What Is a Decentralized Exchange and How Does It Work?

While decentralized exchanges (DEXs) only played a minor role in the crypto industry a year ago, their volumes exponentially increased over the past few months.

From January’s $280 million, the monthly volume of decentralized exchanges surged to nearly $22 billion in September, representing a Year to Date (YTD) increase of over 7,700%.

In addition to occasionally surpassing leading centralized exchanges, DEXs are continuously growing their market share. According to a recent report, the spot trading volumes’ ratio on DEXs compared to centralized exchanges reached 6.06% in August after hitting 3.95% in July.

Based on the above data, DEXs can soon become worthy competitors to centralized exchanges that have been ruling the crypto trading space for a very long time.

But what is the reason behind the rise of decentralized exchanges?

We will find out in this article along with all the essentials about DEXs.

What Is a Decentralized Exchange (DEX)?

A decentralized exchange or DEX is a peer-to-peer (P2P) cryptocurrency service that directly connects buyers with sellers.

As the connection between the parties is direct, there are no middlemen involved in the process. Due to the lack of third parties, DEXs often feature lower fees than centralized crypto exchanges.

One of the most important features of decentralized exchanges is that they take no custody of customer funds.

Contrary to their centralized counterparts, you are in control of your private keys on DEXs. This means that, upon a successful hacker attack against the exchange, malicious parties won’t be able to steal your digital assets via the data they acquired from the service provider’s servers (as your wallet credentials are not stored there).

Also, while centralized exchanges require their users to create an account, submit Know Your Customer (KYC) and Anti Money-Laundering (AML) documents, most DEXs allow their customers to remain (semi-) anonymous while trading cryptocurrency.

Despite what their name suggests, aspects of the DEX solution are only partly decentralized. Such services often include centralized elements, such as order books, central servers to host the platform, and mandatory KYC checks.

Although, some DEXs maintain a high decentralization level with blockchain-based trading services supported by cryptocurrency miners. And, as web-based services could come with increased levels of centralization, some exchange solutions create their own decentralized applications (DApps) for trading.

Still, no matter how decentralized they are, a DEX never controls the users’ private keys or funds.

How Do Decentralized Exchanges Work?

How decentralized exchanges work depends on the solution you use for cryptocurrency trading.

Many DEXs do not support fiat currencies, allowing only crypto-to-crypto trades on their platforms. Due to the lack of national currencies, most decentralized exchanges don’t have to comply with regulations, which allows the solutions to offer services without KYC checks.

Smart Contracts and Trading Accounts

On a decentralized exchange, trading is either fully automated or semi-automated via smart contracts.

Simply put, a smart contract is a computer code that executes a digital agreement between two or more parties automatically if its conditions are fulfilled.

To start trading, users have to either connect their (external) wallets or create a new account (verification is needed for regulated services) to deposit cryptocurrency.

Market Makers and Takers

Most trading platforms include market makers and market takers.

While makers create buy or sell orders that aren’t fulfilled immediately (e.g., they only sell BTC when the Bitcoin price reaches $20,000), takers execute their orders instantly (e.g., they sell their BTC at the current price). Market makers create liquidity, and their orders are filled by takers.

When a market maker creates a new order for a trading pair on a DEX, a cryptographic hash is generated, which is signed with the market maker’s private key.

The order is either sent to the blockchain or off the chain with the maker’s signature.

When a market taker trades against the maker’s order, both the corresponding order data and the signature is sent to a smart contract.

Upon verifying that the signature originates from the maker, the smart contract ensures that the order is not filled or expired.

If all conditions are met, the smart contract automatically exchanges the funds, takes the trading fees, and transfers the funds to both parties’ wallets.

DEX Withdrawals and Atomic Swaps

After a successful trade, users can withdraw their exchanged funds to external wallets outside the DEX’s platform.

Alternatively, some decentralized exchange solutions (especially in the DeFi space) allow crypto users to utilize their own wallets for trading, without requiring them to deposit or withdraw their funds.

These platforms utilize atomic swaps – an instant cryptocurrency trade without third-party involvement – allowing users to connect their own (external) wallets to the service to create and execute trade orders.

How Did Decentralized Exchanges Become So Popular?

Earlier in this article, we mentioned that decentralized exchanges did not play a significant role in the cryptocurrency industry until the past few months.

But what’s behind the popularity of decentralized exchange services?

