February 22

How do decentralized exchanges work?

February 22

The main idea of blockchain and cryptocurrency is decentralization. However, exchanges – the most popular tool of the industry – are still centralized, which conducts quite serious risks for users. Is your cryptocurrency stored in a third-party organization wallet? This article is for you.

Here are some clear examples:

The Collapse of MT.Gox

The site of the exchange stopped working on February 25, 2014 at approximately 7:30 am Moscow time. As a result, it turned out that hackers stole about 744 thousand of bitcoins. At the current exchange rate it is almost $ 6.5 billion.

Bitfinex cracking

Users who came to the cryptocurrency industry during 2017, consider Bitfinex as one of the most reliable and convenient exchanges. However, very few people know that in August 2016 about 120 thousand bitcoins were stolen from its accounts. It is more than $1 billion at the moment.

Bittrex verification

In December 2017, hundreds of thousand users found that they could not withdraw their funds from accounts, because of the exchange’s immediate decision to launch an account verification, which was not required before. The result – a giant wave of support requests, which were not responded for weeks by the platform staff.

Stealing Bithumb User Data

Attackers got access to the accounts of 31 thousand of users of the largest Korean exchange – Bithumb. The exact amount of damage dealt remains unknown, but the fact remains fact: tens of thousands traders were affected.

Also, there is no guarantee that the accounts of the exchange are not to be arrested (cm. the BTC-E exchange case), or that the creators/employees does not plan to run away with all the users money.

The conclusion suggests itself: crypto exchanges in their current state are tools of extreme risk.

What the decentralized exchange is?

It is a technology that allows you to trade through a service, which is carried not by a group of people, but directly by users using the blockchain and smart contracts. I know that it sounds difficult, but let's try to figure out how it works on a concrete example. The decentralized exchange EtherDelta allows users to trade cryptocurrencies with no third parties involved. There is only a wallet of the seller, the blockchain, which isn’t controlled by anyone, smart contracts, and a wallet of the buyer.

How does the trade proceed

  1. The seller creates a sales smart contract of a certain number of tokens from his personal wallet for a certain amount of Ether.
  2. When the offer is fixed in the blockchain, the tokens on the wallet are frozen until the execution or cancellation of the smart contract, and the application is placed on the exchange’s list of orders for sale.
  3. The buyer is searching for good offers on the exchange’s list and chooses the one that suits him.
  4. Then he creates a smart contract to purchase of a certain number of tokens for Ether, which is to be frozen on his wallet until the smart contract is executed or cancelled. All data is recorded in the blockchain.
  5. If all the data is correct, both smart contracts are executed, and the seller's tokens and buyer's Ether are unfrozen and exchanged.

Advantages of Decentralized Exchanges

  1. The crypto-exchange does not have an owner who could steal user money.
  2. You do not create there a private office that could be hacked.
  3. The exchange can not be banned nor it’s accounts arrested, because the exchange does not have a unified control center.
  4. The founders of the exchange don’t have tools to manipulate prices inside the exchange, and they don’t control the funds either.
  5. You remain anonymous. No one is to ask you to verify your account by sending your passport information, or driver's license data, or bank statement.

Your cryptocurrency remains your cryptocurrency!

Disadvantages of Decentralized Exchanges

  1. Complicated interface. Not all the beginners can immediately understand how to work with it.
  2. Lack of support. If you have questions about using the exchange, you are on your oun with your problems. However, these two issues are easily solved by using the Internet, which is full of instructions on decentralized exchanges usage.
  3. Some cryptocurrencies don’t support smart contracts, so can’t be traded on decentralized exchanges. Developers are now struggling to solve this problem.
  4. One of the solutions is atomic swaps, that allow you to exchange cryptocurrencies, built on different implementations of the blockchain, without the participation of third parties. We'll talk later more about this technology.
  5. Small trading volumes and low processing speed. Due to the fact that decentralized exchanges are not easy for beginners assimilation, they are used by quite a limited number of people. Therefore, a warrant for a sale or purchase can hang for a long time in the list of applications, until the interested party appears.

We are confident that time simple and transparent decentralized exchanges will start to appear in a short period of time, and users will be able to trade cryptocurrency without risk of losing their savings because of scam. For now, we can only advise you to begin to sort out more details of how such sites work.

Ананьев Артем
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