In this article, we will explain what decentralized exchanges are with regards to how they differ from centralized exchanges, how a trade is secured on a decentralized exchange, the benefits of a decentralized exchange, notable decentralized exchanges and the how the future might look like. See all cryptocurrency exchange reviews at Cryptocoinzone.
The underlying thesis in all of the blockchain technology is that decentralization is very important for keeping information secure and private. For this reason, using centralized exchanges purchase cryptocurrencies puts users at risk of losing their funds or personal information. There is a slew of previous examples of users losing their funds or data from the centralized exchange. These include the hacks of the Mt. Gox, Bitstamp, Bitfinex, Poloniex and more centralized exchanges. In addition, this includes the US government’s collection of Coinbase user data. This all paints a clear picture as to why decentralized exchanges are such an important layer of infrastructure needed for the blockchain industry.
How do decentralized exchanges differ?
Differences between centralized and decentralized exchanges include:
- Centralization requires coins and information to be stored on the exchange, decentralization does not
- Trading happens directly peer-to-peer through a decentralized exchange but must go through an exchange order book with a centralized exchange
- Centralized exchanges take a portion of each trade as a fee, decentralized exchanges have no fees
A centralized exchange offers users a place to store and trade their cryptocurrency. At the same time, these exchanges collect personal information and data that save to the network’s servers. Trading requires the exchange to hold funds in order to make a purchase or sale, giving the exchange control over all assets. Decentralization, on the other hand, allows for exchanges of cryptocurrency with no information or coins held by a third party, giving control back to token holders.
Users who purchase cryptocurrency through a centralized exchange store and trade directly on the exchange itself. Because the exchange is facilitating the order it takes a fee for its services. Decentralized exchanges create a market in which users trade on a peer-to-peer basis without any third party involvement. A centralized exchange uses an order book to immediately settle and execute trades. However, without a centralized order book, decentralized exchanges have found new ways of completing transactions in a secure way.
How is trade secured by a decentralized exchange?
The process of securing transactions on a decentralized exchange is more complex than with centralization. Decentralized exchanges use a variety of alternative methods which allow for transactions without users giving up control of their assets.
- Multi-signature escrow account
- market-pegged assets
- “Atomic swaps” is currently in development
Multi-signature escrow account
One way to secure trades in a decentralized marketplace is through the use of a multi-signature escrow account. This is done by creating a new account to store cryptocurrency involved in a trade and is accessed when both the buyer and seller sign-off on completing the transaction. This “signature” is time-stamped and recorded on the blockchain so that it is never altered or changed.
The second method to secure a transaction is using market-pegged assets. A market-pegged asset is a newly created currency that has its value tied to an already existing asset, making its price stable and predictable. In the case of cryptocurrency markets, this generally comes in the form of proxy tokens. Proxy tokens represent the value of a crypto-asset or fiat currency but are used in place of tokens on the market.
Development of the third type of exchange, called “atomic swaps” is currently in development. An atomic swap is a smart contract that allows two parties to swap cryptocurrencies without intervention from another party using built-in security measures that assure a successful trade. To complete the trade users enter a cryptographic hash to unlock the transaction and release funds. These cross-blockchain exchanges could serve as the real future of blockchain trading.
Additional forms of security include reputation systems for arbitrators to moderate exchange disputes, keeping them honest. Additionally, some exchanges require deposits in order to place orders, which puts a financial incentive on users to not commit any type of fraud. Other services offer in-person meetups to trade cryptocurrency face-to-face.
What are the benefits?
Decentralization works the same for an exchange as it does for the blockchain in general. The storage of information is anonymous and users can control their own funds. With no outside party handling trading, there is nowhere for hackers to steal account information. The same goes for disruption to the system and server downtime.
Users control their own funds in a decentralized market, not handing the keys over to anyone exchange which could cause a loss of coins or wallet information. This makes it nearly impossible to have coins stolen or destroyed on the exchange itself.
Centralized exchanges can be shut down by local governments who freeze funds and/or gather user information. This was clearly seen in the case of China’s cryptocurrency exchanges. Decentralized exchanges do not run this risk, as their operations span outside of any one central government. This also applies to user privacy, which governments can breach on central exchanges with a simple request of information.
In summary, the benefits of decentralized exchanges are:
- User anonymity
- Users control their own funds
- Lower risk of hacking and stolen funds
- No government intervention
Many decentralized marketplaces have already gained traction and adoption amongst crypto-traders. Here are a few notable decentralized exchanges to date:
Previously known as Bitsquare, the exchange uses multi-signature escrow accounts and off-channel payments for transactions. Users can enter into arbitration to dispute any misbehavior. Not only is sign-up not required, Bisq uses the anonymous web software Tor to hide all user information.
Built on top of the Bitshares platform, with no registration required, giving users the ability to begin trading in minutes. The exchange uses market-pegged assets tied to fiat currency prices (i.e. BitUSD, BitEUR, BitGOLD, etc.).
The quickest way to trade from one cryptocurrency to another without giving any personal or wallet information. The exchange conducts over $10 million in transactions daily. Read our Shapeshift review.
Designed as an ecosystem unto itself, the exchange allows any user to create a new cryptocurrency for trading. This is great for new ICO projects. Waves incorporate some elements of centralization, such as using a centralized service to complete trades.
The future of trading?
It is only a matter of time before cryptocurrency users realize centralized exchanges are not the best place to conduct transactions. Centralization has created the problems they have been trying to rid themselves of by using cryptocurrency to start. If the hacks of exchanges and loss of information in the past have taught the industry one thing, it is the loss of control over assets and personal information can no longer be the norm.
Still, decentralized exchanges have a long way to go in order to become an industry standard. They must become more simple and easy to use for beginner cryptocurrency traders. Governments also have a hard time figuring out how to handle exchanges that don’t track user information or the flow of money. This makes taxation and regulation a nightmare. In the end, it seems as though decentralized exchanges are still in their infancy but have the potential to grow into large players in the cryptocurrency industry.
Store you cryptocurrencies safe. Read more about different safe ways to store cryptocurrencies in our blog post, Store cryptocurrencies safe 2018.