Decentralized Ethereum Exchange – Its Entry & Relevance
Decentralized exchanges have been slowly gaining prominence in the crypto world. It is an effective alternative to the usual centralized cryptocurrency exchanges that might contradict the basic philosophy of cryptocurrency – decentralization. Given the fact that Ethereum is one of the most common and flexible blockchains, a decentralized Ethereum exchange opens up possibilities for creating crypto exchanges that are truly decentralized and are completely trustless.
In this article, we will learn in great detail about the decentralized Ethereum token exchange in specific, cryptocurrency exchanges and decentralized cryptocurrency exchanges in general.
A Brief Introduction to Cryptocurrency & Crypto Exchanges
Cryptocurrency heralded to the world that currency need not be dependent on a regulatory body. It has also shown that a proper payment and settlement mechanism with global scope can exist on a completely decentralized and digital ledger. All this, however, could not position cryptocurrency as a dependable method of transaction, resulting in the creation of cryptocurrency exchanges.
The volatility of cryptocurrency which was considered to be a curse for transactions had flipped its perception when it came to exchanges. Since cryptocurrency exchange businesses make money for every transaction irrespective of the trader making money or not, it positions itself as a lucrative crypto business model.
The Bane of Centralization
Most of these cryptocurrency exchanges, however, were under the control of the administrator, meaning the entire exchange is centralized. Centralization goes directly against the basic policy on which cryptocurrency was built – having no centralized authority or a third-party element to ensure trust.
Decentralized exchanges have also been subject to hacks and the stealing of crypto money. Some of the most infamous hacks like the Mt. Gox have resulted in considerable losses, with the mentioned hack alone accounting for about 6% of all the bitcoins in circulation at that time having been lost.
Purist advocates of cryptocurrency and the blockchain technology – like the founder of Ethereum, Vitalic Buterin, and Nick Szabo- have been quite vocal against centralization and centralized exchanges.
Enter decentralized exchanges
Decentralized cryptocurrency exchanges had been created to remedy the disadvantages caused by centralization. It goes in line with one of the basic founding principles of Bitcoin as outlined in the white paper of Satoshi Nakamoto. The decentralized cryptocurrency exchange completely moves away from the trust-based model.
Although more than three years have passed since the initial proliferation, the volume of trade on decentralized exchanges accounts for less than 1% of the volumes reported on centralized exchanges.
What is a decentralized exchange?
There might not be a clear-cut definition for this question but an approximately blanket answer can be given. A decentralized exchange is a protocol that facilitates the exchange of assets without having direct control over the assets of users. Since the exchange does not hold the keys to the assets deposited, it is completely trustless.
The trust factor is taken care of by smart contracts, making it completely dependent on the blockchain itself and not any third-party. The crux of decentralization lies in the custody of funds. As long as the users have control over the assets exchanged, and exchange is eligible to have the ‘decentralized’ tag.
Atomic swaps can be considered the forerunners of decentralized exchanges. The first full account atomic swap was provided in 2013, and they can operate only within a single blockchain. Since Ethereum is one of the common blockchains that are used for smart contracts and many other applications, Ethereum-based decentralized exchanges have been growing steadily in the recent past.
The different types of decentralized exchanges on Ethereum:
There are about 50 different protocols that are being used by decentralized exchanges belonging to various blockchains. Another 100 more are in separate stages of development. To understand the different protocols and architecture, it is important to glossarize certain key terms.
- A market maker is the one who places an order or a limit order in the order book.
- A market taker is a user who takes the order placed by the market maker.
- Off-chain order books are limit orders placed by users and are in existence outside the blockchain.
- Conversely, on-chain order matching is the instant orders that are matched on the blockchain.
- The on-chain settlement is the exchange of tokens settled right within the blockchain.
Decentralized exchanges on Ethereum can be classified into the following categories:
- Off-Chain or 0x protocol where all the settlement and the order matching happens on the chain, but the order books stay off-chain.
- Fully on-chain protocol where everything including settlement, order-matching, and order books stay within the blockchain itself.
- Semi-centralized or hybrid exchanges which have the settlement on-chain but the order-matching and order-books are off-chain.
- Liquidity pools facilitate on-chain settlements. The trades aren’t peer-to-peer but between traders and a liquidity pool.
The KYC conundrum:
The KYC/AML formalities have been created to safeguard the exchange from being used by people with malicious intent. This includes terrorists, illegal activities, and a lot of other places where the anonymity of cryptocurrency transactions could be exploited.