Reason 1: Major Issues With Centralized Exchanges

First, centralized cryptocurrency exchanges have earned a rather bad reputation while dominating the digital asset trading industry.

As they control the private keys of their customers, centralized exchanges hold user funds in their custody. Because of this reason, upon a successful attack against their services, hackers can steal the traders’ funds by obtaining their private keys.

As a result, there have been many high-profile cryptocurrency exchange hacks with devastating consequences since the industry’s inception. For example, the infamous $460 million Mt.Gox hack shook the crypto industry so much that the BTC price decreased by 45% between February 1 and March 31, 2014.

And attacks are not the only way centralized cryptocurrency exchanges have lost their customers’ funds in the past. In December 2019, the Canadian digital asset exchange, QuadrigaCX, allegedly lost $190 million from cold wallets that only the company’s deceased CEO had access to.

Whether the business’ claims were valid, we don’t know. However, centralized exchanges have long struggled with fraud, wash-trading, weak security, improper customer fund management, and a lack of transparency.

While many centralized providers have made major changes to their services to feature a regulated solution with moderate to high levels of transparency and decent security, their past mistakes have led to the rise of decentralized exchanges.

Despite that DEXs are not hack-proof – as attackers can still exploit flaws in smart contracts – their decentralized infrastructure eliminates single points of failure as well as limits the risks of user funds loss and fraud.

In addition to a higher security level, decentralized exchanges also feature increased privacy, transparency, and interoperability with other blockchain-based applications.

Reason 2: The DeFi Boom

The second reason why DEXs have become so popular is due to the rise of the decentralized finance (DeFi) space.

DeFi refers to a movement within the cryptocurrency space where developers build blockchain-based, decentralized alternatives to centralized financial solutions.

From lending and borrowing to insurance and tokenized assets, DeFi solutions eliminate the middlemen and bureaucracy to make finance more accessible, efficient, and democratic for users.

Based on recent stats, the DeFi industry has grown exponentially in the past few months.

Compared to January 1’s $676 million, the total value locked in decentralized finance applications is standing at $10.91 billion at the time of writing this article, representing a YTD surge of over 1,500%.

With DeFi’s growth, there’s a higher demand for DEXs among crypto users, which many creators have integrated with their decentralized finance applications to expand the ecosystem.

Furthermore, next-generation DEXs like UniSwap and Kyber Network allow cryptocurrency enthusiasts to exchange their coins in a few seconds without leaving their wallets while preserving full control over their funds.

What Are the Pros and Cons of Decentralized Exchange Platforms?

Now that you know the basics of decentralized exchanges, let’s see what the pros and cons of DEXs are:ProsConsDue to the lack of custody, users are in full control over their fundsIncreased control comes with greater responsibility since DEXs are not able to restore access to users who have lost or forgot their credentialsUsers possess their private keys, which eliminates the risk of a single point of failureWhile DEXs feature increased security, flaws in smart contracts can still result in loss of user fundsIncreased security and transparencyDEXs often feature lower liquidity than centralized exchanges and have to use DeFi pools to improve their liquidityMost decentralized exchanges are blockchain-based and automate trades via smart contractsA part of DEXs use centralized components for trading and often move transactions off the chainNo need to create an account or submit KYC/AML documents (in most cases)Some decentralized exchange solutions request KYC/AML documents from users as DEXs face increased risks of regulatory crackdownsNo middlemen involved in the processIntegration with other DeFi applications and services

Where to Trade Crypto: The Top 5 Decentralized Exchanges

Decentralized exchanges are on the rise, and they provide several benefits to crypto enthusiasts.

But which DEX should you use for trading?

We will find out in this section where we listed the top 5 decentralized exchanges currently on the cryptocurrency market!

1. ViteX

Launched in 2019, ViteX is a relatively new decentralized exchange on the cryptocurrency market.

However, despite being a new player, ViteX is growing at a fast rate, ranking in the 110th place among the top digital asset exchanges and featuring an over $700,000 24-hour trading volume.

According to its creators, ViteX is a truly decentralized exchange that uses its own high-performance blockchain for order matching, asset management, and cryptocurrency trading.

With every process running and published on the project’s public chain, ViteX seeks to provide a high level of transparency to its users.

ViteX features its own native token, VX, mined exclusively by the decentralized exchange’s community. Users can mine VX in multiple ways, such as staking, trading, referring, and market-making, to earn rewards on the platform.

What’s interesting about ViteX is that the decentralized exchange distributes all trading fees to the community based on the amount of VX each member holds.

