Cryptocurrencies are based on the premise of decentralization, yet the nearly 200 major cryptocurrency exchanges worldwide are largely centralized, relying on off-blockchain systems to facilitate their buying and selling. If backers of decentralized exchanges have their way, in future those transactions will be nearly as decentralized as the blockchains that underlie the cryptocurrencies.
Even as large institutional investors prepare to enter the blockchain space, decentralized exchanges, or DEX, represent an alternative that, their backers say, supports the ethos of the blockchain space.
Using decentralized exchanges, users maintain ownership of the private keys of their cryptocurrency instead of handing them over to an intermediary. Also, instead of relying on a central server to connect buyers and sellers, they use the decentralized network to facilitate direct peer-to-peer transactions.
A dirty secret about many present-day “decentralized” exchanges: They still rely on centralized trading systems or order books to facilitate trades.
Yet, while the number of decentralized exchanges continues to grow (click here for a comprehensive crowdsourced list), the reality is virtually all cryptocurrency transactions today continue to be made through centralized exchanges, a reality that may be reinforced after Fidelity, Bakkt and other large institutional players enter the space with their own solutions.
A Simple Way
“Building a fully decentralized and efficient exchange remains today something of an utopia,” VariabL CCO Nathan Sexer explained in a blog post early this year. “Exchanges are centralized because it is the simplest way to proceed, and it is either too costly or technically complex to build fully decentralized platforms – for now, at least.” (VariabL is building a trading platform for ether (ETH) derivatives.)
Here are eight things you should know about the potential promise and pitfalls of decentralized exchanges.
They Could (in Theory) Limit Manipulation
Critics of centralized exchanges point to their ability to move markets, and make or break tokens, by deciding which cryptocurrencies to list and, in many cases, charging substantial fees for the privilege. Decentralized exchanges would allow anyone to trade any token without intermediaries or hidden fees, backers argue.
“I definitely personally hope centralized exchanges burn in hell as much as possible,” Ethereum co-founder Vitalik Buterin said in an interview earlier this year. “The more that we can get away from that world and into something which actually … satisfies the blockchain values of openness and transparency, the better.”
They Address the Custody Issue by Making It Unnecessary
While the specific approaches vary, centralized exchanges generally act as escrow accounts for their users’ cryptocurrency holdings. One of the big hurdles institutional players are facing as they enter the cryptocurrency space involves creating custodial solutions that follow regulations governing similar accounts for other assets.
Conversely, decentralized exchanges don’t need to worry about custody because they never hold the crypto being traded. Instead, they facilitate peer-to-peer connections between buyers and sellers that are governed by smart contracts or other transparent rules.
They Represent a Smaller Target for Hackers
From Mt. Gox to Bitfinex, centralized exchanges have been subject to numerous hacks and outright theft. In part that’s because they represent large targets, with tempting “honeypots” of cryptocurrency representing the collective holdings of their users. With decentralized trading, there are fewer large targets to tempt hackers, and users who don’t unwittingly give up their private keys may be less likely to lose their holdings.
They Provide New Levels of Privacy and Openness
Decentralized exchanges would allow greater privacy for transactions. The peer-to-peer nature of these trades would also allow traders to bypass know your customer (KYC) and anti-money laundering (AML) regulations and trade across national boundaries, which centralized exchanges can’t do.
“Unlocking the ability to transact globally, through a decentralized exchange, will affect society in profound ways,” wrote Michael Oved, cofounder of AirSwap, a decentralized trading network. “In the end the borders that blockchain break down will be greater than the borders we saw the internet break down.”
They Don’t Provide Good On-Ramps to the Crypto Space
Decentralized exchanges lack one key feature of their centralized counterparts: the ability to transfer fiat currency from traditional banking accounts for use in buying or selling cryptocurrencies. Stablecoins may represent one way to shift cryptocurrency in and out of fiat-compatible assets, but peer-to-peer exchanges are unlikely to be able to interface with centralized banks and financial institutions.
Many of Today’s Decentralized Exchanges Are Actually Hybrids
A dirty secret about many present-day “decentralized” exchanges is that while they allow their users to maintain ownership of their private keys, they still rely on centralized trading systems or order books to facilitate trades.
They’re Only as Good as Their Host Blockchain
As decentralized apps, peer-to-peer exchanges face the same limitations as their parent blockchains, including slow transaction times and variable transaction fees. Exchanges involving cryptocurrencies that reside on different blockchains, such as ether and bitcoin (BTC), would face the same challenges as other efforts to facilitate transactions across different blockchains.
Liquidity May Be a Problem
Liquidity, or the lack thereof, is a common criticism of today’s fragmented centralized exchanges. But when fewer than 200 exchanges have contributed to a fragmented marketplace, imagine what liquidity looks like with thousands or more decentralized trading networks. “In short, you need liquidity to get adoption, yet in order to attract traders, liquidity must be [available],” wrote Adrian Barwicki of Alphateam Hackers GmbH.
At the same time, backers are confident these issues will be addressed in time. “Decentralized exchanges will succeed … when there is liquidity and usability, both of which do not exist yet on any solution,” Oved said.