All hands on DEX!

Decentralized EXchanges might not be the smooth sail you think.

With crypto, it’s always full steam ahead toward decentralization — Decentralized EXchanges are no exception.

Carried by the hype, decentralized exchanges (DEX) claim to replace centralized exchanges (CEX) with decentralized tools instead of a single entity. To trade free of any governmental and regulatory involvement and zero counterparty risk, sounds pretty sweet right?

To better understand DEXs, let’s first take a closer look at trading.

Why do we need the middleman?

Let’s say I want to trade 1 Bitcoin for 100 Litecoins with my counterparty. We’ve agreed on price. But, neither one of us wants to risk sending their coins first.

The “who goes first” deadlock stalls the trade: if I send my Bitcoin first, who’s to say I will receive the agreed amount of Litecoin? With similar FUD, the Litecoin holder counterparty doesn’t want risk kicking off the trade.

For the trade to happen at all, somebody has to take that leap of faith.

Middlemen exist to avoid such cases.

Fortunately for traders, middlemen have come up with trading tools to bypass the need for trust. On an exchange, fancy order books with clear bids and offers automatically match trades in real-time between thousands of traders.

Moreover, the “who goes first” deadlock has long been solved by placing assets in escrow on the exchange. Should the trade fall through, funds in escrow will be returned to their owner.

Placing funds in escrow works because:

Instead of a random counterparty, you trust a known entity: a registered, regulated exchange. Since the exchange collects a cut from each trade in the form of fees, it cares for repeat business. Thus, it is in the exchange’s own interest to protect each party’s welfare and facilitate the trade. In case of misconduct, you can seek legal recourse through the exchange with which the funds are in escrow.

While this model has been implemented since the early days of Bitcoin, crypto enthusiasts want to take it one step further by decentralizing the exchanges themselves.