These days, everyone wants to claim decentralization. It’s what the cool kids are doing, and even if a brand new “decentralized” exchange isn’t actually that decentralized, people are finding a way to spin it for the marketing! At least, that’s what it can seem like with the DeFi craze that’s causing people to roll out half-baked projects that try to capitalize on the growing desire for decentralization in a world where everyone is tired of traditional financial services that siphon away our wealth.
So, besides slapping on the cool label of “decentralized,” what characteristics are actually important for a crypto exchange to actually accomplish the things that DeFi is trying to accomplish in terms of security and trustlessness? I’m glad you asked.
#1. Non-custodial
A most important criterion for a decentralized exchange (DEX) is that it’s non-custodial. This just means that you are the only one holding your crypto. If you use a centralized exchange like Coinbase or Binance, you deposit your crypto on the exchange, giving them custody of it, and they execute trades for you, using liquidity held by the exchange.
In a DEX, however, you keep your crypto in your own possession and only release it into an automated smart contract that settles the transaction for you on the blockchain. You can choose, however, to be a liquidity provider by placing trading pairs in a DEX’s liquidity pool and receiving yields. This is how trades are made when the traders themselves are maintaining custody of their coins.
#2. No KYC verification
In the financial services world, know your customer verification – otherwise known as KYC – require banks to follow three primary steps of a compliance policy by providing private information to verify one’s identity and purpose of opening the account. This KYC protocol was originally intended to be a means for banks to conduct due diligence on a future customer and assess the risks of the potential account holder. KYC is also one of the costliest, ongoing burdens for a financial institution.
When you use a decentralized exchange for the first time, it may feel strange to not provide any personal information for identity verification because we’re so used to that in every other aspect of the internet and financial services. But to access any DEX worth its salt, you don’t even need an email address; you just connect it to a wallet. Plus, if it’s a non-custodial wallet, you probably didn’t give KYC for that either. It’s not as if you’re completely untraceable, because you’ve likely used a crypto on-ramp, which can connect your wallet addresses to your identity. But in a digital world with ever-shrinking privacy, it’s nice to reemphasize your right to NOT have everything you do gobbled up in data form by big tech and advertisers.
#3. Cross-chain trading
More and more, interoperability is becoming a necessity. Solutions have not become ubiquitous yet, but there are ways of transacting across chains. One of the most common is wrapped tokens like WBTC and WETH, which are pegged to the value of the underlying asset. But that does not completely uncomplicate cross-chain trading because you still have multiple steps and a custodian to be able to trade BTC for whatever ERC-20 you want.
Atomic swaps are getting closer to streamlining interoperability, and some DEXs have begun to use this functionality. A Hashed Timeclock Contract (HTLC) between two users can facilitate a trade across chains, only executing the transaction if both parties meet the contract obligations. With an atomic swap, you don’t even need an exchange platform, although exchanges are useful for finding other traders and providing liquidity.
#4. Decentralized web access
Wouldn’t it be a real bummer to jump through a bunch of hoops to have self-custody of your crypto and trade on a decentralized exchange…only to have your hot wallet compromised when you access a centralized web portal? Yeah, that would be really annoying.
A good DEX will have its user interface on a dApp or a Web3 site, using things like an Ethereum Name Server (ENS) and InterPlanetary File System (IPFS), which remove failure points of centrally registered domains and centrally hosted web servers that can be hacked or censored. Of course, hackers and scammers are working just as hard as security-minded developers so there are always risks, but the more points in the process that are decentralized, the more difficult it is for you to lose your data.
#5. Active community of users
Let’s face it, customer service and user experience leave a lot to be desired in DeFi and crypto in general. Remember using the internet back in the early 2000s? That’s kind of what using DEXs and other dApps is like these days. But since you’re such a cutting edge, forward-thinking early adopter, that’s a burden you must be willing to carry for the future of fintech!
That being said, the best exchanges have robust communities who love decentralization, talk about problems, and help with bugs and fixes that continue improving UX. Because so much of DeFi is open source, that means anyone with the skills and wherewithal can look at code and think about solutions. The hive mind has its uses when everyone is working on solving coding problems. In fact, that’s precisely why crypto exists today!
#6. Low fees
Slipping the noose of service fees in the legacy financial system is a huge reason people are increasingly migrating to DeFi. But, of course, there are still fees, even in the free and open decentralized world. Keeping fees low should be a high priority for any worthwhile exchange.
Network fees are unavoidable when you’re making transactions on the blockchain. Still, service fees vary between different exchanges, and, as you would expect, people tend to migrate to the easiest, lowest cost services available.
- Some of the biggest centralized exchanges are notorious for high trading fees and withdrawal fees.
- Many DEXs only take a fee that is paid to liquidity providers.
- Some exchanges don’t even charge withdrawal fees.
#7. Users and volume
There are always brand new and launching decentralized exchanges that are liable to blow up in popularity and make huge waves in the quickly innovating space. Especially if they present a new solution or reframe how we think about financial service conventions. But, for each one that does, there are a hundred failed projects or scams that can lose you money.
The most reliable DEXs have trading volumes in the top handful of exchanges and a large user base.
If you feel confident in your expertise to explore the wild west and put your crypto on an exchange with unaudited smart contracts and precious few users, go for it. Just know what you’re risking. Plus, we all know that just because an exchange is big today, doesn’t mean it’s guaranteed to be tomorrow. Just ask Mt. Gox, EtherDelta, and possibly even Uniswap if the SEC cracks down.
The decentralized exchange to end them all
You’ll likely be hard-pressed to find a “decentralized exchange” that truly reaches 100% decentralization at every possible point, has many users, low fees, lots of trading volume and liquidity, and isn’t being chased around town by regulators and hackers. But this is a fledgling industry that is working quickly to solve some massive and complex problems. Identifying the best DEXs that are currently available and staying on top of what’s emerging will put you ahead of the curve and position you for some potentially eye-popping gains.
About the Author
Michael Hearne
About Decentral Publishing
Decentral Publishing is dedicated to producing content through our blog, eBooks, and docu-series to help our readers deepen their knowledge of cryptocurrency and related topics. Do you have a fresh perspective or any other topics worth discussing? Keep the conversation going with us online at: Facebook, Twitter, Instagram, and LinkedIn.
