What is DEX — Decentralised Exchanges give investors more control and more profit

Decentralisation is at the core of all the benefits that can be drawn off blockchain technology.

Every app that is built on a blockchain platform today, boasts the fact that it is decentralised. So, it’s not surprising that crypto exchanges also want to jump on the bandwagon and many are on the path to launch their own decentralised exchange (DEX), where there’s no middle man, just traders swapping tokens with each other.

There are currently more than 35 DEXs in existence globally including Uniswap, Kyber, and Bancor — popular alternatives to centralised exchanges. In India, WazirX has plans to launch a DEX of its own sometime this month, CEO Nischal Shetty told the Economic Times in July. The crypto exchange boasts of 7.3 million users as of August, with more than half of its growth this year coming from Tier-II and Tier-III cities.

What is a centralised exchange?

Before we get to what a decentralised exchange is, it’s important to understand what a centralised exchange is.

Pretty much any crypto exchange in the world today is a centralised exchange. This means that when you deposit your cryptocurrency onto the platform, you’re basically transferring it to a wallet that’s held by the exchange. When you deposit fiat currency — whether its the US dollar or the Indian rupee — in order to buy crypto, that crypto is also held in the exchange’s centralised wallet, till you decide to liquidate the crypto and withdraw the money back into your regular bank account.

Crypto wallets have two keys, a public and private keys. Public keys are shared with anyone who wants to send you cryptocurrency, while a private key is what you use to access your own wallet. For exchanges, these are simplified even further so you never have to interact with either of these keys, which — unlike passwords — aren’t the easiest to remember.“Any crypto wallet that won’t give you your private keys should be avoided at all costs,” billionaire Elon Musk had warned once.

It’s not that centralised exchanges are necessarily risky, but it does mean that the investor does not have direct control over their purchases or holdings. In a centralised exchange, when you want to sell crypto, the exchange goes and finds another person who wants to buy your crypto. It facilitates this transaction and if you want to withdraw your crypto, you will essentially have to ask the exchange to sign a transaction on your behalf.

Onto DEX…

If you understood what a centralised exchange is, you can probably guess what a DEX is now. The primary difference, of course, is in the fact that you have access to the private key for your own crypto wallet. You’re not dependent on a central entity to hold your cryptocurrency.

In some decentralised exchanges, the entire process of buying and selling is performed ‘on chain’ — it is completely transparent. You do not have to depend on a third party to facilitate the transaction, which may potentially charge you extra transaction fees on every trade. This is one of the reasons why DEX transactions are often cheaper.

Advantages of DEX

The two obvious advantages of DEXs are security and sovereignty. The fact that they are decentralised means there is no one entity that can be hacked, whereas a centralised exchange is more vulnerable to exploits, which in turn could affect its users. In addition, users retain access to their wallets and hence retain control of their own crypto holdings.

In essence, a DEX is basically a bunch of crypto wallets that are trading with each other. Which leads us to the third big advantage — privacy. Unlike centralized exchanges, a DEX doesn’t necessarily require the user to go through the know your customer (KYC) process, meaning you do not hand over your documents to any one entity, and thereby risk giving access to others if that entity is hacked.

However, KYC documents are also essential in the financial system, because they allow governments and authorities to track the flow of money. Like most things to do with privacy, this could be a double-edged sword in the long run.

Enter Automated Market Makers (AMM)

AMMs have been backed by some of the biggest venture funds in the world and billionaires. The idea is simple, the AMM is essentially an automated order book that facilitates liquidity on the exchange. Uniswap was the first DEX with an AMM to emerge back in 2018.

A centralised exchange doesn’t just find buyers for you, it also works with large traders to ensure that there’s enough liquidity on the exchange and you can sell your crypto virtually whenever you want. Liquidity means there’s enough supply for available demand. If liquidity is low it will be difficult for you to sell crypto, and vice versa.

AMMs look to solve the liquidity problem without depending on large traders using smart contracts — self-executing computer programs that ensure liquidity on the exchange. But the benefits of having an AMM in play don’t stop with liquidity. Eliminating the middle-man also means that the transaction fees won’t change while a transaction is happening.

The AMM algorithms have pre-defined requirements for an entity or individual to become a liquidity provider. Anyone who meets these criteria can become part of the liquidity pool, and hence maintain continuous trading.

Disclaimer: This is a sponsored post in partnership with WazirX.