When Bitcoin, the world’s first cryptocurrency was created by Satoshi Nakamoto, its purpose was to be a peer-to-peer network used for daily transactions. It removed the need for third-party intermediaries such as banks so people can move their funds directly without worrying about extra fees or a vulnerable security.
By relying on cryptographic proof instead of trust, cryptocurrencies introduced the world to a groundbreaking monetary system that is foolproof, immutable and decentralized. To ensure this, records are stored on a public ledger called the blockchain where they cannot be tampered once uploaded.
Having said that, there’s a missing piece to this equation which begs the question: how can people transfer funds from one wallet to another? This is where exchange sites come into the picture. These sites provide a platform where traders can buy and exchange their digital assets.
However, the problem with these sites is that centralised, for-profit companies run them. This means that while cryptocurrencies are decentralized by default, the majority of exchange sites where they can be bought and traded are not.
Centralized exchange sites are not that different from banks in the sense that they also require your private information, store them in central servers, and collect a fee in exchange for their service.
They can also be shut down by authorities, restricting your access to your funds stored in the exchange site’s custodial wallets. Though these exchanges make crypto services accessible and convenient, it comes at the price of control and risk.
Decentralised exchanges to the rescue
Fortunately, organizations who believe in Nakamoto’s vision of a decentralized community created exchanges that do not rely on centralized governance called decentralized exchanges or DEX.
As its name suggests, it’s a trading platform that keeps data on a distributed ledger instead of a central server. It offers a place for traders to exchange digital assets without requiring their private information and storing their funds.
In centralized exchanges, funds are stored on a single wallet that can be hacked. Many exchange sites have lost millions of funds due to security and data breaches, raising alarm for the safety of people’s coins. DEXs improve security by keeping transaction records on a blockchain so there’s no honeypot of funds for hackers to target.
Services offered on DEXs do not differ from those you can enjoy from their centralized counterparts. You can place market orders, trade directly on a peer-to-peer basis and trade coins with the added feature of better security.
Key characteristics of decentralised exchanges
No government or body of authority can take down a decentralized exchange. This means trading activities cannot be halted by anyone.
Centralized exchanges require private information from users before they can trade as part of the Know Your Customer (KYC) and Anti-Money Laundering (AML) protocols. In contrast with this, DEXs don’t need personal information so you can rest assured that your sensitive information isn’t stored on a central server.
DEXs don’t hold your assets so you’re in control of your funds. You need to input your wallet address when trading to ensure it doesn’t go to a third-party wallet.
Decentralised exchanges through the years
Before, a decentralized exchange would mean a marketplace where traders can interact directly with one another so they can ensure the transaction themselves. Coins are not stored on a company’s custodial wallet like a broker site but you can get them directly from a seller. You can customize the transaction details such as the payment method.
In a peer-to-peer (P2P) marketplace, the coins are transferred from one private wallet to another private wallet, ensuring that no third party will have access to them.
LocalBitcoins is one of the earliest P2P crypto marketplaces that are still operating today. Though LocalBitcoins is a centralized site with its own governance, the fact that it does not keep any funds makes it a decentralized exchange. It uses Hash Time-Locked Contracts or HTLC to swap two digital assets instead of a centralized third-party.
While a P2P marketplace is perfect for people who want to buy/sell crypto, it’s not the most ideal place for traders. There are no order books in a marketplace so instantaneous exchanges cannot happen.
As demand for crypto trading grew, more centralized exchange sites were launched and with this came lots of cyberattacks. Mt Gox remains one of the most popular hacking incidents in the industry with over US$473 million worth of Bitcoin stolen, leading to the once-largest Bitcoin exchange site to announce bankruptcy in 2014.
The Bitfinex hacking incident in 2016 followed with the exchange site losing US$72 million worth of Bitcoin. Even exchanges that boast superior security such as Coinbase and Binance were not spared from hacking trends.
With exchange sites losing funds to hackers left and right, the need for a decentralized solution comes to mind. Bisq is one of the earliest DEXs with an order book to appear in 2016. The network features a matchmaking service that finds the most suitable order to trade with. It also offers a P2P marketplace so you can customize your transaction.
Launched by a grassroots collective, Bisq offers a platform for traders who are looking for a secure alternative to centralized exchanges. Its desktop application stores information on your local server rather than on the internet, keeping your data safe from hackers online.
DEXs provided a much-needed service but the problem lies with wide-scale adoption. With few people using it, there are only a select few markets and even fewer market orders. To solve this problem, ring exchanges were created.
Ring exchanges combine the best of centralized and decentralized exchanges. They serve as a temporary bridge between buyers and sellers to ensure a faster and more secure exchange. ShapeShift is the best example of this type of DEX.
With ShapeShift, you can send your funds to them and they will exchange them to whichever coin you want before sending them directly to your wallet. Since they have temporary custody of your assets, ring exchanges are still centralized in nature.
Creating a more decentralized future
The crypto community hopes for the complete distribution of power, control and risk across the globe. For this to become a reality, decentralized exchanges play a vital role. You can only expect better developments to come in the future as the world realizes the importance of decentralized technology.