As the focus moves to more freedom of operations, the decentralized exchange can transform the cryptocurrency industry. Despite the advancement in technology and the emergence of financial markets, there remains a significant chunk of the world’s population without access to a direct credit source. Hence, decentralized exchange poses as a vital alternative to democratize the access to quality financial services at an affordable cost.
How does a Decentralized Exchange work?
It allows participants in a market to directly deal in cryptocurrencies with each other without the interference of a central authority. It promotes a peer-to-peer mechanism. Hence, it has immense potential to change the functioning of the current financial system. All processes are handled by a smart contract, which is a self-executing program.
What are the key differences between a Centralized and Decentralized Exchange?
Centralized exchanges allow the buying, selling, and exchange of cryptocurrencies between participants on a trading platform, but owners maintain control of transactions and act as a custodian for the funds. They have the authority to allow, pause, and block any transaction. They have the power not to provide private keys for users to access their wallets.
Since they place a lot of coins of traders on a single server located in a few locations, they run the risk of being hacked. Once there is a breach in the system, the traders will not be compensated as cryptocurrency is still largely unregulated. Instead, the platform will declare itself as bankrupt, leading to huge losses for the users.
This is where decentralized exchanges step in to prevent a single point of failure. The core functions of accepting deposits, matching orders, and asset management are decentralized. Hence users have more control over their funds.
A step-by-step explanation of the operations of a Decentralized Exchange
- A user can use his wallet address for registering himself on a decentralized exchange without following the cumbersome sign-up process.
- An order can be placed by choosing any available cryptocurrency, the kind of asset to exchange for, the number of units to buy or sell, the minimum value needed, and the time till bidding for the assets is permitted.
- Once the parameters are set, the request becomes public and other users can start submitting their respective bids.
- The system automatically identifies the best offer after reviewing all the proposals.
Reasons why Decentralized Exchange holds a lot of promise
- Lack of intermediaries - By cutting out the role of a middleman, it helps in improving the efficiency of the entire trading process and decreases the overall costs involved. In the absence of a central authority, the participants have all the freedom to manage the cryptocurrencies on their own.
- Offer top-notch security - Centralized exchanges are often affected by security breaches through hacks. Decentralized exchanges are protected from a single point of failure. Hence hacking attempts are prevented as there is no way for intruders to access the tokens. However, they are not 100% foolproof. Smart contracts that play a pivotal role in executing the daily operations smoothly can suffer from some vulnerabilities such as underflows, overflows, and reentrancy attacks. Even traders would lose money if they buy an asset at a higher price or sell an asset at a lower price. Despite some limitations, Decentralized exchanges are safe for exchanging digital currencies, and hence it has a strong role to play in the operations of future applications.
- Provide a better user experience - Faster and cheaper transactions are facilitated for users when compared to a centralized exchange. This is due to the absence of a third-party authority, which would slow down the network and take time to authorize every transaction. Since there is no formal sign-up process to onboard every new user, it is very convenient as wallet nodes have to be connected to begin trading.
Disadvantages of Decentralized Exchanges
- Lack of system functionality - Most of the decentralized exchanges support only basic market functions. Value-adding features, such as margin trading and stop-loss, are not available. While it works for a small user base, no decentralized exchange is functioning for a vast audience. Hence it has issues related to speed and liquidity.
- Absence of fiat exchanges - Decentralized exchanges face issues in the acceptance of fiat currency. In the absence of a proper framework for fulfilling the guidelines related to KYC (Know Your Customer) and AML (Anti Money Laundering). It will become a big problem for traders who possess only fiat currencies. However, its inclusion would mean more control by authorities, which leads to centralization and compromise in decentralization’s fundamental identity.
Why Decentralized exchange development could shape the future of the financial world?
Though it caters to a small set of users now, decentralized exchanges need to improve their scalability, liquidity, and functionality for mass adoption. However, massive strides are made with each passing day. The advantages of decentralized exchanges outweigh its limitations. The possibility of allowing users to manage their assets through a peer-to-peer mechanism is a viable idea.
Decentralized exchanges need to be applied more in the outside world in real-life use cases to have a more significant impact in the cryptocurrency industry. As blockchain technology continues to garner a higher level of interest from users, holders of digital assets would prefer using decentralized exchanges to have more control and security in their engagement with exchanges. This will lead to decentralized exchange development, having a profound impact on the world’s financial system.
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