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Decentralized Exchanges: Is It Safe to Use?

Dec 15, 22  |  Bakhtain Afzal

The advent of decentralized exchanges has upended many long-held norms in the crypto industry. Since the inception of decentralized exchanges, cryptocurrency owners have had greater freedom and control over their holdings. Despite these benefits, the increasing popularity of DEXs has led to a sharp increase in focus on their potential risks. 

Hearings on GameStop's trading volatility illustrate skepticism about the widespread use of decentralized exchanges or DEX. 

Before you start with using a decentralized exchange, here's what you need to know about decentralized exchanges and if they're safe to use.

What Are Decentralized Exchanges?

Decentralized exchanges provide a safe online marketplace where customers can buy cryptocurrency directly from one another via Peer-to-Peer (P2P) crypto transactions. When compared to traditional, they are more conventionally centralized cryptocurrency exchanges. You'll notice a significant divergence where a trusted third party was responsible for protecting users' funds.

For the centralized exchanges, third-party firms oversee security and asset transfer between users. It's understandable to consider the potential downsides of decentralized exchanges, even though they initially appear to be a more attractive option than centralized exchanges. While decentralized exchanges have the potential to improve upon the flaws of existing financial systems, they come with their own set of drawbacks.

How Do Decentralized Exchanges Work?

Decentralized exchanges are defined in a way that reveals a lot about their operation. DEXs differentiate themselves from centralized cryptocurrency exchanges by integrating blockchain functionality through intelligent contracts. Blockchain networks, which play a significant part in explaining how decentralized exchange works for cryptocurrencies, are used to construct decentralized exchanges. 

Users can maintain custody of their money through blockchain networks' smart contracts. By considering the various varieties, you can form a more accurate image of the answers to the question, "how do decentralized exchanges work?" 

You can clearly understand how do decentralized exchanges work once you thoroughly understand the three primary sorts of DEXs.


What Are the Types of Decentralized Exchanges?

There are mainly three types of decentralized exchanges. The list includes DEX aggregators, order books DEXs and automated market makers, commonly known as AMM. These different types of decentralized exchanges allow direct trade between the users via a smart contract. The three types of decentralized exchanges are discussed further in this article.

DEX Agreggators

They function as trading protocols that source and route liquidity across various DEXs by predetermined parameters. DEX aggregators are, therefore, not required to service traders solely from their liquidity pools. DEX aggregators are crucial in providing effective methods for bitcoin trading.

A few examples of DEX aggregators are Slingshot, 1inch, and Ox or Matcha.

Order Books DEXs

The order book paradigm is one of the oldest methods used in creating decentralized exchanges (DEXs). All open orders for buying and selling specific pairings of assets are recorded in order books. The purchase orders signify a trader's desire to acquire or make an offer to buy an asset at a particular price. On the other hand, sell orders indicate that a trader is ready to part ways with the purchase at a specified price. The difference in prices determines the depth of the order book and the asset's market price.

There are two types of Order Books DEXs; on-chain and off-chain order books. On-chain order book DEXs are those DEXs that keep track of their open orders on the chain. Using money from lenders on their platform, on-chain order book DEXs may assist traders in leveraging their positions.

However, the order books of the blockchain networks are kept on off-chain order books DEX or decentralized exchange platforms. The value of centralized cryptocurrency exchanges is provided by the off-chain order book DEXs, which only allows transaction settlement on the blockchain.

The potential for liquidity problems on an order book decentralized exchange, or DEX platform, is another significant factor to consider. In essence, order book DEXs compete with centralized exchanges and charge more for on-chain transactions. Off-chain order book DEXs, however, can save costs despite the dangers associated with smart contracts.

Today's prominent order book DEXs include IDEX, Loopring, and Gnosis Protocol.

Automated Market Makers (AMM) 

So, what is AMM? The Automated Market Maker system effectively uses smart contracts to solve DEX liquidity issues. AMMs use blockchain-based services to collect data from exchanges and other platforms when setting the price of traded assets.

In this context, blockchain oracles are blockchain-based services. The smart contracts in AMM-based decentralized exchanges use DEX liquidity pools instead of matching the buy-and-sell orders. The DEX liquidity pools, essentially pre-funded pools of assets, are vital to AMM-based DEXs.

Users who contribute money to the DEX liquidity pools are compensated with transaction fees allotted for trading on the relevant pair. Such users, sometimes called liquidity providers, are required to deposit the equivalent value of each asset in a trading pair to employ liquidity mining to generate interest on their crypto assets.

Order execution by traders is made possible by liquidity pools in decentralized exchange developments based on AMM. And rankings for AMM-based DEXs are often determined by the total amount of money tied up in those contracts.

A severe drawback to AMM-based DEXs is slippage resulting from a lack of liquidity. Slippage is apparent when the buyer pays more than the market price for their orders due to a lack of DEX liquidity. Furthermore, larger orders are more likely to experience increased slippage under such circumstances. And, due to the volatility of one asset in trading pairs, liquidity providers may also be exposed to the risk of temporary loss.

AMM DEXs have unique applications, such as Bancor, Balancer, Sushi, Curve, and Uniswap.

What Are Risks Associated With DEXs?

To better understand the practical consequences of decentralized exchanges, it's essential to have a brief understanding of the vulnerabilities of DEXs. The major DEX risks that you should be aware of are listed below. 

Liquidity Risks

For all financial instruments and assets traded on a specific exchange, liquidity is significant. 

