What is DEX? How Decentralized Crypto Exchanges Work

Many believe that centralized exchange platforms such as Binance have distorted the basic nature of cryptocurrencies, which consists in rejecting intermediaries when making transactions without compromising the security of users with their anonymity. DEX (decentralized exchange platforms) are moving towards this ideal.

For example, here are some notable decentralized platforms:

• Bitsquare
• Uniswap
• PancakeSwap
• 1inch

In a nutshell, the development of a decentralized financial sector and money markets is happening very quickly. In this regard, decentralized exchanges play a key role, since they facilitate public P2P trading without any restrictions, such as identity verification.

Decentralized Exchange (DEX) is an English term, and it is about providing a decentralized service, not about developing a centralized crypto exchange service (CEX).

The main difference between DEX and CEX is that on a decentralized exchange, cryptocurrencies are managed directly by users through their own or specially designed crypto wallets. A decentralized exchange plays only a supporting role, creating a peer-to-peer trading platform and network where each participant is part of the trading exchange itself.

Ideally, there is no longer a third party with a central server. This means that a well-built decentralized exchange can no longer be stopped and has virtually no jurisdiction. Now cryptocurrencies can be freely and seamlessly exchanged between the two parties, like cash, without the need to involve a third party.

Protocols are being developed so that this happens painlessly and almost automatically. These include the inter-chain atomic exchange protocol, special protocols for developing a decentralized exchange and trading platform (LoopRing), as well as other protocols for implementing inter-blockchain communication.

The Bitcoin Lightning Network is also well suited for this, and two different DEX variants powered by Lightning are already being developed – Sparkswap and Boltz exchanges.

Problems of Creating Decentralized Exchanges

Obviously, this development will not happen by itself, and it is in full swing. Especially when it comes to implementing a decentralized trading platform, several problems will have to be solved.

A good decentralized crypto exchange should be able to integrate three key components into a user-friendly solution: order matching using algorithms, liquidity, and transaction processing using a protocol such as atomic swap. This will allow users to directly create requests for the conversion of cryptocurrencies (swap contracts) with each other, find a suitable option, and perform the transaction.

The introduction of atomic swap protocol technology is not enough to create a decentralized cryptocurrency exchange. Liquidity or fast financing for order processing is essential.

Why? If there is no counterparty for the desired order, the transaction will not take place. Trading will not start, there will be no liquidity on the exchange, which will lead to low prices. The exchange will stagnate and have an anti-network effect, forcing users to leave the exchange for a faster-centralized exchange with better prices.

If the new decentralized crypto exchange succeeds and creates a network effect with an increase in the number of users, improving spreads and prices, third parties will have to be involved to provide the necessary liquidity. This party is known as a liquidity provider (LP) and is a trading party that works as a market maker, providing the necessary cash flows, making prices much more profitable for users, while the market maker takes the spread between supply and demand as profit. Thus, a positive network effect is created inside the exchange, and more and more users will use it. Conventional cryptocurrency exchanges can act as market makers within a decentralized crypto exchange.

It is hoped that more and more major players, such as Kraken, will start creating their own decentralized branches or play the role of an exchange trader on a good decentralized exchange. In addition, protocols are being developed to increase the liquidity of decentralized exchanges. Specific examples are Loopring and Arwen.

Binance and Bitfinex are two crypto exchanges that plan to create a decentralized cryptocurrency exchange. Bitfinex will do this as an EOS block producer by investing in EOSfinex. It will be a new generation crypto exchange based on the EOSIO platform.

What makes DEX Attractive to use

There are a number of important disadvantages of using a cryptocurrency exchange or a crypto exchange:

1. When your crypto assets are on an exchange, you depend on technology, security, and third-party transactions. When you don’t have private keys, you don’t have access to your assets.
2. Creating a good service provider involves significant costs that must be reimbursed at the expense of users.
3. A poorly designed centralized cryptocurrency exchange can be hacked, looted by its owners, or shut down by the government.

Due to the complexity of operations and the risks associated with them, there are few good cryptocurrency exchanges. There is a certain centralization since large investors and traders want to work only on the best and largest exchanges, such as Binance.

Conclusion

Although it is much safer to trade on a decentralized exchange, the development of a scalable and fast decentralized crypto exchange with sufficient liquidity is a rather complex technological task. Fortunately, quite interesting projects have been started and progress has been made. Lightning DEX projects (such as Boltz) are very interesting to follow right now. These decentralized crypto exchanges use atomic swap and Lightning Network technology.

For the average user, the easiest way is to use a centralized cryptocurrency exchange. But simpler doesn’t always mean better. It is DEX that is the best solution, but you need to test, search and compare a lot to understand which decentralized cryptocurrency exchange suits you the most, and is the most reliable.