Bitcoin was originally designed to eliminate intermediaries from financial transactions. While Coinbase and other centralized exchanges have made it easier than ever to buy and sell cryptocurrencies, they represent the same kind of financial intermediary that Satashi Nakamoto was trying to prevent when developing the first cryptocurrency.
Decentralized exchanges, or DEXs, were developed to eliminate intermediaries through the use of blockchain order books and smart contracts. They provide crypto holders with greater security and privacy through peer-to-peer transactions, but currently, these benefits come at the cost of slower transactions, less liquidity and potentially higher fees.
Let’s take a closer look at decentralized exchanges, DEX crypto use cases, pros and cons to consider, and tax implications to keep in mind.
What Are Decentralized Exchanges?
Most crypto traders and investors use centralized exchanges, such as Coinbase or Binance. After depositing fiat money or crypto into the account, the exchange buys and sells crypto assets off-chain between its own users, executing its own periodic transactions to balance the books. The exchange also acts as a custodian and holds the private keys to the account.
Decentralized exchanges, or DEXs, were developed to enable peer-to-peer transactions without the need for a centralized intermediary or custodian since you own the private keys. The most popular DEXs use smart contracts to operate automated order books or market makers while others maintain on-chain or off-chain order books to match transactions.
- Security: Many centralized exchanges have been the victim of hacks and theft. Since DEX transactions are peer-to-peer, there is no risk of an exchange-related hack and the risk falls entirely on the individual’s device or account.
- Privacy: Centralized exchanges are required to follow Know Your Customer (KYC) laws in many jurisdictions and may report transactions to regulatory authorities. Since DEX transactions are peer-to-peer, there is no reporting and may not be any central record.
- More Tokens: Centralized exchanges only offer a handful of highly liquid tokens whereas DEXs may offer unlisted tokens as long as there’s supply and demand. It’s easier for you to purchase these kinds of tokens while still using a popular wallet.
- Speed: Centralized exchanges typically facilitate trading off-chain, which dramatically increases transaction speed. Bitcoin can be bought or sold in seconds rather than minutes or even hours with some DEX transactions.
- Liquidity: Centralized exchanges with a large number of accounts have access to deep pools of liquidity to provide attractive pricing to traders and investors. In contrast, some DEX transactions may have limited liquidity depending on the asset.
- Fees: Centralized exchanges charge relatively low fees since they don’t always have to process trades on the blockchain. Since many DEXs involve blockchain transactions, the fees tend to be higher, especially when the network is congested.
At the end of the day, DEX platforms are ideal for cryptocurrency investors that value privacy and security, but may not be appropriate for short-term traders that need speed liquidity. Of course, these platforms are always improving and speed and liquidity could soon compete with centralized exchanges, providing traders with a compelling alternative.
What Are the Main Types of DEX Platforms?
There are a few different approaches to building decentralized exchanges and each of them has their own pros and cons. For example, traders may find some DEXs unusable due to the possibility of front-running trades whereas others may have higher fees. You should carefully consider each approach and its implications before making a decision.
The three main types of DEX platforms include:
- On-chain order books assign network nodes to maintain a record of all orders. Since it’s on a blockchain, miners are required to confirm each transaction and add it to the record. Bitshares and StellarTerm are two examples of DEXs using on-chain order books.
- Off-chain order books record transactions in a centralized location with relayers to help manage the order book, making them only partly decentralized. Binance DEX and EtherDelta are two examples of DEXs using off-chain order books.
- Automated market makers use smart contracts in lieu of order books to create liquidity pools and automatically execute trades. Uniswap, SushiSwap and Kyber Network are a few examples of automated market makers.
Automated market makers have become the preferred DEX type over the past several years. In addition to decentralizing everything, there are a number of user-friendly wallets that have helped make AMMs more accessible, including MetaMask and Trust Wallet. Of course, the development of DEXs remains early-stage and more innovation could be around the corner.
What Are the Most Popular Decentralized Exchange Platforms?
- Bamboo Relay
- Loopring Exchange
How to Handle Taxes with DEXs
Decentralized exchanges provide a lot more privacy than centralized exchanges, but that doesn’t mean that traders and investors can avoid taxes. Over the past year, the IRS has stepped up its investment in blockchain analytics and other enforcement tools. The blockchain record is permanent and there’s no statute of limitations for fraud!
At the same time, DEXs may not provide the same tax forms that centralized exchanges offer, which can make tax time a little more challenging. You may need to download a transaction record as a CSV or XLS and manually match transactions to compute your capital gain or loss—or pay an accountant to do the same thing at a high cost.
ZenLedger dramatically simplifies the process by connecting with your exchanges and wallets, importing all of the transactions, and automatically matching them to compute a capital gain or loss. The platform even provides pre-filled tax forms that you need each year to eliminate any ambiguity and connects with TurboTax to automate the process for some users.
The Bottom Line
Centralized exchanges, such as Coinbase or Binance, have made it easy to buy and sell cryptocurrencies. Despite their ease of use, some users prefer greater privacy and security as well as access to unlisted tokens. Decentralized exchanges, or DEXs, were designed to provide these benefits and have been growing in popularity.