The Importance of Decentralized Exchanges
Why are decentralized exchanges important? and what are we building towards?
Decentralized Exchanges (DEXs) are a trustless solution that allows users to buy and sell cryptocurrency without roping in a third party. DEXs are a key component of an end-to-end decentralized financial ecosystem, which is a significant factor in building a more equitable future for all.
The first DEXs appeared in 2014, but these platforms only became popular as decentralized financial services built on blockchain gained traction, and Automated Market Makers (AMM) technology helped solve the liquidity problems previously faced by DEXs.
Let’s talk about decentralization and why it matters by starting off with an everyday example. For this example, I take inspiration from Punk 6529 on Twitter, who writes about gradual centralization here.
Gradual centralization is occurring in a majority of industries. A few examples include small businesses suppliers to Amazon, Taxi cabs to Uber/Lyft, and local produce stores to large grocery chains.
Let’s look at Taxi cabs:
With cabs, anyone can grab a taxi at any time as long as they have cash. The only way a group or government can stop you from grabbing a cab, is to arrest you — which requires law courts, due process, etc. With Uber, lyft etc — all that is required is a single update in a central database to ‘suspended’ your account status.
Do we think about centralization in Taxi’s? of course not. And is this bad or nefarious in itself? No. But the trendline shows gradual centralization.
Calling a taxi is globally centralizing into <5 spheres. Now today, this is not an issue. You can still call a Taxi, and Uber won’t suspend your account (unless provided a reason to).
This is an example of a larger trend of centralization. Applying this trend to other spheres highlights the importance and need for transparency, on-chain data, and decentralization that’s provided by Web3.
How does this apply to exchanges?
Almost 96% of trading volume is currently conducted on centralized databases where a single update by a centrally controlled admin can stop you from accessing your funds.
A crypto exchange is a platform that allows crypto investors to buy and sell digital assets. You can trade on both Centralized Exchanges (CEXs) and (DEXs). When you trade on a CEX, you need to rely on a centralized third party to hold your deposits in a custodial wallet. That means the exchange holds your private keys and crypto assets. In potential events of liquidity or solvency crises, the exchange may pause withdrawals and prevent you from taking control of your assets.
A centralized exchange also requires traders to submit their personal information for verification before transacting. Even trading organizations must submit their corporate details for verification before they start using the provided trading platform and tools.
This is what we are used to in Web2 and requires significant trust in centralized entities and gatekeepers. But as we have seen with events like the FTX collapse, there are sometimes malfunctioning guardrails to prevent misuse of customers' data and funds.
A decentralized crypto exchange is a platform that allows crypto traders to buy and sell digital assets like cryptocurrencies without intermediaries, meaning traders do not have to deposit their funds into a third-party account when transacting. DEXes are self-custodial and permissionless.
DEXs allow users to hold their private keys, and assets and trade against other parties through verifiable smart contracts.
A future where trading, swapping, and exchanging are decentralized is a key component to building an end-to-end decentralized financial ecosystem.
A transition from centralized exchanges won’t be easy, but here’s what’s needed:
Decentralized Exchanges need to provide the following
- Central Limit Order Book Experience — To bring institutions and professionals to decentralized exchanges, DEXs must offer the order book experience that users are used to and optimized for.
- Non-custodial — DEXs must decentralize as much as possible, but primarily the custody of assets.
- Public, not Private blockchains — True decentralization means that DEXs are not running on a separate private chain but a public ecosystem where users can get all the benefits of composability. With composability in ecosystems like Arbitrum, DEXs can become a key part of an end-to-end decentralized financial ecosystem.
Looking Forward
Prior to the creation of Ethereum, traders were forced to use a centralized system to exchange and trade any asset. Smart contracts have opened the doors to a trustless and completely open financial system that, if used correctly, has the chance to bring economic benefits to all participants.
Pratyush from Susa Ventures noted, “In general, exchanges have been the application with the biggest winners in crypto so far and may continue to be a ripe opportunity for investment.”
DEXs are a key component of an end-to-end decentralized financial ecosystem, which is a significant factor in building a more equitable future for all. It will be exciting to continue to track innovation and updates in the space.