The average trading volume on DEXs is a significant element causing liquidity issues on decentralized exchanges. The average trading volume still represents a minor portion of trading volume on controlled exchanges. Due to DEXs' recent development, the trading volume on regulated exchanges is larger. However, the crypto economy as a whole has yet to grow in size to support increased trade volume on DEXs.

Scalability 

Due to scalability limitations, decentralized exchanges, or DEXs, commonly encounter network congestion problems. Decentralized exchanges are built on blockchain networks like Ethereum. Therefore the scalability problems with Ethereum apply equally well to them.

DEXs still adhere to the first-layer network transaction restrictions, which results in scalability inconsistencies. And, with an expanding trading volume and no scaling solutions, DEXs cannot be relied upon for widespread use.

Security Risks

Enabling users to control their private keys enhances security in distributed networks. This is only sometimes the case, especially if the DEX platform is not thoroughly audited. As decentralized networks are not insured, DEX money is wholly lost and nonrefundable in theft situations.

Is Trading on DEX Safe?

One of the primary motivations for adopting a Decentralized Exchange is security, which is of much greater importance in the crypto sphere. Non-custodial wallets, like MetaMask, are a fancy way to express that the wallet's owner solely has access to the cryptocurrency non-custodial wallets link to DEXs.

The saying "not your keys, not your coins" refers to the fact that wallets like this provide users "keys" that only they can access. Custodial wallets are where cryptocurrency on controlled exchanges is kept.

Additionally, since wallets are never really held on decentralized exchanges—only connected—the user has access to their bitcoin. With the DEX only serving as an interface for money transfers. As a result, since your coin was never kept on a DEX in the first place, it cannot be "hacked" from a DEX.

What Is a Decentralized Wallet?

Let's get to the meaning of a decentralized wallet. You're mistaken if you assume a bitcoin wallet looks like a conventional leather wallet. To make a digital coin wallet easier to grasp for the average individual, comparisons to a traditional wallet are acceptable. However, a bitcoin wallet is not a place where you can keep actual money. Only system software allows you to access your records (and crypto assets) on a digital ledger or a decentralized trading platform  by storing your public and private keys.

Considering the decentralized wallet meaning, a decentralized wallet allows the owner of the keys access to the cryptocurrency wallet. The owner may use the keys to transfer or receive bitcoin from anywhere.

How to Create a Decentralized Cryptocurrency Exchange?

Now that you know about a decentralized wallet meaning, le's move towards creating a decentralized cryptocurrency exchange. You can begin creating your cryptocurrency exchange after figuring out the commercial aspect, the technological needs, and the sort of exchange. Ensure the development team you work with has a track record of success and can offer you successful case studies. Choosing a seasoned provider might assist you in reducing your development costs. 

The following steps are typically involved in the development of a decentralized exchange platform:

UI/UX Design 

According to the market research and needs, create a clear, perceptive, and smooth user interface (UI).

Development

An application of user interface (UI) design is the front end. The developers are now creating a user-visible side of your exchange. The front end is in charge of your platform's appearance and feel, which is crucial for attracting and keeping users' attention.

The inner portion controls your platform's logic and all essential activities. The result of a conventional trading exchange optimized for the region of the exchange registration can be used by the development team. Then, this framework is adjusted to meet your needs, and a unique trading engine is developed. The business can also utilize a variety of APIs to further integrate with resources from third parties.

Security Functions

Experts incorporate several security functions at this development stage to ensure the platform is dependable for both you and future users. A password-protected user interface and an encrypted database are essential security features.

Add Digital Currency to Exchange

The development team adds the required coins to the platform after deciding which cryptocurrencies to put on the exchange. After that, users can purchase and trade various kinds of cryptocurrencies.

Launch DEX

Your bitcoin trading platform is ready to use following all the testing and modifications. Although there is a lot of advertising and support work, a high-quality software product will make these tasks much more straightforward.

We encourage you to spend enough time picking the correct blockchain development partner because of how heavily dependent blockchain technology and cryptocurrency trading are on the calibre of software development.

FAQs 

What Is a Decentralized Market?

Digital technology in a decentralized market enables buyers and sellers of securities to transact directly rather than at a traditional exchange. Real estate is a typical instance of a decentralized market, as buyers and sellers engage directly in this industry.

How Do Crypto Exchanges Make Money?

Centralized cryptocurrency exchanges serve as a middleman between buyers and sellers and generate revenue through commissions and transaction fees. You may think of a CEX as a stock exchange for digital assets. Binance, Coinbase Exchange, Kraken, and KuCoin are well-known cryptocurrency exchanges.

What Is Decentralization in Cryptocurrency?

Decentralization in the context of blockchain describes the transfer of power and decision-making from a centralized entity (an individual, an organization, or a collection of such entities) to a dispersed network.

Final Note

The first decentralized exchanges appeared in 2014, and as DeFi has grown in popularity, they have attracted attention. The power of the Automated Market Maker technology has allowed DEXs to advance past their typical order book model limitations. Decentralized cryptocurrency exchanges, on the other hand, have established themselves as essential venues for users to lend money to leverage their positions or provide liquidity to earn trading commissions.

By putting their cryptocurrency assets in liquidity pools, DEXs have also made it possible for customers to profit passively from their crypto investments. Instead, there are still potential hazards associated with implementing smart contracts in DEXs. 

Find the finest options by learning more about decentralized cryptocurrency exchanges.


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