ViteX also features a unique role in the community called the operator. Operators can run their own mini decentralized exchanges (called zones) on top of ViteX to set up new trading pairs and earn transaction fees from users who trade in their zones.

For every transaction on the platform, ViteX charges a base fee of 0.2%. However, if a user trades in an operator’s zone, he could pay an up to 0.2% additional fee (0.4% in total with the base fee).

Permission, the next-generation blockchain-based advertising platform, has listed its native ASK coin on the decentralized exchange.

2. Uniswap

Uniswap is an Ethereum-based decentralized liquidity protocol that allows users to swap ERC-20 tokens via its DEX solution.

What’s so special about Uniswap is that it doesn’t require buyers and sellers to create liquidity, eliminating a significant issue decentralized exchanges face.

As part of an open-source solution, Uniswap doesn’t rely on order books or other centralized components to facilitate cryptocurrency trading.

Instead, Uniswap utilizes a model called “Constant Product Market Maker” and operates through smart contracts to create liquidity pools. Users trade against these pools, which are supported by liquidity providers who deposit their tokens in the pool.

In exchange for maintaining liquidity pools with their coins, providers receive a share of trading fees based on the proportion of their tokens in the pool.

As long as there is a liquidity pool for the coin, any ERC-20 token can be listed on Uniswap without permission from the service providers.

To trade on Uniswap, crypto users only need an Ethereum wallet they can connect to the decentralized exchange.

3. Kyber Network

Like Uniswap, Kyber Network is another “DeFi unicorn” that features a decentralized liquidity protocol and allows crypto users to exchange coins instantly via smart contracts.

For instant cryptocurrency swaps, Kyber also utilizes liquidity pools. However, unlike Uniswap, which focuses mainly on end-users, Kyber Network seeks to cater to various participants of the cryptocurrency market.

A typical participant is a cryptocurrency project with a native platform token.

Suppose a user doesn’t hold that specific coin. In that case, he has to register an account at a cryptocurrency exchange, transfer his digital assets there to convert them, and then withdraw the project’s token to his wallet.

It’s a long, tedious process that can discourage some users from utilizing a specific crypto service.

Kyber solves this issue by allowing crypto services to integrate its protocol into their platforms, allowing customers to instantly exchange their coins to the project’s native token.

In addition to supplying projects with liquidity, crypto projects can use Kyber to accept transactions in numerous tokens, but receive the payment in their preferred coin to their wallets.

While Kyber Network supports instant swaps for several tokens, the DeFi solution aggregates liquidity from multiple sources to provide the best rates for traders.

4. Bisq

Bisq is an open-source, decentralized cryptocurrency exchange that features its own DApps (iOS, Android, and desktop) for trading.

Bisq is governed via a decentralized autonomous organization (DAO). This means that the DEX is not maintained by a business but the community itself to achieve a high decentralization level.

An exciting feature of Bisq is that it is built on top of Tor, a highly anonymous network, to make the decentralized exchange truly censorship-resistant and private.

Bisq provides a high level of security and privacy to its users by offering a non-custodial crypto exchange service as well as featuring security deposits, 2-of-2 multisig escrow, and a decentralized human mediation and arbitration system to prevent fraud.

Despite the lack of account creation and KYC/AML checks, Bisq allows users to exchange both crypto and fiat currencies privately.

For this, the DEX uses a similar process as the peer-to-peer exchange Localbitcoins, where traders have to choose between other users’ offers (instead of automatic order matching).

However, while Localbitcoins is a centralized exchange, Bisq operates on a fully decentralized nature, without any central servers to store user data.

5. ShapeShift.io

For users who seek a non-custodial cryptocurrency exchange with fast coin conversions and an easy-to-use interface, ShapeShift is a good choice.

You select the coin you want to purchase, the digital asset to use for the transaction, and the amount of cryptocurrency to buy. ShapeShift then provides you with an address to deposit your crypto.

After you have successfully deposited, the service will automatically convert your coins and send them to your wallet.

While ShapeShift is considered a DEX, it features a lower level of decentralization than the previous services we listed.

Because of this reason, you have to create an account with the service to exchange cryptocurrency and submit KYC documents to verify your identity. As a result, ShapeShift transactions are not as private as with the other DEXs.

Also, ShapeShift holds user data on centralized servers and uses multiple off-chain processes for trading cryptocurrency.