While on the surface, this might seem like a necessary activity for centralized exchanges, it has also led to a perspective of criticism. The introduction of the KYC/AML formalities compromises heavily on the privacy of user information. Therefore, any compromise on the security of the centralized exchange will result in private data and personal information about the traders getting into the hands of people with malicious intent.
This has resulted in creating a divide among the fans of decentralized cryptocurrency exchanges with one faction stating that it is important for the exchange to know its customers, and the other stating that it is a compromise on the identity, and it goes against the anonymity that cryptocurrency promises in the first place. The government of the United States mandates that all exchanges should collect KYC/AML information.
When it comes to the market share, in almost every dimension, centralized cryptocurrency exchanges perform better than their decentralized counterparts.
The volume of trade is often taken as one of the parameters by which the market size of a cryptocurrency exchange is measured. However, there is one aspect that unfairly tilts the skills in favor of centralized exchanges – centralized exchanges can be faked by emulating bots trading within themselves. Therefore, the market volume cannot be taken at its face value. When it comes to decentralized exchanges, IDEX leads the market in terms of volume, handling over 28% of the total trades that happen on decentralized exchanges. It is closely followed by Bancor which holds about 21% of the total market value.
Alternatively, the market size of exchange can also be measured by the number of transactions, the number of active users, the site traffic, and the balance of smart contracts. Even in all of these parameters, IDEX leads the charts, making it the numero uno decentralized cryptocurrency exchange in almost every aspect.
Advantages of decentralized exchanges
A decentralized Ethereum exchange brings a big list of advantages that position it better than centralized exchanges.
- Security – This can be stated as the foremost advantage that decentralized exchanges offer over centralized exchanges. The decentralized exchanges mean that there are no custodians for the funds of customers, and the customers have complete control over the funds they have invested in the exchange. The trust in decentralized exchanges is taken care of by a smart contract or a protocol instead of any centralized corporation or human intervention. Security and its offshoots have become the litmus test for determining whether an exchange is fully decentralized or not. For example, Bancor, a semi-decentralized cryptocurrency had its assets stolen from the smart contract, and some crypto critics have outright called it not a decentralized exchange.
- Anonymity – Another advantage brought about by decentralized exchanges is the second level emphasis on anonymity. The KYC/AML formalities are mandatory for centralized exchanges. However, quite a huge chunk of decentralized exchanges do not require KYC sign-up or registration. This implies that users can anonymously trade by just attaching their cryptocurrency wallets through browser plug-ins or by creating local wallets. Most centralized exchanges have a cumbersome and lengthy sign-up process. However, since most of the “trust” is taken care of by smart contracts, decentralized exchanges do not require KYC/AMLmaking them truly anonymous.
- Legal sides – the legal regulations governing decentralized cryptocurrency exchanges have been hazy at best. That have been instances of exchange on us having been pressured into taking down their websites. However, it cannot be denied that anyone has the right to create a new decentralized exchange that needs to interact with an existing smart contract. Keeping in mind the legal implications, some exchanges like IDEX have geo-blocked the United States from accessing their website.
- Transparency – Decentralized exchanges are extremely transparent, and they function only according to what is coded on the smart contract. This makes the possibility of human errors almost close to zero, bringing enhanced trust for the investors and traders.
Disadvantages of decentralized exchanges
Decentralized exchanges are not only about advantages.hey have their fair share of disadvantages as well.
- Decentralized exchanges can only trade on a single blockchain. This means that some of its common transactions like trading between Ethereum and bitcoin cannot be done on user-friendly decentralized exchanges.
- Decentralized exchanges are notoriously impractical to use. They have been known to face liquidity issues and order collisions.
There might be intermittent instances of decentralized exchanges offering shot rating, but it is not a common feature.
Ever heard of an innovation having a problem, and a solution being introduced to curb that problem, only to find out that it takes you back to the issue that was attempted to be solved in the first place? Centralized cryptocurrency exchanges precisely fall into the category. It tried to make cryptocurrency more practical, only to end up in defeating decentralization.
Anything said challenges that plague the new technology can be expected to be sorted out very soon. With the COVID-19 crisis challenging the elements of classical economy, cryptocurrency has all the credentials to present itself as an alternate mode of transaction and a dependable source for hedging.
Given all these attributes, now would be the perfect time for you to launch a cryptocurrency exchange, and if you are looking at decentralized exchanges, decentralized Ethereum token exchange is the perfect bet for you. If you are one of those aspiring entrepreneurs all you need to do is get in touch with a company that specializes in the development and customization of a decentralized Ethereum exchange.