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What is a Decentralized Exchange?

2023.08.21 MEXC

Well-known exchanges such as MEXC, Binance, Coinbase, and others fall under the category of centralized exchanges (CEX). Conversely, there exist decentralized exchanges, commonly referred to as DEX.

1. Differences Between DEXs and CEXs

1.1 Asset Control: On CEXs, users' assets are controlled by the exchange, and users deposit their assets into the exchange's wallet. Users entrust their assets to the exchange, which manages and safeguards them. Conversely, on DEXs, users control their own assets. DEXs only offer token exchange services and earn trading fees, without providing asset custody services.

1.2 Transaction Efficiency: CEX transactions occur off-chain, with extremely fast execution speeds and no cost erosion as long as there is sufficient liquidity. DEX data is recorded on the blockchain network, with each transaction and state change logged, resulting in relatively slower speeds and higher costs.

1.3 Security: Due to centralized management of a large volume of user assets, CEXs are susceptible to hacking attacks, as seen in the "Mt. Gox incident." DEXs are responsible only for trade matching, with users maintaining control over their assets.

1.4 Token Trading: CEXs usually select mainstream tokens and those with a certain level of popularity to list on the exchange. However, DEXs are not restricted by this selection process. Anyone can provide liquidity for a token, leading to the availability of almost all tokens on a DEX.

2. Characteristics of DEXs

On-chain Execution: All transactions are executed through smart contracts and are considered complete only after blockchain confirmation. Traditional exchanges record data in centralized databases, which can be rolled back at any time.

No Identity Verification Required: Users can directly log in to different DEX platforms for trading as long as they have a decentralized wallet account, without the need for complex registration and KYC verification.

No Asset Custody Required: In decentralized exchanges, cryptographic assets are stored directly in users' wallets, giving users absolute control over their assets. This significantly reduces the risk of exchanges unexpectedly ceasing operations or engaging in unscrupulous activities.

3. Development of DEXs

In 2014, Counterparty, a token crowdfunding platform based on the Bitcoin blockchain, was established, allowing all Counterparty tokens to be traded on the Bitcoin-based DEX.

In 2017, IDEX emerged on the Ethereum network, mimicking Counterparty. Its total trading volume for the year was less than $5 million.

In 2018, Bancor introduced the concept of building an Automated Market Maker (AMM). However, the platform's lower trading volume impacted liquidity providers' earnings, resulting in weaker attraction.

In November 2018, Uniswap launched, offering a more user-friendly design and supporting permissionless listing of crypto assets.

It was also in 2018 that DEX trading volume exploded for the first time, reaching $2.8 billion.

In 2020, the unforgettable DeFi Summer was written into history.

During that year, Curve emerged online, focusing on stablecoin trading. AAVE underwent a redesign and relaunched from ETHLend. Uniswap V2, Bancor V2, and AAVE V2 were successively launched. Balancer, Compound, and Sushiswap initiated liquidity mining, and Uniswap token airdrops began competing for liquidity.

By the end of 2020, the DeFi market's trading volume exceeded $29 billion.

4. Types of DEXs

As of now, there are two main types of DEX, one based on order books and the other based on liquidity pools.

4.1 Order Book-based DEXs

An order book is a list of buy and sell orders for a specific asset at different price levels, similar to how a CEX operates. Examples of platforms embodying this approach include dYdX and Loopring. Unlike CEXs, where assets are stored in the exchange's wallet, DEX assets are stored in users' wallets.

DEX order books can exist either on-chain or off-chain. Due to high gas fees on Ethereum, on-chain order books on Ethereum-based DEXs have become problematic due to the heavy load on the blockchain, since all the orders are recorded on-chain. Exploring alternatives such as layer 2 solutions or blockchains with high TPS, like Solana, could present viable options.

For off-chain order book-based DEXs, trade orders are placed off-chain, while the actual executions occur on-chain. This approach is considered semi-decentralized.

4.2 Liquidity Pool-based DEXs

Automated Market Makers (AMMs) are among the most innovative inventions in recent DeFi history, and most liquidity pool-based DEXs utilize AMMs. AMMs significantly enhance capital utilization efficiency.

Liquidity pools serve as reservoirs for two or more tokens, stored within the smart contracts of the DEX, available for users to trade at any time. Think of liquidity pools as pools of tokens available for trading. If you want to exchange ETH for USDT, you would participate in the ETH/USDT liquidity pool by contributing ETH to the pool and extracting a specified amount of USDT from the pool through algorithmic processes.

5. Will DEXs Replace CEXs?

The explosive growth of DeFi has highlighted the potential of DEXs within the crypto community. The enduring impact of the Mt. Gox incident and the rapid collapse of FTX's massive crypto empire in less than 10 days have raised concerns regarding the safety of user assets on centralized exchanges due to the recurring risks associated within the CEX realm.

While the shortcomings of centralization have faced longstanding criticism, DEXs currently face issues of low trading efficiency and high fees. Thus, as of now, CEXs and DEXs coexist, with CEXs still dominating the mainstream. However, as the crypto market continues to expand and develop, and as solutions for the challenges DEXs encounter on the blockchain emerge, a future where DEXs potentially supersede or capture a significant market share from CEXs is foreseeable.

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