DeFi Part 3: Deep Dive into Decentralized Exchanges

In Part 2 of this series, we gave you a quick overview of the various decentralized finance applications. Moving forward, we’re going to do a deep dive into each of the individual DeFi application categories to give you a deeper understanding of it. 

For this installment, we’re going to do a deep dive into decentralized exchanges, see what makes them special, how they hold up against centralized exchanges, and when to use them. 

So without any further ado, let’s jump in. 

Table of Content

  • Understanding the Inner Workings of Decentralized Exchanges
    • Pros of Decentralized Exchanges
    • Cons of Decentralized Exchanges
  • Centralized vs Decentralized Exchanges
  • Which Type of Cryptocurrency Exchange Should You Use?
  • Key Takeaways

Understanding the Inner Workings of Decentralized Exchanges

As we established in the previous installment, decentralized exchanges are a combination of money exchangers, banks, and financial institutions—all packed into a single, decentralized application. 

What that means is that all the daily operations are executed by smart contracts (blockchain code) without any human intervention. This autonomous mode of operations is what makes decentralized exchanges so powerful. 

To get a more nuanced understanding, let’s consider the pros and cons of decentralized exchanges.

Pros of Decentralized Exchanges

  • Lightning Fast Transactions: All orders are fulfilled in a matter of seconds. Without any regulatory requirements, these platforms can execute sophisticated financial functions within the blink of an eye. 
  • Minimal Transaction Fees: The lack of human intervention means these platforms don’t have hefty payrolls to take care of. Legal bills are another expense they don’t have to deal with. Given how easy it is to start an exchange (you don’t need any license), these platforms operate on razor-sharp margins. Their goal is to pass all the savings on to end customers like yourself so they can remain competitive. 
  • Abundant Supply of Projects: Anyone can create and put a crypto token on a decentralized exchange. These platforms don’t discriminate against small creators. However, this also means that you’re a lot more likely to face unscrupulous characters as anyone can list their project. The key is to do your due diligence before investing in anything. We’ll cover how to do that in a future installment. 
  • Extremely Secure: The lack of centralized power means that everything is managed through blockchain. Since there is no central server to attack, it’s nearly impossible to hack into DEXes. There’s still a small chance of failure as developers can make mistakes. But as long as the setup is done correctly, DEXes will be impenetrable. 
  • User-Controlled: On a decentralized exchange, you get full ownership of all your assets. The platform cannot limit or restrict your access in any way. This is in stark contrast to centralized exchanges, which often block users and freeze their assets on the slightest of suspicions. 

Cons of Decentralized Exchanges

  • No Support for Fiat: You can’t buy cryptocurrencies on a decentralized exchange using your credit card or bank account. These platforms deal exclusively in cryptocurrencies only. That’s how they can sidestep legal requirements that centralized platforms must deal with. In other words, you’ll likely have to buy cryptocurrencies through a centralized exchange like Coinbase and then use that to participate in decentralized exchanges. 
  • Limited Liquidity: Decentralized exchanges rely on the community to maintain liquidity. So if you wanted to buy bitcoin by selling your ether, someone else must be willing to sell bitcoin in exchange for ether. So the more liquid a market is, the more likely you are to make a successful exchange. While most popular cryptocurrencies have more than enough liquidity, smaller projects sometimes don’t. 
  • No Consumer Protections: The lack of regulation is a dual-edged sword. Where it brings all the benefits we covered previously, it also adds another layer of risk as there are no consumer protections whatsoever. However, most of the risks can be mitigated by using the most reputable DEXes only. 

Centralized vs Decentralized Exchanges: A Real-World Comparison

Coinbase is the biggest centralized cryptocurrency exchange within the U.S. It’s fully regulated and listed on NASDAQ, which in of itself proves its legitimacy and trustworthiness as an organization. As a result, institutional investors prefer Coinbase, which shows through in their trading volume of over $3 billion per day. 

Uniswap, on the other hand, is arguably the biggest decentralized exchange out there. This platform is so wildly successful that it processes over $1 billion in daily trades. 

Now that you have a brief introduction to both of these platforms, let’s put them head-to-head across a variety of categories to get a more nuanced picture of what each represents. 

  • Transaction Costs: Due to its massive overhead in terms of payroll costs and legal bills, Coinbase charges 0.5% in transaction fees per trade. Whereas Uniswap charges 0.05% for stablecoins and 0.3% for standard trades. Interestingly, Uniswap passes virtually all the collected transaction fees to liquidity providers. 
  • Privacy and Control: The internet is flooded with horror stories about the KYC requirements of Coinbase. They flag some users as high risk and ask for surprisingly invasive documents. Users who fail to satisfy their verification agents end up with their assets frozen for months. With Uniswap, however, there are no verifications or restrictions. 
  • Variety of Cryptocurrencies: Coinbase maintains a curated list of vetted projects only. Whereas Uniswap lets anyone list a crypto token. There’s no clear winner here as the wild levels of profits and losses both come from newer projects.
  • Operational Costs: In 2021, Coinbase crossed $1 billion in trading volume with a team of 1,249 employees. Uniswap, on the other hand, processed $800 million daily transactions in the same period—but they did with just 38 employees. This is the power of decentralization and why many brilliant minds keep raving about the unbounded potential of this technology. 

Which Type of Cryptocurrency Exchange Should You Use?

If you’re only starting out, you should consider going with a centralized exchange. Doing so will allow you to purchase your first cryptocurrency with your credit card or bank account. 

Once you’re more experienced and ready to delve deeper into the Wild West that decentralized finance is, you can take your assets and move to a decentralized exchange. 

Key Takeaways

Here are the key takeaways from today’s article: 

  • Decentralized exchanges are faster, cheaper, private, secure, and community-centric. Whereas centralized exchanges are regulated and support fiat currencies.
  • For newcomers to the world of decentralized finance, it’s generally a good idea to start with a regulated centralized exchange.

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