Decentralized exchanges, part 1. Why does the market need them?

The concept of a “decentralized exchange” could be perceived as an oxymoron by a no-coiner: how can a centralized entity for asset trading become decentralized? Well, everything is possible in the crypto community, and the concept of "decentralization" has a rather narrow meaning: "the performance of functions using a distributed network structure in a mode that eliminates the influence of a person or organization."

Who is annoyed by centralized exchanges

The existence of centralized exchanges has always been a reason for supporters of true blockchain values to turn up their noses. Still, the realities of life have forced many to step over their beliefs: the crypto market needs liquidity, users’ support, and simple services. The exchanges perform these tasks fully. Anyway, there are lots of questions left.

How to make an exchange a decentralized one? Would the final version look like an exchange at all? What are the usual exchange instruments are to be sacrificed in favor of openness, independence and lack of centralized control? Perhaps, we have to sacrifice some part of decentralization for the sake of convenience and popularity?

It is likely that such conversations would have remained a theoretical discourse on a desirable and unattainable ideal for a very long time. However, many incidents with existing crypto exchanges facing regular multi-million leaks of funds caused waves of anger and forced many developers and entrepreneurs to look for alternative options.

Disadvantages of centralized exchanges

Users of centralized exchanges interact with the services of these organizations, entirely controlled by their owners, who can manage their functionality, suspend and re-launch various tools, and also make changes to quotes during trading.

There are lots of assumptions about the biased management of the exchanges, suspicious activity with specific cryptocurrencies, staff involvement in various dishonest schemes, etc. Unfortunately, it is impossible to say that these are baseless, and it is impossible to guarantee that certain excesses will not recur in the future. Centralized exchanges act as operators of personal data, storing information about transactions and private keys, having access to customer accounts — the risk of fraud always exists.

Besides, the principles of operation of centralized exchanges allow the storage of participants' funds. Thus, the service that stores these funds is a tempting target for hackers. Hacking allows you to gain access to large amounts, which means that it’s economically justified and will happen sooner or later.

How decentralized exchanges eliminate these disadvantages

Decentralization is the solution offered by blockchain. The use of a distributed ledger is not an unconditional solution to problems, but it all depends on the implementation. The opportunity is out there. Conducting operations with the use of the blockchain and smart contracts allow to customize this interaction with bidders and doesn’t require the storage of their private keys and other data.

Distributed data storage doesn’t jeopardize the whole exchange in case of hacking one of the participants. The absence of a central body (organization, group of persons or person managing the exchange) allows avoiding unfair influence on the course of trading. When a client of the exchange doesn’t transfer his or her funds to the wallet on the exchange but sends the funds directly — there is no sense to hack the exchange to get money.

Are decentralized exchanges flawless?

There is no such thing as perfection, and the benefits of exchanges without centralization come side by side with their shortcomings. Like operations in the blockchain require some time for transactions to be recorded in blocks and confirmed by the network.

Problems with scalability are not uncommon: an inflow of a large number of people in cryptocurrency transaction will inevitably cause loads on the network resulting in delays, increased commission fees and other problems which occurred in the past.

Also, the immutability of the blockchain as one of the fundamental principles leads to the fact that the committed transactions cannot be canceled: the refund is incompatible with a distributed ledger. Users who have committed an operation by mistake or have lost control over their keys will not be able to recover the lost funds. It still is an essential question of whether mass consumers are ready for such responsibility. The technical complexity of operations with blockchain tools for unprepared participants is another factor that is difficult to attribute to the advantages of decentralized exchanges.

KYC and AML are controversial. The large and considerable projects of the blockchain world are rushing into the arms of regulators, unconditionally accepting their game conditions. To obtain legal status and thereby open its doors to participants with large capitals, the exchange introduces identity verification procedures and detailed types of reporting. However, decentralization is a step in the opposite direction. It seems that in this matter there would be more difficulties with the massive introduction of decentralized exchanges.

A little of decentralization

The solution could be a semi-decentralization — if this term makes sense at all. In order to offer customers a familiar service and increase security, the exchange's functionality is partially transferred to the blockchain. Smart contracts are the main tools through which trading can commence; decentralized applications and protocols operate the exchanges, but they are managed centrally as the services are based on central servers.

We have considered the basic principles, advantages, and disadvantages of decentralized exchanges. We will discuss projects that work on decentralized principles in the following article.

Image courtesy of Coincentral