What are Decentralized Exchanges and How Reliable are they?

We have already mentioned how the blockchain technology is the first step towards a decentralized world, and we also know cryptocurrencies are one of the most significant applications of the blockchain. But, how do we trade these digital currencies? Is this system decentralized as well?

Decentralized Exchanges

Decentralized exchanges do not rely on services of third parties for holding the customer’s funds. Instead, it facilitates trades to directly occur between peers through an automated process. This can be achieved through methods like:

  • Proxy Tokens (Crypto assets representing a certain fiat or cryptocurrency)
  • Proxy Assets (e.g., representing shares of a company)
  • The decentralized multi-signature escrow system

The system is in contrast to the centralized system in which users deposit their funds while exchanges issue IOUs which can be traded on the platform. If a user has to withdraw funds, they are converted back into the cryptocurrency and sent to the owner.

Benefits of the Decentralized Exchange System

Being a decentralized system, there are numerous advantages, some of which are:

  • Users are not required to trust the honesty or security of the exchange since the funds are held in the personal wallet of the user and not any third party.
  • High level of privacy is maintained as users do not have to disclose their personal details to anyone except in case of bank transfers. In this case, identity is revealed only to the person with whom trade is executed.
  • Hosting is distributed through nodes thereby eliminating any risk of server downtime.
  • Increased fungibility which can be described as the traceability of cryptocurrencies.

Drawbacks of the Decentralized Exchange System

Since the system is still relatively new, there are a few limitations which can be resolved after proper experimentation and analysis. Some of these drawbacks are:

  • Certain exchanges require users to remain online for an order to be listed and execute the trade. This requires performing actions like giving signals on receipt of payment.
  • Trading features like Margin Trading, Lending and Stop loss are currently unavailable in this method as they permit only the basic exchange of currency for a predetermined value.

Major Exchanges in the world

Some of the popular exchanges are:

Bitsquare: An open-source exchange allowing users to exchange cryptocurrencies and national currencies without any third party or middlemen. It relies on a decentralized multi-signature escrow system which will ensure all trades are executed honestly.

Bitshares & Openledger: This platform has its own native currency called Bitshares (BTS). Users can trade either Bitshares or other market-pegged assets and user-issued assets.
Market-pegged assets are crypto assets pegged to another currency/commodity which always has 100% or more of its value backed by the Bitshare core currency. A User-issued asset can be issued by anyone to represent shares, currencies, commodities, etc.

NXT: A crypto-platform permitting users to issue and trade assets. However, these can only be exchanged for the NXT coin and not any other cryptocurrency. Asset-to-asset exchange is not possible.

Counterparty DEX: It’s a meta-coin smart contract layer which embeds data into regular Bitcoin transactions. It permits anyone to issue assets or tokens within the Bitcoin blockchain.
While trading for other assets, the counterparty protocol acts as a decentralized escrow service which holds the funds till the orders are matched. When trading an asset for bitcoin, the asset is initially held in an escrow while another user has to manually make a bitcoin payment with the use of a counterparty wallet.

Read More: Cryptocurrency Theft Insurance

Are Decentralized Exchanges the Next Big Thing?

Traditional exchanges have been plagued by multiple scandals such as:

  • Theft
  • Lower Transparency
  • Insider Trading
  • Poor Operation
  • Market Manipulation
  • Trading friction caused due to intermediaries

Thus, considering the overall picture, blockchain enthusiasts believe decentralized exchanges can significantly contribute to the security of the overall ecosystem. Multiple decentralized projects are under significant developments but are still subjected to constraints of the underlying blockchain system and other cross-chain obstacles. Presently, these solutions can only provide asset transfer services within a single blockchain system.

Decentralized exchanges eliminate third parties, by relying on decentralized smart contracts for tracking all transactions. This makes them much faster since centralized verification may take several days or weeks for completion. Additionally, users maintain control of their own finances. There’s no deposit into the exchange and no centralized servers, making them theoretically immune to various types of cyber attacks and regulatory problems plaguing centralized exchanges.

Though decentralization seems to be a better option, it leaves users financially exposed if any market crash occurs. For example, the market crash in March 2018 when the market lost nearly $500 billion in value. These are instances which makes governments hesitant towards the acceptance of cryptocurrencies.

Conclusion

Decentralized exchanges are now supplemented with centralized exchanges. However, future decentralized exchanges require efficient cross-chain solutions for eliminating various barriers and support asset exchanges across various blockchain systems.

More articles by the author:

  1. Solving Hyperinflation by way of cryptocurrency
  2. Are Cold Wallets really safe?
  3. What is a P2P Network?

Have you used a decentralized exchange yet? Share your experience with us in the comments section below.

Financial Analyst for JP Morgan Chase | Content Writer for eduCBA | Mentor

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