Bitcoin, the first blockchain-based cryptocurrency, was created as a peer to peer payment system that allows its users to transfer value with no central authority or third party involved. Since a network of distributed and mostly anonymous miners are all in charge of processing the transactions, we are ensured that problems like censorship, fraud, and others are not possible.
The automated issuance mechanism of bitcoin through mining also seeks to remove the control of money printing from privately owned banks that lend said money to governments at an interest, creating the debt-based economy that led to the crash in 2008, which in turn led to the creation of Bitcoin. However, we have become somewhat detached from the primary goal of Bitcoin, to return the control of money to its owners, and we entrust our Bitcoin with third-party services daily. The most popular of these services being exchanges.
Centralized exchanges are easy to use, easy to access and they provide advanced trading functionalities like margin trading and others. However, they also represent a security risk for your funds. While some exchanges are better guarded than others, hacks are not an uncommon event in the cryptocurrency scene, and some like the recent Bitfinex hack have led thousands of users losing their savings. Some exchanges are simply incompetent or malicious, practicing fractional reserve systems that can either lead to a voluntary elimination of the excess instruments (Mt. Gox hack from June 2011), bankruptcy (the demise of mybitcoin) or a new investor bailout. The Mt. Gox case had such an impact on the Bitcoin community that it led to the term “Getting Goxed”.
Nevertheless, we need to exchange our currencies. There are certain items and services that we cannot buy with Bitcoin (yet) and in order to acquire Bitcoin or cryptocurrencies, most people have to exchange it for a national currency. Furthermore, some cryptocurrencies like Ether or Bitshares have special features or tools that are not present in Bitcoin. So how can we exchange our coins without entrusting them to a third party service? The answer lies with decentralized exchanges.
What is a Decentralized Exchange
A decentralized exchange is an exchange market that does not rely on a third party service to hold the customer’s funds. Instead, trades occur directly between users (peer to peer) through an automated process. This system can be achieved by creating proxy tokens (crypto assets that represent a certain fiat or crypto currency) or assets (that can represent shares in a company for example) or through a decentralized multi-signature escrow system, among other solutions that are currently being developed.
This system contrasts with the current centralized model in which users deposit their funds and the exchange issues an IOU that can be freely traded on the platform. When a user asks to withdraw his funds, these are converted back into the cryptocurrency they represent and sent to their owner.
The most obvious benefit to using a decentralized exchange over a centralized one is their “trustless” nature. You are not required to trust the security or honesty of the exchange since the funds are held by you in your personal wallet and not by a third party.
Another advantage to the decentralized model is the privacy it provides. Users are not required to disclose their personal details to anyone, except if the exchange method involves bank transfers, in which case your identity is revealed only to the person that is selling or buying from you.
Furthermore, the hosting of decentralized exchanges is distributed through nodes meaning that there is no risk of server downtime.
Of course, there is always a downside and this case is no exception. Centralized exchanges are extremely popular for many reasons.
Some decentralized exchanges like Bitsquare require users to be online in order for an order to be listed and for the trade to take place, requiring users to perform certain actions like signaling that a payment was received.
Trading features like margin trading, lending and stop loss are currently not available in the decentralized model as they only allow the basic exchange of currency for a predetermined value.