What is a decentralized exchange
Decentralized exchanges operate on the basis of a distributed registry. They do not have a single controlling center, a company that is responsible for the operation of the exchange. A decentralized exchange does not store traders’ money in their accounts. Traders have private keys to their wallets and only they can manage their accounts. The exchange administration or other third parties, including government bodies, do not have access to traders’ closed accounts.
A decentralized exchange is a platform that brings together a seller and a buyer. There is an exchange based on a smart contract. Therefore, a decentralized exchange can only work with those cryptocurrencies and tokens that are capable of supporting smart contracts. A decentralized exchange is usually managed by users, miners, and node owners. It all depends on what kind of consensus algorithm the exchange uses and the charter of the exchange.
Based on the charter of the exchange, a smart contract is created, which manages the exchange.
Often, decentralized exchanges use the PoS consensus algorithm. The main decisions are made by the owners of large amounts in the wallet. They process transactions, maintain the exchange network and receive payment in the form of commissions. There are cases in the management of the exchange all token holders participate, but usually those with more tokens have more rights. It all depends on the charter.
In most decentralized exchanges, the internal token of the exchange is attached to a pair of cryptocurrencies that users want to exchange and acts as an intermediary token. However, there are exchanges where the exchange of cryptocurrencies is carried out directly without the participation of an intermediary token. Usually these are semi-decentralized exchanges in which the exchange process itself is carried out in a centralized mode, which provides an instant exchange of funds.
In truly decentralized exchanges, it takes time to exchange funds until the miner processes the block. But much still depends on the algorithm that the exchange uses. Many exchanges use the PoS consensus algorithm, which provides a faster exchange of funds.
Another possible centralized element in the work of decentralized exchanges is the servers on which all information about transactions and clients of exchanges is stored. Often, information is not stored in distributed miner registries, but on centralized servers.
Therefore, most decentralized exchanges are actually semi-decentralized. There is nothing wrong. On the contrary, this can be called a kind of compromise, since decentralized exchanges, along with the numerous advantages, also have many shortcomings.
The creators of decentralized exchanges to get rid of the shortcomings of decentralized exchanges are forced to abandon decentralization in a number of ways in order to make the exchange work faster and more convenient for users. But sometimes this convenience affects security. So, for example, storing information on exchange servers is convenient, but dangerous for the exchanges themselves, since hackers can hack exchange servers. But if the information is stored in a distributed registry, transaction processing will take longer.
Each decentralized exchange solves similar problems in its own way, therefore, traders have a choice which exchange to choose, depending on what is more important for them, safety or convenience.
There are even decentralized exchanges that specifically go for centralization, creating a law firm, gaining jurisdiction, passing KYC procedures for users to protect the rights of traders in case of disputes. The fact is that decentralized exchanges are anonymous, and anonymity has a negative side. No one is responsible for anything.
How decentralized exchanges differ from centralized
Let’s consider the main differences between decentralized exchanges and centralized ones:
- There is no single company controlling the work of a decentralized exchange. The main decisions on the operation of the exchange and transaction processing are made by miners. Often, the owners of decentralized exchange tokens participate in the management process.
- Anonymity. No KYC procedures, registrations.
- The state cannot close such exchanges or suspend dubious operations on them.
- Traders do not have to pay taxes.
- Miners servicing decentralized exchanges do not pay taxes.
- State authorities cannot make any claims to a decentralized exchange, since there is no single body to which claims can be made.
- In most states, the status of exchanges is not regulated. The authorities of the countries simply do not understand what to do with decentralized exchanges.
- Traders cannot make claims to the exchange, since there is no one to make claims against.
- Miners serving exchanges and confirming transactions are also unable to make claims against the exchange.
- Traders’ money is stored in their private key wallets. Only traders are responsible for the safety of funds. But hacking decentralized exchanges is almost impossible. Nothing to hack.
- Decentralized exchanges do not work with fiat.
- Decentralized exchanges do not support cryptocurrencies and tokens that are not compatible with a smart contract. Including they do not work with Bitcoin, since there are no smart contracts on Bitcoin.
- Decentralized exchanges do not provide customer support.
- All information about transactions is stored in a decentralized manner, usually on the servers of miners, it is almost impossible to crack.
- All network maintenance is carried out by miners. The charter of the exchange provides for the procedure for making fundamental decisions in the life of the exchange, as well as the procedure for the functioning of various funds, for example, for development.
- All the work of a decentralized exchange is regulated not by a person or company, but by a smart contract, which is drawn up on the basis of the charter of the exchange.
These are the main differences between decentralized exchanges and centralized ones. There are not so many decentralized exchanges in their pure form. Most exchanges have elements of centralization or are semi-decentralized.
Which decentralized exchanges already work
In 2018, many states tightened their policies and regulations regarding centralized cryptocurrency exchanges. Some states obliged exchanges to obtain licenses and permits, traders were obliged to undergo KYC procedures and report their income to tax authorities. They also obliged exchanges to report the income of traders to the tax authorities. States have the right to block the accounts of exchanges or traders in case of suspicious transactions.
This behavior of state bodies has led to the emergence of a fashion for decentralized exchanges, to which the hand of the state does not reach.
The second reason for the growth in popularity of decentralized exchanges is the increase in activity by hackers. In 2018, hacking of exchanges continued, they became even more compared to 2017. Hackers have become more sophisticated.
All the measures of states to strengthen control over centralized exchanges, which the authorities explained by putting in order and protecting the rights of traders, did not lead to the desired result. Despite the strengthening of state control, exchanges continued to crack, traders continued to lose money. The states could not protect them.
