In a recent blog post we looked at centralised exchanges. We discussed their benefits and features, as well as their limitations. In this blog post we will be doing the same. One of the three core values here at Koda is education. By educating our audience we are enabling them to make informed decisions about the best crypto investment solution for them.
As with everything in life, there are pros and cons. It’s just the same when you invest in cryptocurrencies. You need to know the benefits and the limitations. This allows you to weight up the pros and cons to ensure you’re making the best decision for your investment in the world of crypto.
What Is A Decentralised Exchange?
Similar, to a centralised exchange, a decentralised exchange has the purpose of allowing people to trade their crypto assets. However, the structure of this type of decentralised exchange is what makes it fundamentally different to a centralised exchange.
It’s important to note that there are two main types of decentralised exchanges. These are known as Order Book DEXs and Automated Market Marker DEXs. Below we look at these two main types of decentralised exchanges.
• Order Book DEXs
Just like a centralised exchange, the older generation of decentralised exchanges will operate from a decentralised version of an order book system. There are a lot of well-known order book decentralised exchanges out there, many of these you may have heard of. Unlike a centralised exchange though, they use an algorithm. This algorithm finds and routes the trades between individual crypto users. Smart contracts will then record the exchanges on the blockchain to reflect the crypto coins and tokens that are moving between both buyers and sellers.
There is a market with an order book decentralised exchange. However, there is nobody in the middle selling the crypto coins and tokens for you. Instead, the algorithm is selling the crypto coins and tokens for you. This is how the service remains decentralised for its users.
• Automated Market Marker DEXs
Automated Market Marker decentralised exchanges are also known as AMM DEXs. They tend to embody the more recent swathe of exchanges. The automated market marker decentralised exchanges were developed as a response to a key problem that is prevalent in crypto exchanges, and that is a lack of liquidity.
However, instead of matching buyers and sellers, the trades on an automated market marker decentralised exchange are carried out by using liquidity pools. These liquidity pools are managed by the decentralised exchange own smart contract. The liquidity is sourced from users who give their crypto coins and tokens, in trading pairs, in exchange for passive income. It can also come from users that take a more calculated approach with their crypto investment, as part of a broader yield farming strategy.
The decentralised exchange itself will set the price of the trades between crypto coins automatically. This will be done dependent on the supply and demand for those crypto assets. The pricing of the trades is completed by an algorithm. The algorithm is constantly rebalancing, and this is what reflects the changes in the liquidity of the decentralised exchange. This is often not in sync with the rest of the market. It is this that creates the prime opportunity for eagle-eyed and active crypto investors to make yield through arbitrage.
The Benefits Of Decentralised Exchanges
Firstly, let’s look at the features of benefits of decentralised exchanges. These are the things that make a decentralised exchange platform stand out from a centralised exchange platform. If you’re not sure of the benefits and features of a centralised exchange, check our latest blog which covers this topic.
Due to the fact that a decentralised exchange doesn’t exist as a central entity, this means that there is no platform to put your funds into. Instead, you connect the decentralised exchange to your own wallet. This means that you use your own private keys to manage your own crypto funds in your own wallet. This is where decentralised exchanges are different to centralised exchanges. While the burden isn’t taken off the crypto user to store and secure the funds and private keys, the benefit is that the crypto coins will always be owned by you and not the exchange platform.
While centralised exchanges have always been seen as the easier to use option by new crypto investors. This is changing as the cryptocurrency ecosystem evolves. There is a growing list of integrations. These now include may decentralised exchanges that use a DEX for swapping while managing the specifics of self-custody, which can still be a seamless experience. They couple clear signing and ease of use from within the ecosystem of the ledger. This is done with the absolute security of cold crypto storage.
• No Onboarding Data
Decentralised exchanges have no interaction with fiat money. This means that they don’t need to be KYC (Know Your Customer) compliant. In turn, this means that as a crypto user of a decentralised exchange platform you won’t be asked for any proof of identification to begin using the platform. The good thing about this is that your privacy is respected while you trade on the decentralised exchange. This means that your details wont be left on a digital network for anyone to hack or steal.
