What is Decentralized Exchange?

Maciej Zieliński

25 Sep 2021
What is Decentralized Exchange?

DEX is far more than just another DeFi trend in the game. Decentralized exchanges allow crypto traders to swap tokens in a peer-to-peer model. Direct transactions between parties, no need to sign in - these are just some of their advantages over centralized exchanges.

In this article, you will find:

  • How does decentralized exchange work?
  • Decentralized exchange vs centralized exchange 
  • Pros and cons of decentralized exchanges
  • What do DEXs mean for the world of decentralized finance?

Definition: 

Decentralized exchange, also known as DEX, is a platform where crypto investors can buy and sell cryptocurrencies without intermediaries.

Substantially any exchange working on a peer-to-peer basis could be called decentralized. Yet, in this article, we will focus on those with backend existing on a blockchain. 

Thanks to the usage of that technology, no one takes custody of your assets and the safety of transactions is guaranteed by protocol. Therefore, you don't have to give the exchange this amount of trust as in the case of centralized exchanges.

How does CEX work?
How does CEX work?

How does centralize exchange work?

Centralized exchanges, for example, Coinbase, are digital markets where people can buy, sell and trade digital assets such as Bitcoin, Ether, or other cryptocurrencies.

To access the site, you have to sign up by providing banking details and identifying personal data. This is the part of KYC and AML practices, which have to be followed by every centralized exchange. Because such data is fragile, it's quite clear that a security dilemma is present even before one starts trading.

Buying cryptocurrencies on a centralized exchange

The price of each coin on the site is based on an "order book" - consisting of orders to buy and sell.

Trading on centralized exchanges generally seems simple. You just need to choose coins and confirm a transaction.  The exchange will show the funds you acquired in your account. Then you can trade them for other digital assets.

Yet, users don't really hold their funds. Exchange work here as a custodian of customer funds. Furthermore, trades don't occur on the blockchain. Instead, they take place only within the exchange's database.

Disadvantages of central authority

From a technical point, when you deposit funds on a centralized exchange, you lose control over it. Exchange puts your funds into wallets controlled by it.

Additionally, it owns your private keys. Therefore, if you want to withdraw your money, the exchange has to sign the transaction on your behalf.

Security

With CEXs come some vital security questions.

Firstly, exchanges can limit user access to their assets or even restrict the ability to trade them.  Secondly, the risk of a hacker attack is always present. Exchanges work very hard to avoid it, yet as the example of Mt. Gox shows, they are still vulnerable.

Advantages of centralized exchanges

Generally, this type of cryptocurrency exchange is easier and more convenient to use than decentralized exchanges. Especially for the newcomers.

Moreover, trading there is often faster because the whole process doesn't take place on a blockchain. Additionally, trading fees can be lower as well.

Decentralized exchanges vs centralized exchanges
Decentralized exchanges vs centralized exchanges

How do decentralized exchanges work?

In many ways, decentralized exchanges are similar to centralized ones. However, differences are more than substantial. Essentially in decentralized exchanges, trade rely on a blockchain (most often Ethereum or Binance Smart Chain). Trading between users is conducted using smart contracts - orders are executed on-chain. Thanks to that, during the whole process exchange, doesn't take control of users' assets.

Cross-chain exchanges are a very promising novelty on the DEX market. Yet, most of the popular decentralized exchanges operate only on one blockchain - most often Ethereum or Binance Smart Chain.

There are three ways in which decentralized exchanges operate trading:

  • On-chain order book
  • Off-chain order book
  • Automated Market Maker
How does decentralized exchange handle trading?
How does decentralized exchange handle trading?

On-chain order book

There are decentralized exchanges where every transaction is written to a blockchain. It means that every order, as well as cancellation or alteration, is handled on-chain.

Without a doubt, this is the purest approach to decentralization. There is absolutely no third party involved at any stage of trading. Everything is extremely transparent. Unfortunately, there are vital downsides as well.

The on-chain order book is far less practical than the other two options. Firstly, because every node on the blockchain record the order, placing it requires paying a fee. Furthermore, users have to wait until the miner adds necessary data to the chain. It translates to high costs and poor liquidity.

Front running

Front running refers to a situation when some insider posses information about a pending transaction and uses this knowledge to place an order before the transaction is completed. Because he benefits from the fact that is inaccessible to the public, it’s illegal. Some believe that’s a serious threat in the on-chain model.

It can't occur in the traditional way, since everything is recorded on the global ledger. Yet, a miner can observe the order before it's added to the blockchain,  and add their order first.

Off-chain order book

Off-chain order books are a bit more centralized than their counterparts. But they are also far more practical. In this model, orders are hosted elsewhere and only the final transaction is settled on the blockchain. Moreover, you can still benefit from non-custodial storage.

