Decentralized exchanges execute trades and manage liquidity with the help of smart contracts. Uni swap, sushi swap, pancake swap, and radium what all four these highly popular exchanges have in common is one thing decentralization.
Long gone is the era of creating an account filling out tedious KYC documentation and putting yourself at the risk of a centralized trading platform security. Following the true spirit of blockchain technology, cryptocurrency investors are currently free to exchange and hold assets without interacting with any intermediaries at all.
There are many benefits to using decentralized exchanges and the latest trends show the community isn’t oblivious to the power of decentralization. According to Defipulse, the top 5 dexes hold a total of 25 billion dollars in collateralized value. The coin market cap reveals that the top decentralized trading platforms exchange on average two billion dollars in volume each day. There’s still a long way to go until a platform like a uni swap can compete with exchange giants such as Binance and Ftx which have a combined trading volume of 60 billion dollars.
Nevertheless, the trend is there and it’s obvious to everyone that decentralized exchanges are the future of crypto trading. If you’re looking to boost your crypto know that you’re at the right place here at our site a leader in automated portfolio management and blockchain education.
Through this article, you will learn What decentralized exchanges are and how they work? More importantly, you’ll also discover what makes these exchanges such a great alternative and what potential drawbacks investors face while using them.
What is a decentralized exchange?
A decentralized exchange is an online trading platform that executes trades and manages liquidity with the help of smart contracts. By relying exclusively on smart contracts these exchanges succeed in eliminating all third-party intermediaries and maintaining a peer-to-peer trading environment.
If we take a centralized exchange for example only a part of its core components is decentralized like deposits and withdrawals. However, every other factor is processed primarily off-chain and there’s no blockchain that automates or records tasks. We have the complete opposite situation on decentralized exchanges. On a blockchain-powered platform like uni swap, all tasks are processed by smart contracts. When providing liquidity you temporarily store assets onto a smart contract.
When swapping ether for tether yet again you interact only with a smart contract. The same goes for lending governance deposits withdrawals and payments. Most of the decentralized exchanges that are popular today work on the basis of an automated market maker or AMM for short. An AMMis a bundle of smart contracts that enable automated and decentralized trading using algorithms and mathematical formulas to store and price assets in liquidity pools.
To put it in simpler terms an AMM is merely a replacement for a centralized exchange’s order book. The main idea behind automated market makers is that they form a cohesive trading ecosystem by incentivizing practically all types of users to utilize the platform. Those holding crypto assets are motivated to lend their capital to liquidity pools for the sake of earning interest on their existing speculative investment. Traders benefit from swapping assets by paying lower fees, avoiding intermediaries, and staying anonymous by having to file no personal KYC documents.
Last but not least the prices of assets exchanged between these two parties are held at equilibrium not only with the help of ingenious algorithms but also by arbitragers willing to capitalize on temporary price differences. Therefore holding the same power and function as price oracles.
How do decentralized exchanges acquire liquidity?
Rather than depending on market makers and whales to move prices and provide liquidity dexes rely on the market itself. As previously mentioned decentralized exchanges offer monetary rewards in return for liquidity. When liquidity providers lend their assets the exchange offers them to a trader in exchange for their own crypto and charges a trading fee. A portion of this trading fee is then paid back to the group of liquidity providers that originally lent the cryptocurrency used in this transaction. Objectively speaking this is much more efficient from the standpoint of an exchange.
Why hire a market maker when the market itself does the job for you? Since all three parties including exchange operators liquidity providers and traders provide value while taking another valuable service or object in return everyone is incentivized to work together. Now that you understand how they work it’s time to talk about the advantages and disadvantages of trading on decentralized exchanges.
Advantages of Decentralized exchanges
The advantages are unmistakably obvious first things first decentralized exchanges bring back the old anonymous crypto trading experience. There’s no need to prove your identity to anyone since smart contracts don’t care who’s trading as long as all the rules are followed. A platform like a uni swap will never request your id or selfie since knowing your customer and anti-money laundering compliance isn’t a thing on dexes. Having no counterparty risk is another great benefit since users are not forced to move their capital to exchanges. There’s no way to lose them to a hacker. Remember the infamous mount gox hack you won’t find yourself in a court case lingering for nearly a decade to get your money back, plus you retain full control over all your cryptocurrency how cool is that?
Another important factor at play is the number of supported tokens. There are so many cryptocurrencies on decentralized exchanges that you can’t even keep track of them all. While coin base and Binance have to fill a checklist of potential compliance issues before onboarding a new cryptocurrency sushi swap and pancake swap will let you trade and invest the second a token is released. And thanks to dex token listings having no effect on price. You won’t have to deal with being front-run by other investors. So are decentralized exchanges the land of milk and honey certainly not there are more than a few drawbacks and for some users, they can be deal breakers.
Disadvantages of Decentralized exchanges
First off decentralized exchanges are not connected to any traffic institutions. You need to already own crypto in order to trade cryptocurrencies since there’s no way of purchasing digital assets with fiat currency like with a debit card for example. You might also find it difficult to find your way around on a dex. Had to go as far as to follow dozens of guides before even getting started with trading. Secondly, trading volume is significantly smaller on decentralized exchanges. With smaller amounts of liquidity comes higher slippage and with that comes an illiquid market. Market makers didn’t earn their name without a reason. They’re the ones who put in asks and bids and create liquidity zones when investors need them most.
But then again illiquidity is only a problem if you’re trading a new token. There’s an abundance of trading volume when it comes to trading large cap assets like Ethereum, Solana, uni, and chain link. Trading fees are another topic worth talking about these are not always higher on decentralized exchanges, especially on those using off-chain order books. The truth is that they tend to reach extreme levels once network congestion strikes. For example, if Ethereum receives more transaction requests than it can normally process it will raise gas prices so that only high-value actions get processed by the network.
Disadvantages are not that bad in fact there are temporary disadvantages as the market evolves and blockchain developers work on newer solutions issues like fees, user experience, and low trading volume will eventually disappear. Unlike centralized exchanges, decentralized ones clearly have no fundamental drawbacks that are part of their design. For anyone who’s still on the fence remembers one thing, the trend is your friend. There’s a reason why the entire g5 market reached a 100 billion dollar valuation the previous year and even now it’s higher than that it’s because decentralized finance is here to stay.
What do you think is the likelihood of decentralized exchanges completely replacing centralized trading platforms in the next few years? Leave your thoughts in the comment section below.