Bitcoin, users can also embrace this with decentralized exchanges which in many cases allow users to freely list new tokens and trade their own crypto assets with no loss of custody up until the point of trade execution. Due to the decentralized architecture many decentralized protocols also enjoy the emergent benefit of being censorship resistant which allows users to freely move and trade their holdings even under strenuous circumstances often found in countries which may be hostile to this new industry.
Types of Decentralized Exchange
Two main types of decentralized exchanges today which can be considered as belonging to two separate generations. First generation or order book based decentralized exchanges such as Kyber Network and 0x Protocol emerged in prominence mainly around 2018, where more recent swap based decentralized exchanges emerged in prominence during the current bull market of 2020.
Orderbook based DEXs
Like their centralized counterparts, some of the most common and the pioneer decentralized exchanges started by building protocols to assemble an open record of all the current buy and sell orders. Examples originally include Kyber Network and the 0x Protocol but this category has seen renewing development with products such as Binance DEX. Order book information is often held on chain as data or is anchored to a blockchain so users can retrieve the data and execute trades where orders match. Once orders match then the trade executed, and ownership of the funds is transferred between participants on the applicable blockchain.
A more recent generation of decentralized exchanges has emerged which no longer requires orderbooks to facilitate trades and discovery prices. Such platforms usually implement various unique liquidity pool protocols to determine asset pricing by allowing users to loan their funds for yield.
Uniswap is one of the most popular swap-style decentralized exchanges which allows users to swap any two ERC-20 tokens built on top of Ethereum using the underlying Uniswap liquidity pool. Uniswap as such acted as a public utility for people to match their orders and determine the price of assets. SushiSwap further innovated on top of this by a building a similar product based on UniSwap but with a native token known as SUSHI which behaved as a share in the overall activity of the swap protocol, allowing investors to generate a profit by providing liquidity to the pool. In addition to this SUSHI is also a governance token which gives holders voting rights on the future direction of the exchange protocol when new proposals are made, similar to how vote baring shares work in private companies. Like shares in a private company, if the SushiSwap exchange continues to grow in popularity, value and utility then the price of the token is something which can be expected to grow with it. Following these developments in SushiSwap, a new UNI token was created in September 2020 to maintain the competitive of the exchange and was airdropped to existing users to maintain the economic competitiveness and liquidity of the exchanges.
Due to the fragmented ecosystem of decentralized exchanges and protocols liquidity in this emerging class of exchanges become disjointed and subject to arbitraging. This problem has been attempted to be solved through the creation of DEX aggregators which help deepen liquidity between decentralized exchanges and also to make it more inviting for centralized liquidity safe when getting involved.
Two popular aggregators exist today including:
1inch Exchange which scans decentralized exchanges to the lowest possible price for would be traders and bolsters liquidity through the use of the 1INCH crypto token which similar to UNI and SUSHI, incentivises the community to provide liquidity to its automated market maker protocol.
DeversiFi is another protocol that aggregates liquidity between decentralized and centralized exchanges through the implementation of layer 2 settlement and also implements zero-knowledge batch transaction settlement protocol which enables high throughput of trades for participants.
Decentralized exchanges are a hot and competitive area of development in the broader cryptocurrency ecosystem and are beginning to mature as fully-fledged competitors to centralized exchanges. Due to the high-value users’ place on privacy, security, liquidity, whether or not usage and token listing is permissionless, fund custody and censorship resistance it is likely we will continue to see this area accelerate for some time as the increased burdens of regulatory compliance on centralized exchanges and the rapid pace of decentralized exchange development.