Decentralised exchanges, or DEXs, provide investors with an alternative to centralised exchanges. Because DEXs do not harness a third party to hold or "custody" customer funds, they are not vulnerable to hacks in the same way as their centralised counterparts. However, these exchanges are not without their weaknesses, as they can suffer from problems such as low liquidity.
Decentralised exchanges allow peer-to-peer transactions, which make it so that users can make exchanges without having to rely on a third party. These trades are set up using an automated process.
These exchanges have a handful of key characteristics. For starters, they are "trustless" because individual users are holding their funds in a wallet instead of leaving it in the care of a third party or custodian.
Benefits Of Decentralised Exchanges
The trustless nature of DEXs is a significant draw for investors because many digital currency exchanges have suffered hacks. Nefarious parties stole more than US$800 million from these exchanges in 2018. Certain high-profile hacks have generated significant visibility:
- Bitfinex, a Hong Kong-based exchange, lost nearly 120,000 bitcoins when it was hacked in 2016. At the time, that amount of Bitcoin had a market value of roughly USD$72 million.
- Mt. Gox, an exchange located in Tokyo, lost 850,000 bitcoins in early 2014. At the time, that amount was worth close to US$450 million. In February of that year, the exchange filed for bankruptcy.
Another benefit of DEXs is that their hosting is decentralised, which helps eliminate a single point of failure that could otherwise prevent the network from running continuously. These exchanges use the various nodes involved to host the network, as opposed to leveraging one or more servers.
Another benefit of decentralised exchanges is that they provide greater privacy than centralized ones. When making transactions through these entities, users are not required to reveal personal information unless a bank transfer is involved. In cases like that, users only need to disclose that information to the other person involved in the exchange.
Centralised exchanges provide a stark contrast, as going through the validation process requires providing significant amounts of personal information. By concentrating this key information in one place, centralised exchanges are providing significant incentive for hackers, who could potentially gain access to this information and then use it for nefarious ends.
Drawbacks Of Decentralised Exchanges
While DEXs have their benefits, the are not without their weak points.
These exchanges suffer from low liquidity, which results from them not having a significant user base. This low liquidity results in slippage, which takes place when a trader's order gets executed at a price different from the expected price.
Another major problem is the front-running that takes place at decentralised exchanges. Front-running amounts to using non-public (insider) information on transactions to execute trades. This comes in different forms, but in DEXs, market participants are leveraging algorithmic trading programs or "bots" to engage in this activity, according to an academic paper produced by researchers at Cornell Tech and other institutions.
Harnessing these programs, market participants are paying higher transaction fees and leveraging the latency or slowness of DEXs to engage in front-running.
Decentralised exchanges or DEXs allow users to make peer-to-peer transactions, eliminating the need to rely on a third party to custody exchange funds. A DEX doesn't concentrate the information and funds of their users in one place, so it doesn't provide a single point of vulnerability that hackers can then exploit.
Exchanges of this type also offer users greater privacy than their centralised counterparts because they don't obligate their users to provide significant amounts of personal information. This eliminates the incentive that centralised exchanges give hackers to gain the personal data of users.
While DEXs have their strengths, they also have their weaknesses, as these exchanges have frequently suffered from problems like low liquidity and high latency.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…