Newcomers to the cryptocurrency world often ask, "What is a decentralized cryptocurrency exchange?" To answer that question, it's best to look at exactly how decentralized exchanges (also known as DEXs) work, what their advantages are and where they fall short.
When an exchange does not hold the users’ funds, then it is called "decentralized." In these cases, all the trading takes place between the system's users automatically. These user-to-user transactions are typically called "peer-to-peer," or P2P for short.
DEX's often use assets like "virtual shares" or components called "proxy tokens" to transact trades. Tokens are considered to be a form of cryptocurrency assets that stand-in for the actual cryptocurrency during a trade. Besides proxy tokens and virtual shares, some DEX's use an escrow system.
IDEX is a popular DEX with many trading pairs to choose from
So what's the difference between a decentralized system (a DEX) and the standard centralized model? For one thing, centralized platforms require all users to send deposits to a wallet under the exchange’s control. After that, the user can trade the asset with others which are also stored in a wallet belonging to the exchange. A decentralized exchange does not have control of a wallet or deposit address, the funds are handled by a smart contract, and don’t ever move into a wallet controlled by a third-party.
Compared to centralized exchanges, decentralized ones don't have the burden of relying on trust. There's absolutely no need to put your faith into the exchange platform's "honesty". The key to this advantage is the fact that users actually hold the funds, cryptocurrencies in this case, in their own virtual wallets. A third party is not the holder of the funds.
For some users, the most significant advantage of DEX's is the privacy aspect. No user in a DEX needs to reveal any personal data to anyone. Also, DEX hosting is not susceptible to downtime (of a server) because there are multiple nodes that handle transactions. So, many users prefer decentralized cryptocurrency exchanges.
But, as is the case with every type of transaction model in existence, there are some disadvantages to using a DEX.
It makes sense that there must be at least some downside to decentralized systems because so many people prefer centralized exchanges.
One drawback of DEX's is the fact that users cannot engage in placing stop-losses, lending money, or trading on margin. The typical decentralized exchange is only set up to handle essential functions.
Another is that the amount of liquidity on DEXs is often drastically lower than on centralized exchanges. This will likely change in the future as DEXs gain more popularity.
When currency is exchanged on a DEX, users are constrained to working with a predetermined amount of currency for a specific transaction. There's no "wiggle room" to do fancy trades such as leverage or margin trading, or other activities that are quite routine on centralized exchanges.
Overall, it's best to view both centralized and decentralized exchanges as having their own sets of pros and cons.
Centralized exchanges excel because:
DEX vs Centralized Exchanges
Users who lack the technical knowledge and patience required to utilize a DEX should ensure they use a centralized exchange which is known to be trustworthy. Blokt has a list of the best cryptocurrency exchanges which is a good starting point for your research.
Super-high liquidity, the ability to use advanced trading tools, and the overall ease of use are the three primary advantages of centralized systems. But it's not all sunshine. Centralized platforms are not typically anonymous, which means there's no privacy for users.
In addition, the exchange has full control of the funds, which creates a risk for users as the exchange could be hacked. Finally, centralized systems can suffer from server downtime.
Decentralized cryptocurrency exchanges don't have to endure server downtime or worry about hacks. Users have full control of their own funds and all transactions are anonymous. For many users, these advantages far outweigh the fact that DEX's are not liquid, not very easy to use and offer only the most basic trading features and functions.