Because orders aren't stored on-chain, this approach is faster and less costly. Furthermore, it helps to achieve better liquidity of trades. However, it can encounter some of the security issues typical for CEXs.

Automated Market Maker (AMM)

Automated Market Maker, sometimes called Proactive Market Maker, has some serious advantages over the previous two solutions.

In order books model, if you have Bitcoin and want to trade it for Ether, you need someone who wants to buy Bitcoin and have Ether. Moreover, they have to be willing to trade at an agreed-upon price.

AMM simply removes counter-parties and applies algorithms that deal with asset pricing. With Automative Market Maker, you can trade Ether regardless of whether there’s someone who wants it for Bitcoin. 

To achieve it, AMMs typically use liquidity pools. We'll explain this term in another article.

Decentralized margin trading

Margin trading refers to the practice of borrowing funds from a broker to trade a financial asset, which forms the collateral in lending from the broker. Usually, a broker in DeFi is one of the AMMs.

Pros and cons of Decentralized Exchange
Pros and cons of Decentralized Exchange

Pros of decentralized exchange

Lower risk

Decentralized cryptocurrency exchange doesn't hold users' assets. Because they are held in a private wallet, and you have the keys, they are immune to hacks.

No KYC needed 

Most of DEXs doesn’t have to follow KYC and AML requirements, because they don’t intermediate in transactions between parties. That’s why it’s often more convenient to build your own DEX than CEX. 

More options

On the DEX platform, trades of tokens that aren’t listed on CEXs are possible.

Cons of decentralized exchange

Trading volume

The volume traded on CEXs is still much higher than that on DEXs. Liquidity is lower as well.

Higher fees

It's not an absolute norm, but when it comes to fees CEXs often offer the best price.

Convenience

Decentralized exchange is less user-friendly than a traditional one.

Conclusion

Decentralized Exchanges can be considered as one of the key factors in the current Defi boom. That’s why we mentioned them among the top DeFi trends for 2021. To this point, everything indicates we were right. Just look at the success of projects like Uniswap or PancakeSwap. 2021 definitely belongs to DEXs. Apparently, today crypto traders value high security, privacy, and the wide range of options that they bring. 

Yet, DEXs are still a relatively new branch of the crypto world. Therefore, there is still much space for innovation. That’s why more and more investors become interested in building their own Decentralized Exchange. With the high speed of blockchain technology development and the growing popularity of alternative crypto assets, circumstances are more than promising.

Most viewed


Never miss a story

Stay updated about Nextrope news as it happens.

You are subscribed

Authorization and Identity: Chainlink Use Cases

Karolina

14 Feb 2024
Authorization and Identity: Chainlink Use Cases

Chainlink stands at the forefront of enhancing security and compliance within smart contract-enabled blockchain networks. By enabling direct access to real-world data, Chainlink ensures that blockchain applications can operate with the same level of trust and verification as traditional systems. This integration is crucial for a wide range of applications, from financial services requiring Know Your Customer (KYC) and Anti-Money Laundering (AML) compliance to any form of digital agreement that needs to securely verify the identity of parties involved.

Overview

Chainlink is a decentralized oracle network that plays a critical role in bridging the gap between smart contracts on blockchain networks and real-world data. It enables smart contracts to securely interact with external data.

  • Decentralized Data Oracles. Chainlink's network of decentralized oracles ensures that data fed into smart contracts is accurate and tamper-proof, mitigating risks associated with relying on a single data source.
  • Smart Contract Connectivity to Real-World Data. It facilitates the seamless integration of external data sources, such as financial market data, weather information, and much more, enabling smart contracts to execute based on inputs from the real world.
  • Chainlink VRF (Verifiable Random Function). This feature provides a secure and provably fair source of randomness for blockchain applications, crucial for gaming, NFTs, and any application requiring random number generation.

READ: "What is Chainlink"

When it comes to authorization and identity verification, Chainlink's role becomes even more crucial. By connecting smart contracts with external data sources, such as governmental identity databases or digital identity verification services, Chainlink enables the creation of blockchain applications that require verified human identities. This capability is essential for applications that must adhere to regulatory standards or for those seeking to mitigate the risk of fraud.

Moreover, Chainlink's decentralized nature ensures that the process of identity verification is not only secure but also resistant to manipulation. By leveraging multiple independent oracles to fetch and validate data before it's provided to a smart contract, Chainlink ensures a level of reliability and trustworthiness that centralized data sources cannot match. This decentralized approach to authorization and identity verification opens up new possibilities for blockchain applications, making them more accessible, compliant, and secure for users around the globe.

The integration of Chainlink's decentralized oracle network into the domain of authorization and identity verification heralds a new era of security, efficiency, and compliance for blockchain applications. By leveraging real-world data and external verification services, Chainlink enables smart contracts to perform functions that were previously unthinkable in the blockchain space. Here, we explore several key use cases where Chainlink's technology significantly impacts authorization and identity verification processes.

