People trust the US Dollar believing it is backed by the United States government; but
, the dollar bill states, “In God we trust”. The community places their faith in the governing entity and advertently the entity takes the safe road. Built on this simple logic of “trust and community” and solving the needs of common people, technological advancement has led to a new market for peers to exchange cryptocurrencies on a Decentralized Exchange popularly termed as (DEX). This DEX allows users to come together on the internet and place their faith in one another. (Working mechanism of decentralized network, a.k.a blockchain, shown in Fig.1)
Hassle free DEX offers quick transaction execution and greater security guardrails. Not only does DEX save one’s precious time on performing Know Your Customer (KYC) checks, it doesn’t require third party authorizations either.
DEX provides a more enhanced trading experience without requiring entities to comply with anti-money laundering laws. These are some of the many perks of this phenomenal Exchange. The use of external crypto wallets like MetaMask, Coinbase and Fortmatic makes the trade of cryptocurrencies easier, secure, faster and more efficient.
The purpose of DEX is to give power to the people rather than to one central organization for handling funds. Traditional methods to exchange stocks, commodities and Real Estate Investment Trusts (REIT) posed significant problems with pricing of the assets, maintaining liquidity in the market, storing information of the owners, guarding data from cyber criminals, and what not.
DEX solves the problem of pricing and liquidity using Oracles and Automated Market Makers (AMM), making the platform Peer to Maker (P2M) rather than Peer to Peer (P2P).
 Oracle is a separate extension on blockchain helping smart contracts by serving as a mechanism to price tokens (using weighted average price for every transaction). It collates data from the outside world with a goal to reflect the true market value of crypto coins.
Since data on Blockchain is stored on nodes, it requires verification from every computer for any new information that is being added. This process makes the system trustless and resilient to any attack from the hackers. DEX provides a platform whereby members of the same network do not need to rely on each other or any external party for trading. Instead, the system performs independently based on the underlying architecture of blockchain consensus algorithms. A smart contract follows a pre-determined function, basically a computer coded algorithm which has the power to self-execute, self-constrain and self-verify transactions on blockchain.
One of the smart contracts on Ethereum blockchain is ERC 1155 which accords multiple tokens in one single contract, a major advancement from ERC 20 token which required distinct smart contracts for each crypto coin. This shift by the developers of DEX has mitigated the excessive load on blockchain and attracted more customers by enabling the Exchange to charge less gas fees. Apart from P2P transfer, DEX also provides customers the facility to stake any of their fungible tokens to support liquidity in the market and earn interest on their assets, often known as Decentralized Finance (DeFi). Currently, only cryptocurrencies are on blockchain and the perfection of DEX model reflects how it can provide solution to other assets as well.
“Gradually, decentralized trust will be accepted as a new and effective trust model. We have seen this evolution of understanding before – on the Internet” by Andreas Antonopoulos, British Entrepreneur and Bitcoin investor
There are two main types of DEX:
- On-Chain DEX
As the name suggests, on-chain DEX does not transfer your order or data to the external server; rather it stores the data on blockchain itself and executes the deal using smart contracts (working model represented in Fig.2). Network nodes are assigned to maintain the records of all orders. It also requires the operation of miners to validate each and every transaction, which can be expensive for the users due to high gas fees.
Systematic upgrades have been made to the on-chain DEX to increase both efficiency and latency. Earlier model of DEX had a constant single liquidity pool acting as an AMM, coined by Bancor and further adopted by Uniswap , forcing clients to first exchange currencies using Ethereum and then with other alternative coins. The liquidity pool was popularized by the equation “Token A x Token B = K” with K serving as a constant.
This concept was further enhanced by Uniswap V2 and V3 models by bringing oracles for better pricing, establishing multiple pools for direct swapping of currencies (leading to less gas fees, quick transfer process) and creation of concentrated liquidity groups. This enhanced model allowed users to pledge their assets in a custom-created range as per their needs and thus, enabled them to earn interest accordingly.
Moreover, the new version of Uniswap Exchange elevated different commission tiers with respect to the risk taken by each customer: 0.05%, 0.30%, 1%. Some of the well-known platforms that use on-chain order books include Bitshares, Stellar Term, Uniswap, Sushiswap, and Pancakeswap.
Different strategies with respect to service fees and platform design are assimilated by these companies, but
, the methodology to function is more or less the same.
2. Off chain – On chain DEX
This type of Exchange is popularly known as quasi DEX as the orders posted by the taker and maker are handled on a separate server and then recorded on blockchain (Fig.3). This leads to reduced service fees, instant processing, anonymity of the players, security by the third party, therefore making this model much more environment friendly due to lower power consumption.
The reason behind its efficiency is that unsettled or canceled deals are not posted on blockchain. The taker and maker can submit their orders to the relayers which are built by the company to help connect different parties. Each party/dApp can make its own relayer on the platform to provide liquidity in the market.
Additionally, it can create, find and fill orders on the Exchange. The relayer matches the order from different DEX’s and transmits data to smart contracts for its execution (as shown in Fig.4). Not downplaying the theory of DEX, but the platform does not have ownership of the respected parties’ funds.
The exchange occurs between crypto wallets through blockchain. The off chain-on chain model can be more prone to viruses as compared to the on-chain model, due to hacking of relayers. However, the benefit of low service fee is a boon to the customers. Some of the notable companies using this process are Waves, IDEX, Ox and Loopring.
Key differences between the two DEX models involve transaction fees, information processing and added security parameters. The on-chain model has higher gas fees, but takes less time to process information and provides maximum security from DDO’s attack. Both the models of DEX are constantly improvising to achieve market shares and have called for a combat against Centralized Exchange (CEX).
“Whereas most technologies tend to automate workers on the periphery doing menial tasks, blockchains automate away the center. Instead of putting the taxi driver out of a job, blockchain puts Uber out of a job and lets the taxi drivers work with the customer directly.” Vitalik Buterin, Co-Founder of Ethereum conceptualizing the role of blockchain in future
While on the subject of CEX, what do you think of considering CEX to trade cryptocurrencies?
Well, ever heard of “Not Your Keys, not your coins”? Since CEX has a single point of failure, it’s more vulnerable to getting hacked and flooded with malwares. Moreover, CEX uses private keys to access all the funds of users. Thus, one could really lose all their deposits/savings at once. Furthermore, CEX does not store customers’ data on blockchain.
The CEX’s verification process is highly tedious and time-consuming, requiring a pile of documents from the users, raising red flags around security breaches and privacy threats. This may ultimately lead to compromising Personally Identifiable Information (PII). As a reminder, the economy has experienced price manipulation of assets in the recent past by many Wall Street firms, due to their massive involvement with centralized entities.  Recent instances as that of GameStop stock price fluctuation, halt of trading on Robinhood for certain shares and Robinhood’s relationship with Citadel, have challenged the open market operations guaranteed by regulatory authorities and centralized parties.
On the other hand, DEX architecture professes that if the company closes its operations, customer funds are secured. The reason for this level of security promised by DEX is because it is backed on the blockchain and other cold storages provided by the crypto wallets.
These are some of the benefits of crypto which are now known across the globe. Although CEX provides barter of fiat currencies on its platform, the revolution brought by cryptocurrencies in the near future will indeed replace the “Benjamin” (US Dollar) with funky crypto coins. Gone are the days when people used to question Bitcoin and Blockchain.
The trillion-dollar cryptocurrency market has evolved within a short span of a decade, proving that the general public is much more involved in blockchain space than what was initially expected. Gaining popularity and increased activity of blockchain have already tilted the focal point from CEX to DEX, encouraging a propitious future for crypto trading.
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