After centralized cryptocurrency exchange platforms, decentralized exchanges are gaining significant traction. Decentralized exchanges generally refer to the use of distributed ledger protocols and applications. They enable crypto users to trade cryptocurrencies directly without requiring any third-party or centralized party dependence. Decentralized exchanges offer various potential advantages including lower transaction fees, lower counterparty risk, and a range of crypto trading pairs with greater liquidity. Given the increased demand for these features, the adoption of a decentralized crypto exchange is expected to witness significant growth in the development and usage in the future. In this blog, you can explore the architectural structure and benefits, performance, and security advantages of decentralized crypto exchanges.
Decentralized crypto exchanges describe both blockchain-based exchange protocols, as well as applications that use the protocols. Essentially, a decentralized exchange protocol refers to a software program that we host on or integrate into one or more distributed ledgers. It facilitates automated peer-to-peer transactions on the distributed ledger. Further, users get the ability to retain sole custody of their private keys throughout the transaction process and thus, ensure privacy. Additionally, users have access to the readily available information. It is because a decentralized crypto exchange platform develops on top of a decentralized exchange protocol. Also, it integrates with an on-chain and off-chain order book database and a GUI (Graphic User Interface) and APIs. Put simply, we can break a decentralized crypto exchange application into four components.
A decentralized exchange application may not be completely decentralized in all four components. It is because, for various decentralized exchange applications, one or more components can be off-chain/centralized. So, let’s discuss each of these components and explore how a decentralized exchange protocol implements these components.
Generally, decentralized exchange protocols operate with tokens that feature the same technical implementation while being on the same distributed ledger platform. For example, Stellar’s decentralized exchange is operable with tokens issued on the Stellar network,10 and BitShares’ With Stellar decentralized exchange, users can also trade off-chain cryptocurrencies and assets could also be traded through the Stellar decentralized exchange. A few decentralized exchanges also employ atomic swaps for automatic trade of cryptocurrencies existing on different blockchain networks. Numerous decentralized exchange applications, however, focus only on token trading within one chain.
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The mechanisms for counterparty discovery directly connect buyers with sellers who want to conduct transactions on mutually agreed terms. For instance, traditional cryptocurrency exchanges such as Binance require users to submit both market orders and limit orders. Further, protocols automatically match these orders with unidentified counterparties using an exchange’s central limit order book, an aggregator of all user orders.
However, decentralized crypto exchanges also have order books, which may exist on-chain, hosted on a distributed ledger, or off-chain, hosted by third parties. Essentially, instead of aggregating orders of all counterparties, a decentralized order book shows separate orders of each counterparty. So, a user needs to identify a particular order, and essentially, a particular counterparty, for initiating trading. In some cases, a decentralized exchange may not have order books. Instead, it may feature a reserve-based model. A reserve model enables the supply and demand of various tokens readily available for the execution based on the reserve’s quoted buy and sell prices for that particular token. These reserves are on-chain which require smart contracts solutions to enforce the execution and settlement of the trade. We can also automatically determine a trade’s price with a smart contract.
On-chain order books are directly hosted on the blockchain’s distributed ledger. Once all orders submitted to the distributed ledger, members of the network validate and process them. It enables anyone to host and access an order book’s copy. Also, anyone can submit their orders to the order book if the distributed ledger is public. Instances of on-chain order books include such as Bitshares and Stellar decentralized exchanges. So, when two orders intersect in price, a decentralized platform automatically executes and settles the trade.
No dependency on a centralized party for hosting and operating the order book. No centralized point of attack, compromise, or liability and thus, a low risk of the order book being shut down or specific orders being restricted.\
Hosting an on-chain order book on a decentralized network means that one needs to trust centralized, off-chain actors for accurate and reliable publishing or broadcasting of the order books.
Generally, a centralized authority hosts an off-chain order book outside of a distributed ledger. The centralized entity enables trading participants to match with other parties to make an offer on the asset. Also can restrict access to view or submit to the order book. The use of on-chain and off-chain order books depends on the performance of the chain. A few decentralized exchanges face challenges with employing on-chain order books due to constant updates of orders to the blockchain. The constant updating incurs transaction fees and wait time. However, the use of an efficient blockchain platform for a chain can ensure negligible transaction fees and reduced wait times.
Matching mechanisms initiate the process of pairing buy orders with sell orders that have mutually acceptable terms. Decentralized exchanges provide automatic matching as well as manual identification and fill an order. The use of computer algorithms pair and execute buy and sell orders to enable automatic matching. Manual order filling requires a taker to manually identify a resting order on the order book, including actively executing actions for that particular order.
It is critical to analyze a decentralized exchange’s order matching algorithm. It affects its ease of use, provision for fair exchange rates, and the latency of order fulfillment (wait time between order creation and order fulfillment).
Mostly, decentralized exchanges feature on-chain transaction settlements. It is a critical element that eliminates the dependence on a centralized party (such as a centralized exchange). The on-chain settlement ensures that users can publicly validate their trade settlements on the ledger according to their desired terms. A decentralized exchange performance is limited due to latency involved in the secure confirmation of transactions on the underlying distributed ledger technology like blockchain. It makes the speed of transaction confirmation on a distributed ledger network a bottleneck for decentralized exchanges. However, at Oodles, we provide crypto exchange development services equipped with methodologies that ensure the use of distributed ledger-based blockchain platforms that feature significantly higher latency than others.
A decentralized crypto exchange’s security remains limited due to the underlying distributed ledger. Thus, it is important to ensure the ultimate security of a decentralized exchange by using an efficient underlying distributed ledger like Stellar blockchain. Also, to ensure transaction security, we must settle them with thoroughly audited smart contracts and distributed ledger platforms having a consistent history of functionality.
Generally, new cryptocurrencies are available for trading through decentralized exchanges. It is because it takes time for centralized exchanges to list new tokens due to regulatory risks. A user may be able to attain and trade in various cryptocurrencies over decentralized exchanges only. Additionally, the interoperability of a decentralized exchange’s protocols can enable pooling liquidity for “networked liquidity” with applications that use the same protocol. Interoperable protocols significantly spur greater networked liquidity.
The latency of confirmation times of a decentralized exchange depends on the underlying distributed ledger. We can facilitate the development of a distributed ledger network that permits significantly faster on-chain settlements with unique consensus mechanisms.
Centralized exchanges still face security and other challenges, including such as a delay in the listing of latest cryptocurrencies. Users can adopt decentralized exchanges for a more enhanced, secure, and efficient crypto trading experience.
We are a crypto exchange development company that includes decentralized exchange development in its offering. We have expertise in developing platforms that provide lower trade latency, higher liquidity, and intuitive user interfaces, making them more attractive for mainstream crypto users.