E-Signatures

In the digital age, e-signatures have become the norm for legally binding agreements, eliminating the need for physical presence or paper-based documents. Chainlink oracles facilitate the integration of blockchain applications with leading e-signature providers like DocuSign. This integration ensures that e-signatures can be verified and recorded on the blockchain, providing immutable evidence of agreement and authorization. Furthermore, by enabling smart contracts to interact with e-signature solutions, Chainlink opens the door to automated contract execution based on the completion of digitally signed agreements, thereby streamlining business processes and reducing the time and cost associated with manual verification.

Biometrics for Smart Contract Authorization

Unstoppable Domains uses Chainlink oracles to enable users to tie their off-chain Twitter identity to their on-chain Ethereum domain name (Source: chain.link)

Biometric verification offers a high level of security and convenience for identity verification, leveraging unique physical characteristics such as fingerprints or retinal patterns. Chainlink enables smart contracts to securely access and verify biometric data, ensuring that only authorized individuals can trigger certain actions on the blockchain. This use case is particularly relevant for access control systems, secure transactions, and identity verification processes that require a high degree of trust and security. By connecting smart contracts with biometric databases and verification services through Chainlink oracles, blockchain applications can achieve a new level of security and fraud prevention.

Credential Verification

Credential verification is crucial in numerous applications, from financial transactions requiring proof of funds to access systems demanding specific security clearances. Chainlink oracles play a pivotal role by securely relaying credential verifications from external systems to the blockchain. This capability allows smart contracts to automatically verify users' credentials in real-time, facilitating seamless transactions and interactions that require verified identity or authorization credentials. For example, a decentralized finance (DeFi) platform can use Chainlink to verify a user's creditworthiness or asset ownership before allowing them to participate in lending or borrowing services.

Social Media Identity and Domain Names

The integration of social media identities with blockchain applications enhances user experience by providing more intuitive and human-readable identifiers, such as domain names or social media handles. Chainlink oracles facilitate this by securely linking off-chain social media identities to on-chain addresses or domain names. This use case not only improves the usability of blockchain applications but also adds an extra layer of verification, as users can easily confirm the authenticity of the parties they are interacting with.

Intellectual Property Management

Chainlink's decentralized oracle network enables smart contracts to interact with external IP databases for verifying ownership and facilitating transactions related to intellectual property (IP). This application is particularly useful for copyright and trademark management, patent licensing, and royalty distribution. By automating IP verification and transactions through Chainlink, creators and owners can more efficiently manage their rights and receive payments, while users gain access to verified IP assets.

Contribution Bounties in Open Source Projects

Open-source projects can leverage Chainlink oracles to automate the verification of contributions and the distribution of bounties. By connecting smart contracts with public code repositories like GitHub, Chainlink allows projects to automatically track contributions, verify the fulfillment of predefined conditions, and release payments to contributors. This application streamlines the contribution process, incentivizes open-source development, and ensures that contributors are fairly compensated for their work.

Conclusion

Chainlink significantly impacts blockchain, enhancing security and compliance, especially in authorization and identity. It bridges real-world data with blockchain, ensuring trust and wider adoption. As blockchain evolves, Chainlink's innovations promise a more inclusive digital future. Its key role in securing and streamlining blockchain applications marks a crucial step forward for digital interactions. Chainlink is pivotal for a secure, compliant, and efficient blockchain ecosystem, shaping the future of digital transactions.

If you are interested in utilizing Chainlink or other blockchain-based solutions for your project, please reach out to contact@nextrope.com

Chainlink vs. Avalanche: Exploring the Blockchain Frontier

Karolina

13 Feb 2024
Chainlink vs. Avalanche: Exploring the Blockchain Frontier

Chainlink emerges as the bridge between the real world and the blockchain. On the other side, Avalanche flashes through the blockchain space with a lightning speed platform that promises scalability without compromise. Both are revolutionaries in their own right, yet their paths are markedly different. Chainlink's quest to secure the integrity of off-chain data in a decentralized manner contrasts with Avalanche's mission to redefine blockchain's scalability and usability. But what happens when these paths intersect?

Overview

Chainlink is a decentralized oracle network that plays a critical role in bridging the gap between smart contracts on blockchain networks and real-world data. It enables smart contracts to securely interact with external data.

  • Decentralized Data Oracles. Chainlink's network of decentralized oracles ensures that data fed into smart contracts is accurate and tamper-proof, mitigating risks associated with relying on a single data source.
  • Smart Contract Connectivity to Real-World Data. It facilitates the seamless integration of external data sources, such as financial market data, weather information, and much more, enabling smart contracts to execute based on inputs from the real world.
  • Chainlink VRF (Verifiable Random Function). This feature provides a secure and provably fair source of randomness for blockchain applications, crucial for gaming, NFTs, and any application requiring random number generation.

