As trading cryptocurrency becomes more and more popular, the confusion between the characteristics of a cryptocurrency (such as Binance) and a decentralized cryptocurrency exchange must be addressed. The following are the most asked questions in this regard, and the answers are aimed to explain the matter as simply as possible.
What is a Decentralized Exchange?
Cryptocurrency or decentralized exchanges on Ethereum make trade between crypto coins on the blockchain itself. Decentralized exchanges do not exchange fiat currency for cryptocurrency, and one has to be in the crypto ecosystem already to participate on such a platform. An Ethereum based decentralized exchange allows you to trade ERC 20 tokes with other ERC 20 tokens.
What is an ERC 20 token?
An ERC 20 token is a coin or token that Ethereum allows you to build with smart contracts without actually having to build a blockchain. On a decentralized exchange on Ethereum cryptocurrencies like these are exchanged (and sometimes with Ether as well using a different method).
How is a decentralized exchange different from a cryptocurrency exchange?
A decentralized exchange is different from a typical cryptocurrency exchange and has its own benefits. The ease of using the cryptocurrency exchange is that a user doesn’t have to manage anything – the exchange does it all instead. The users don’t have to manage their private keys or accounts. All they have to do is log on to the website, buy cryptocurrency. Then they can choose to either keep it there, sell it there, or sell it for cash. The exchange manages everything in the middle.
In a decentralized exchange, however, users have to manage their own funds. This is a good thing because there have been instances of security breaches of typical cryptocurrency exchanges where the funds left on the exchanges were stolen. This paved the way for a legitimate of blockchain technology use case – a cryptocurrency exchange that runs on the blockchain itself. It’s a blockchain-based asset that can be swapped with other blockchain based technological innovation. In this exchange, the trade occurs between Ethereum based tokens from one wallet or account to another, and the fund never leaves the wallets till the trade actually settles. So, if a maker who makes the order or a taker who takes the order, the exchange between the two users is powered by smart contracts that swaps the tokens without holding them on in the middle. This rectifies the vulnerability of the typical crypto exchange and prevents the currency from being siphoned out.
How does a decentralized exchange work?
A dApp or DEX is a decentralized application and operates as follows:
- A user signs in to the DEX with their wallet address.
- A maker or token owner places an order specifying the number of units for sale, its price, and the time limit for bidding. These assets are exchanged with other assets available on the DEX.
- Setting the settling order triggers other users to submit bids by signaling a buy order.
- After the specified window for bidding closes, the bids are reviewed. The smart contract is executed and the assets are transferred directly in the user’s wallet.
Decentralized exchanges have handed the control back to the users over their own funds and broadcast orders. The absence of a centralized server also leaves the security and encryption aspects of this process on the user-end.