However, it is important that you don’t get carried away with thoughts of anonymity on decentralised exchanges. While you won’t need to share your personal data to use the decentralised exchange, all exchanges have to comply with ‘know your customer’ measures. This could even be when crypto coins are first purchased. Ultimately, this means that every crypto trade that is floating around in the blockchain ecosystem can be related back to the real owner of the crypto coin.
• Wide Range Of Cryptocurrencies
The selection of crypto coins and tokens on a decentralised exchange is not limited to a central entity. This means that users are more or less free to find, trade and get involved in the projects that they are interested in. One of the best things about this is that crypto users can be early adopters in up-and-coming crypto projects if they choose to be.
This is great for those crypto traders that want to take the time to do research and new projects. You will often find that a decentralised exchange is the first place these kinds of crypto traders will go when looking to place their chips on the table (so to speak).
• Distributed Governance
Many automated market marker decentralised exchange (AMM DEXs) offer their users governance tokens. This is done to further democratise the control of the crypto trading platform. It is also done as a reward for traders that are providing liquidity to the decentralised exchange through their crypto trading.
This distributed governance allows crypto users to participate in the decision-making processes of the exchange platform and also the future of the crypto exchange. This is becoming increasingly relevant as a consideration for crypto traders as more and more decentralised exchange choose to fully distribute their management to their crypto users.
The Limitations Of A Decentralised Exchange
The biggest downside of decentralised exchanges compared to centralised exchanges is that they tend to be harder to navigate. Decentralised exchanges can often be trickier for less experienced crypto traders to use too. This is why decentralised exchange are often less popular among people new to the world of cryptocurrencies.
While the lack of ease of use is the biggest downside of decentralised exchanges, there are other limitations of a decentralised exchange. We look at some of these limitations below.
• No Fiat On-Ramping
Unlike their centralised counterparts, decentralised exchanges do not accept payment in fiat (traditional currencies). This means that decentralised exchanges will not be anyone’s first step into the world of cryptocurrencies and crypto trading.
One of the biggest issues of decentralised exchange is liquidity. This is the same for order book decentralised exchanges and automated market marker decentralised exchange systems. When it comes to order book decentralised exchanges there is often a lack of available trading partners. This can result in slow trade, also known as slippage.
When it comes to automated market marker decentralised exchanges, they will often offer poor rewards for their liquidity providers. Crypto traders using the decentralised exchange might find themselves with a deficit. This is something that is really important to consider before you embark on your decentralised exchange adventure.
• Freedom = Responsibility
While you may love the idea of being in the drivers sat and having total freedom of your crypto assets, this can be a downside too. It leaves you to deal with the storage and security of your crypto exchange assets. It is not possible to leave your crypto exchange assets on the exchange. Instead, you need to make sure that your crypto wallet is compatible with the service, but also immune to any risks. This is key to your decentralised exchange experience.
• Do Your Own Research
As with all investments we would always recommend that you do your own research. However, this is even more prevalent in the world of decentralised exchanges. One of the great things about decentralised exchanges is that users have the ability to trade freely. This can be done while the users retain complete control of their crypto coins, tokens and other assets. However, this freedom results in extra responsibilities for the crypto user and trader.
With decentralised exchanges, any cryptocurrency can be listed on the exchange platform. This means that the cryptocurrency may not be authentic or real. This is why it is even more important to do your own research when it comes to decentralised exchanges. You need to ensure that the crypto project that you are buying into is authentic and right for your investment.
• Blind Signing
Decentralised exchange transactions are powered by the omnipresent smart contract. Details of this smart contract can’t always be displayed when you sign them. This is why it is essential that decentralised exchange users take the steps to understand the risks. Knowing how to minimise these risks is essential when it comes to crypto trading on decentralised exchanges.
Still not sure if you should be crypto trading on a decentralised exchange or centralised exchange? Contact our crypto specialists at our head office in England. We will take the time to understand what you want from your crypto investment and recommend the best crypto exchange for you.