On the other hand, you can take advantage of the DEX’s 24/7 customer support as well as rapid, user-friendly service.

For each transaction, ShapeShift charges a 0.50% spread as well as a miner’s fee. However, you can eliminate most fees if you hold the company’s native FOX token in your wallet.

How to Trade on a Decentralized Exchange?

By now, you know how a DEX works and what the best services are. The next step here is to explore how to trade on a decentralized exchange.

Below, you can find a short but comprehensive step-by-step guide for purchasing on ViteX, one of the top decentralized exchanges on the crypto market.

Step 1: Download the Vite App

To get started with ViteX, you have to create an account with the service (no need to submit KYC documents) or connect a compatible wallet (e.g., Ledger).

While ViteX features both a web platform and native apps (iOS, Android, Windows, Mac), you have to download and install the application on your device to create an account.

To do that, use the following link or click the “Log in” button near the top right corner of the trading platform, and head to “Create an Account.”

On the next page, you can find the QR codes (for mobile) or links (for desktop) to download and install the Vite App.

Step 2: Create a ViteX Account

Once you are done with the installation, it’s time to open the application.

Here, you need to click “Log in” and the “Create an Account” button again. On the next screen, fill out the form with your login credentials (make sure to choose a strong password).

After you are ready, the service will generate you a mnemonic seed, which you can use to restore your ViteX wallet.

Important: Write down (either physically on a paper or in a doc file on your computer) your seed and store it in a safe place you have exclusive access to. Don’t share it with anyone as it could compromise your security and may result in a loss of funds.

When you are ready with your seed phrase backup, click the “Submit” button to proceed.

Step 3: Deposit Funds Into Your Wallet

When your ViteX account is ready, it’s time to deposit funds into your exchange wallet.

To do that, click the wallet icon near the top left corner of the page, select BTC, and click the blue “Deposit” button next to it.

After you click “Confirm and Proceed” on the pop-up, ViteX will display your wallet address. Scan the QR code (for mobile) or copy the address and paste it into the wallet you will use for sending funds.

It’s essential to double-check (or even triple-check) your wallet address to ensure that you are transferring your coins to the correct place.

When you are ready, initiate the transfer, and wait for miners to process your transaction (ViteX BTC deposits need two confirmations). Unless the network is congested, this shouldn’t take longer than an hour or so.

Step 4: Trade Crypto on ViteX

When your Bitcoin has arrived in your ViteX wallet, the next step is to click the trading icon on the top left side of the page and select your preferred coin pair (e.g., ETH/BTC) under the “Exchange” menu.

On the next screen, you will see a chart as well as a form to submit your order to buy the cryptocurrency (ETH in our example) with your BTC.

Specify the price you are willing to pay for each token as well as the total amount of coins to purchase.

When you are ready, click the green “Buy ETH” button to submit your order. ViteX will then match you with a seller, execute your trade, and deposit your newly purchased tokens into your wallet.

Decentralized Exchanges: The Solution to Trade Crypto Without Middlemen

With the rise of the DeFi industry, decentralized exchanges have been increasingly popular in the cryptocurrency space.

Due to their decentralized nature, DEXs provide increased security, transparency, and privacy to users who are looking to find a solution to the common problems of centralized exchanges.

From ViteX to Bisq, it’s not hard to find a decent decentralized exchange solution on today’s crypto market.

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FAQ

Is Coinbase a decentralized exchange?

No, Coinbase is a centralized exchange where the service provider controls the users’ private keys.

Unlike with decentralized exchanges, Coinbase users have to create an account with the service and verify it by submitting different KYC and AML documents. Because of this reason, it is not possible to trade cryptocurrency anonymously (or privately) on Coinbase.

Why is an exchange decentralized?

A cryptocurrency exchange can be decentralized for a wide variety of reasons.

With a decentralized exchange, users have full control over their funds, which decreases the risks of losing funds due to a hacker attack. Also, many DEXs use blockchain technology and smart contracts to automate trading, increase transparency, and provide a high privacy level to their customers.

What is an example of a decentralized exchange?

A good example of a decentralized exchange is ViteX that uses its own blockchain to match buyers with sellers.

Instead of utilizing centralized servers, ViteX is maintained by miners who receive rewards for supporting the DEX’s ecosystem.

While you have to create an account to get started (unless you can connect a compatible wallet), you don’t need to submit KYC or AML documents for verification, allowing ViteX customers to trade cryptocurrency privately.