What Actually is a Decentralized Exchange?
Coke vs. Pepsi. The true fans of each brand will speak to the world of differences between them but, at the end of the day, they’re both drinks. Both quench your thirst, both are carbonated, and both will clean the corrosion off your car’s battery.
But when it comes to centralized exchanges (CEX) versus decentralized exchanges (DEX), the differences are far more than for the world’s two leading beverages. Coinbase, Binance, and most of the “major” exchanges that you’ve probably heard of are all CEXs. In a sentence, centralized exchanges are where you can swap crypto and fiat (i.e., government-backed money like the bills in your wallet). Because centralized exchanges deal with government-issued currencies (which, in turn, are controlled by centralized organizations such as reserve banks), they’re typically subject to some amount of regulation.
In this post, we’re concerned with the other type of exchange–namely, what actually is a decentralized exchange?
Decentralized exchanges address many of the shortcomings or weaknesses of a CEX. Specifically, they typically offer:
- Lower transaction fees paid to the exchange
- Access to many more tokens (and the projects to which they correspond)
- The ability to hold crypto directly versus in a custodial account managed by the CEX
- Little-to-no government control which, to be clear, is one of the key reasons for crypto
Let’s dive into this first point (i.e., lower transaction fees) to understand the why and how that makes this possible. Note: While decentralized exchanges typically offer lower transaction fees, this is not universally the case across every single DEX. For purposes of this article, however, we won’t concern ourselves with such “edge case” examples. Rather, we’ll focus on the majority of DEXs that conform to our previous statement.
You see, decentralized exchanges are not non-profit entities; they’re not charities operating out of a sense of altruism.
Their ability to offer lower fees stems from a fundamentally different way of facilitating transactions compared to centralized exchanges. Namely, DEXs eliminate the middlemen that take a cut of the transaction fees (which, ahem, is what causes said transaction fees to be higher in the first place).
Essentially, in a transaction occurring with a DEX, swaps happen directly between a buyer and a seller (no CEX holding custody of said crypto, no banks, etc.). The only intermediary is the software (AKA smart contract) itself that both the buyer and seller use. Now this, of course, simplifies what is actually a very technical process.
Are you still with us? We’ll explain how this process actually works.
An Introduction Automatic Market Makers
In centralized exchanges (and even in traditional stock markets), intermediaries connect buyers and sellers to facilitate transactions. For example, if you want to sell 1 BTC for $20,000, an intermediary would find someone willing to buy 1 BTC for that price and would facilitate both the connection between the buyer and seller — and their transaction.
On the flip side, decentralized exchanges typically use Automatic Market Makers, or AMMs, which replace human intermediaries with software algorithms. Essentially, holders contribute liquidity to the DEX, meaning no one has to wait around for a match in the order book, which is especially good for low-volume tokens.
Another perk? Consider the fact that crypto trading takes place 24 hours per day, 365 days per year. AMMs facilitate round-the-clock transactions, unlike people-based exchanges that work defined hours on set days.
DEXs also make aggregators possible
In our next post, we’ll dive even deeper into the ways that decentralized exchanges make it possible for aggregators to operate. Not sure what that is? Then you’ll want to stay tuned. In the meantime, you can learn more about the ins-and-out of crypto and blockchains for visiting the Bridges Knowledgebase at https://learn.bridges.exchange/. You can also explore how the newly-launched Bridges Exchange employs some of the very technologies we talk about above.