READ: "What is Chainlink"

What is Avalanche?

Overview

Avalanche is a highly scalable blockchain platform designed for decentralized applications (dApps) and custom blockchain networks. It distinguishes itself with its emphasis on scalability, speed, and eco-friendliness.

Key Features of Avalanche

  • High Throughput and Low Latency. Avalanche boasts a high transaction output rate with low latency, making it an ideal platform for scaling dApps and financial solutions.
  • Eco-friendly Consensus Mechanism. Unlike proof-of-work (PoW) systems that require significant energy expenditure, Avalanche uses a novel consensus mechanism that is energy-efficient, contributing to a more sustainable blockchain ecosystem.
  • Scalability and Interoperability. The platform supports the creation of multiple custom blockchains that can interoperate seamlessly, facilitating a diverse and scalable ecosystem of applications.

READ: "Avalanche’s Investment in Real-World Assets Tokenization"

As blockchain technology continues to evolve, understanding the nuances between different platforms and solutions like Chainlink and Avalanche becomes increasingly important. Here's how these two blockchain giants stack up against each other:

Underlying Technologies and Architectures:

  • Avalanche utilizes a unique consensus protocol known as Avalanche consensus, combining the benefits of classical consensus algorithms with the decentralized nature of blockchains. This protocol allows for high throughput, quick finality, and energy efficiency.
  • Chainlink, on the other hand, is not a blockchain but a decentralized network of nodes that provide data to blockchain networks. It uses a network of independent node operators who are incentivized to provide accurate data to smart contracts.

Consensus Mechanisms:

  • Avalanche employs a Proof of Stake (PoS) model designed to be lightweight and energy-efficient. Validators participate in reaching consensus by staking AVAX tokens, contributing to the network's security and governance.
  • Chainlink does not use a consensus mechanism in the same way a blockchain network like Avalanche does. Instead, it relies on a decentralized network of oracles to validate and relay data, ensuring the integrity of information provided to smart contracts.

Chainlink is best suited for applications that require secure, reliable, and tamper-proof data inputs from the real world. This includes:

Avalanche is optimized for a wide range of blockchain applications needing high throughput, quick finality, and scalable infrastructure, such as:

  • Scalable DeFi platforms and DEXes.
  • Enterprise blockchain solutions.
  • Custom blockchain networks (subnets).

Examples of Real-World Applications and Partnerships:

  • Chainlink has partnered with Google Cloud for cloud data integration and with numerous DeFi platforms like Synthetix and Aave for price feeds and randomness.
  • Avalanche has formed partnerships with Deloitte for enhancing security and speed in disaster relief platforms and with top DeFi protocols to build on its highly scalable network.

Ecosystem and Community

Development Community and Ecosystem Support:

  • Both Chainlink and Avalanche boast robust and active communities. Chainlink's community is highly engaged in developing external adapters and securing data for smart contracts. Avalanche's community focuses on developing dApps and custom blockchain networks.

Tools, Resources, and Support:

  • Chainlink offers extensive documentation, a vibrant developer community, and grants for projects integrating Chainlink's technology.
  • Avalanche provides developers with comprehensive resources, including tutorials, technical documentation, and funding for ecosystem growth through the Avalanche Foundation.

Tokenomics and Market Performance

  • LINK (Chainlink's token) is used to pay for services within the Chainlink network, including data requests to oracles. It incentivizes node operators to provide accurate data.
  • AVAX (Avalanche's token) serves as the native currency within the Avalanche network, used for transaction fees, staking, and governance.
  • In terms of market performance, both LINK and AVAX have shown significant growth and adoption, reflecting their utility and the demand for their respective network's services. However, their performance can vary based on overall market trends, technological advancements, and adoption rates in their specific use cases.

LINK vs AVAX

Potential for Integration

The potential for integration between Chainlink oracles and Avalanche’s blockchain platform is substantial. Chainlink’s decentralized oracles can provide Avalanche-based applications with secure and reliable real-world data, enhancing the functionality and scope of Avalanche’s already fast and scalable blockchain. This integration can benefit a wide range of applications, from DeFi and insurance to gaming and prediction markets, by providing them with the essential data needed to operate effectively and transparently.

Conclusion

Chainlink and Avalanche, while serving distinct purposes within the blockchain ecosystem, demonstrate a powerful synergy when combined. Chainlink’s ability to provide secure, reliable, and decentralized data complements Avalanche’s high-throughput, scalable blockchain platform, enabling developers to build more complex, useful, and transparent applications.

READ ALSO: "Chainlink vs Polkadot"

If you are interested in utilizing Chainlink or other blockchain-based solutions for your project, please reach out to contact@nextrope.com