Before going further into decentralized exchanges, let’s start with something that everyone is more familiar with: centralized exchanges.
The way we buy and sell in centralized exchanges is similar to how securities trading and spot trading happen. There is first a process by which users open their accounts. In a centralized cryptocurrency exchange, this process will happen online. First, users register on the exchange’s website using their email address or mobile number. Next, there will be a KYC (Know Your Customer) identity authentication process that has to be completed. Due to different laws in different countries and different strategies among exchanges, some exchanges allow you to perform cryptocurrency transactions right after you complete registration. However, if users want to perform transactions with fiat currency, it generally requires the completion of the KYC process. In a KYC process, users need to provide proof of identity like an ID document, proof of residence, or bank account. Users can only perform transactions once they are approved, a process which may take around three to seven days.
Most centralized exchanges nowadays provide two types of transactions: The first is currency-to-currency trading. In this type of trading users can trade the cryptocurrencies they already have on hand. They could have obtained them through mining, transactions outside the exchange, or through other means. Users fund the personal account they have created in the exchange by transferring over cryptocurrency, and then they can start trading. For example, if they are shorting BTC, then they can trade their BTC to USDT, and wait until the BTC market is better to buy it back. The second (and more common) type of transaction is fiat currency trading. In this type of transaction, users first need to have a bank account linked to the centralized exchange. Next, they must transfer funds from their bank account to the personal account they’ve created in the exchange. Using the funds in their exchange account, users can purchase BTC or ETH to start trading cryptocurrency.
The process of trading cryptocurrency relies on makers and takers. A user can place a market order to sell their cryptocurrency at a certain price, and wait for another user to take the order, or vice versa. If there are many market orders with the same price that are pending, transactions will be matched based on the rules and logic set out by the exchange.
When a user wants to make a profit, they can always withdraw the cryptocurrency or fiat currency they have to their personal wallet or bank account. However, since it is a centralized exchange model, there are two things to pay attention to:
From what we’ve described above, it can be said that centralized exchanges face a couple of issues:
Decentralized exchanges use smart contracts to write and determine trading logic, and then distribute these contracts on the blockchain. Decentralized exchanges combine the traits of open-source programs, private keys on the blockchain, and the ability to have personal accounts. By doing this, they have solved some of the issues that centralized exchanges face:
Because of the advantages of decentralization mentioned above, in September of 2020 DEX Uniswap's single-day trading volume surpassed centralized exchange Coinbase's volume to reach $426 million USD. This record was later surpassed in March of 2021 by DEX PancakeSwap. To date, both DEXs have broken the record of 1 billion USD in single-day trading, which shows the amazing potential for DEXs. That being said, this does not mean that DEXs do not have drawbacks:
In conclusion, there are advantages and disadvantages to using DEXs (decentralize exchanges) or CEXs (centralized exchanges.) Regardless of which platform a user decides to use, a good practice is to always start with a product that they are familiar with. They should understand it thoroughly and avoid making large investments at the beginning to ensure the safety of their assets.
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