What is a Decentralized Exchange (DEX)?

What is a Decentralized Exchange (DEX)?

In the previous article, we explored the question of trust in a centralized crypto exchange and found that, for reasons which are hard to put into words, we may not trust them as much as we would like. In this article we’ll look at the alternative, a Decentralized Exchange (DEX), and whether that’s any better. But first off, what is a DEX?

The short answer: It’s the same thing you’ve always known, with one small difference. No central control.

What is it?

A crypto exchange is to crypto what a stock exchange is to stocks. The NYSE is a place where you can buy shares of companies (like Apple) and a crypto exchange is a marketplace where you can buy crypto (like Bitcoin). A very famous (or infamous) crypto exchange is FTX. FTX is what is known as a centralized exchange. A centralized exchange has a central point of control. The central point of control for FTX was Sam Bankman-Fried (SBF). Now, if we were to remove SBF from FTX (and not replace him with another central party), that would be a decentralized exchange. There would be no central point of control (or central point of failure).

The problem, however, is only partly with SBF. The real problem is that he holds the keys to the kingdom. And holding the keys to the kingdom means that he holds your bitcoin. He is in control of the custody thereof. That effectively means he puts your coins in his own wallet. Now we all hope he’s a good guy and he won’t use your coins for himself, but there’s really nothing to stop him. He holds the keys after all.

In a DEX, there’s no person/entity in control and they never take custody of your bitcoin. The coins always remain in your possession (in your own wallet), until you sell/use them. The transaction is recorded on the blockchain, which means anyone in the world can, at any time, see which wallet address holds the coins and which wallet has it in their possession – you, in your own wallet.

There’s a famous saying in the crypto world: “Not your keys, not your coins”. This means that if you don’t have custody of your coins (i.e. they are in someone else’s wallet – like a centralized exchange), you may wake up one day to find that they are gone.

Benefits of a DEX

The benefits are plentiful. One of the key benefits of DEXs is the increased level of security they provide. Centralized exchanges have been the target of numerous hacks and security breaches in the past, which has led to the loss of millions of dollars' worth of assets (think of Mt. Gox). In a DEX, there is no central point of failure, making it much more difficult for hackers to steal funds. Additionally, since users are in complete control of their private keys, there is no need to trust a third party with their assets.

Another advantage of DEXs is that they offer a high degree of privacy and anonymity. Transactions on a DEX are recorded on the blockchain and can be seen by anyone, but the identity of the participants is not revealed.

DEXs also have the potential to provide more financial freedom to people living in countries with strict capital controls. Centralized exchanges are generally subject to government regulations, which can limit the ability of people in certain countries to trade or access their funds. DEXs, on the other hand, are not subject to the same restrictions.

Disadvantages of a DEX

A key challenge for DEXs is the lack of support for fiat currencies (like USD). While many DEXs allow for the trading of cryptocurrencies, it can still be difficult for people to convert their fiat currency into a digital asset. This is one reason that centralized exchanges are still so popular, as they typically offer a direct connection to traditional banking systems and are used as an on-ramp to the crypto ecosystem.

A new way forward

DEXs are a new way of trading digital assets that offer a solution to the trust problems faced by centralized exchanges. Because DEXs are not controlled by any single person/entity and operate on a blockchain network it means that users have complete control over their assets and transactions, without having to rely on a central authority to manage their funds.

It is therefore not so much a new way of doing things as it is the way the crypto community always envisioned it would be. No-one wanted to simply create a new asset class for the next Bernie Madoff to misappropriate.

So, do I trust it?

Bringing this back to the initial point that got us here, trust, it does raise the important question: Do I trust a DEX to buy or sell my crypto? We did, after all, argue that the problem with exchanges was the central point of control. Now that it’s gone, am I more comfortable? I will quote a lawyer friend of mine in this answer – it depends.

There are certain elements to a centralized company owning and running an exchange which are quite comforting. They have a call center (they never pick up, but they have one), I have someone to complain to (they don’t care but at least they’re there), I have my favorite “forgot password” button (because somehow, it’s still hard to store it somewhere safe). There is that feeling of comfort that if something does go wrong, I can at least contact someone. They may not fix it and there’s the risk of losing all my funds due to internal mismanagement, but I do like knowing that there is someone central to blame.

Final thoughts

The problem seems to be that it’s hard to move away from what you know and to try something new, even when you know how risky the current option is. I believe there’s a place in the market for centralized exchanges, but I also believe there will be a time when we’ll look back in amazement on a world where the only option was to completely trust a central party to get it done. Having bumped my own head multiple times, most recently as a result of FTX, I think I’m ready to move on. Are you?

Examples

There are a number of very successful DEXs out there and I’ve included a few links below.

Uniswap: https://uniswap.org/

Pancake Swap: https://pancakeswap.finance/

SushiSwap: https://www.sushi.com/

THORchain: https://thorchain.org/ (this community actually calls Chris Hemsworth its CEO – just as a joke)