Therefore, it is not surprising that the idea of creating decentralized exchanges in 2018 continued to develop actively. People wanted to protect themselves, both from the actions of hackers and from the actions of government bodies and centralized exchanges themselves, which often, under the pretext of state control, blocked the accounts of large traders.
In decentralized exchanges, no one can block the user account: neither the exchange itself nor the state. Yes, and hackers to steal money is much more difficult on multiple accounts of traders than on a single account of the exchange.
The main pros and cons of decentralized exchanges
Thus, at the moment, despite the many advantages of decentralized exchanges, they are not able to compete with centralized ones. Till….
It will be seen further.
Consider the main pros and cons of decentralized exchanges.
Lack of centralization.
Exchanges cannot be hacked, since all money is stored on users’ wallets.
The state cannot close exchanges, as there is no single company responsible for the exchange. There is a development, a smart contract. The developer company itself is only responsible for technical support. Miners process transactions and support the exchange network; token holders make the main decisions on the exchange. The decentralized exchange operates on the basis of a smart contract, which is drawn up in accordance with the charter of the exchange, where the basic parameters of the exchange and the principles of its operation are determined.
Unable to freeze user accounts. Neither the state nor the exchange itself can do this, since the exchange does not have access to the funds of traders.
No need to pass verification.
No need to pay taxes, and the exchange itself will not inform the tax authorities about the income of traders. And centralized exchanges do this and block accounts at the request of tax authorities and other government agencies.
A decentralized exchange cannot work with fiat, as well as with a cryptocurrency that does not support tokens, for example, with Bitcoin.
No trading tools.
In case of problems no one can help.
Miners process transactions, so it takes time to process transactions.
To make an exchange, an intermediary token is required, because of this, the exchange takes even more time.
If technical problems are solved by using centralized elements in decentralized exchanges, which simplify and speed up the exchange, then the problem of lack of liquidity on decentralized exchanges has not been resolved.
The fact is that there are simply no traders on decentralized exchanges, since they are inconvenient in work. If you want to sell a little-known asset, then the buyer can wait a very long time and not wait. Therefore, in terms of trading volumes, all decentralized exchanges are not even in the first hundred.
Currently, the problems of decentralized exchanges are being addressed by introducing centralization elements into the platform. Thus, the exchange is semi-decentralized. How successful is this combination of decentralization with centralization says the Waves Dex exchange example. This is the most popular platform among decentralized exchanges. It retained the essence of decentralization, while there are a large number of centralized elements that only improve the work of the exchange.
Regulation of decentralized exchanges
A decentralized exchange is a program, a smart contract, the maintenance of the blockchain of which is carried out by miners. The developer of a decentralized exchange is only responsible for creating a smart contract. After that, all rights under the smart contract are transferred in accordance with the charter.
Usually, the main activities of the exchange are determined by the holders of the exchange tokens. The exchange may have a development fund or any other fund, but the token holders are determined by the token holders according to the terms of the smart contract.
Thus, legally it turns out that a decentralized exchange belongs to token holders.
A decentralized exchange has no registration, no jurisdiction, no authority. Miners carry out ongoing maintenance of the system, investors (token holders) – making vital decisions.
This is the nature of a decentralized exchange. And states do not understand what to do with this nature. A decentralized exchange cannot be closed, since there is no one to close. Miners and investors of the exchange are located around the world.
There are no KYC procedures on decentralized exchanges, no registrations. It is impossible to freeze the accounts of traders, just as it is impossible to suspend trading operations.
State traders cannot control the income and traders do not pay taxes.
Suddenly, states like this state of affairs.
The only way out for states is to control the movement of fiat. If a decentralized exchange wants to exchange cryptocurrencies for fiat, it must fall under state regulation. Then there are mandatory KYC procedures and government regulation.
If decentralized exchanges do not work with fiat, they are out of state control …. Till…. But the authorities of all countries of the world actively think what can be done with this and how to regulate decentralized exchanges.
Prospects for Decentralized Exchanges
Unfortunately, decentralized exchanges still have too many shortcomings that hinder their widespread distribution and development.
At the moment, the solution is to combine centralized elements in decentralized exchanges. The main plus of all centralized exchanges is ease of use. All elements of trading are concentrated on one platform, there are convenient trading tools, charts. Centralized exchanges are able to carry out large volumes of trades and allow traders to earn money on trade.
It is impossible to trade large volumes of assets on decentralized exchanges, as they simply do not exist. No liquidity. It is also impossible to trade little-known tokens, since the seller will not find a buyer. On decentralized exchanges, it is currently not possible to engage in professional trading at all.
Mostly, decentralized exchanges are used by traders to buy or sell some asset for their own needs in small volumes and at the same time remain invisible.
Now the main problem of decentralized exchanges is the lack of liquidity. Different platforms solve this problem in different ways. Often, by using centralized elements only for the trading process itself, to make trading faster and more convenient for the user. Some exchanges even offer automated trading, that is, without the participation of miners.
Another option is to use the PoS algorithm for mining and a limited number of nodes. Due to the small number of nodes, mining is carried out quickly, since it does not take a lot of time to confirm the payment.
Decentralized exchanges are becoming more convenient to attract more users.
The idea of decentralized exchanges is very much in demand. The world’s best startups are now looking for solutions to create decentralized exchanges that are more convenient and suitable for trading. Many centralized exchanges are creating platforms for decentralized trading. For example, Binance. This exchange takes 1st place in terms of trade as a centralized platform. Now the exchange team is creating a decentralized platform. This exchange already has a large base of traders who are interested in the possibility of trading on a decentralized exchange.
We see how blockchain technologies are developing rapidly. Decentralized exchanges have promising prospects and too many people are interested in their ideas being realized and the most elegant, convenient, simple and practical solution for all traders was found.