The blockchain entails decentralization. However, paradoxically, the exchanges that have operated in the blockchain and crypto space since its inception were all centralized. If we look at the landscape of cryptocurrency exchanges and examine their development from the standpoint of their basis, detached from the legal and regulatory requirements, we will notice that all of the major ones like Binance were deployed by a group of people who later took custody of the legal entity and the funds entrusted to it by the users.
The collapse of several exchanges like FTX in 2022 and the ensuing crackdown on the part of the US Securities and Exchange Commission revealed some glaring vulnerabilities in the crypto space regarding users’ neglect towards exchange decentralization and the security of centralized entities. Following the troubles with Binance and other exchanges, trading on decentralized exchanges soared by 444% in early 2023. This opens up an entirely new chapter of opportunity for DEXs and their positioning as the only true and reliable hubs of crypto exchange in the industry.
The DEX Opportunity
Decentralized exchanges offer a number of significant advantages over their centralized adversaries. Apart from being free of a legal entity that would be vulnerable to external interference and pressure, DEXs grant the advantage of being more secure by the same virtue of having no centralized operating mechanism. The hackers will have a difficult time accessing not just most, but even some of the hubs that make up a DEX, eliminating the possibility of a breach by simply outweighing the potential gains by the resources required to achieve such a feat.
Though significantly more secure and attractive as a trading venue by virtue of their inherent technical characteristics, DEXs still have a number of shortcomings that limit their spread. Among the most important drawbacks is the slow influx of liquidity, which is being restricted by poorly developed interfaces and lack of knowledge among users, as well as trust.
The cross-chain experience is also still in its infancy, since many DEXs are limited to a single blockchain network and are only just tapping into the potential of Layer 2 and other interaction solutions. There is also the issue with slippage, but it is a small price to pay for security and reliability.
The main selling points that DEX are currently pushing forward are transparency and reliability by capitalizing on the peer-to-peer trading approach. This means that users have to be proven that they can trust DEXs, as they are not entrusting their funds and operations to a centralized entity, but to an automated system that simply links them with other users.
The key competitive advantage that would set DEXs apart from their centralized adversaries is the ability to attract users with a holistic experience that would trump the need to place trust in a centralized traditional authority. Liquidity is much less important in the given market, since it is available to those who require it and there is no longer any difficulty in finding buyers for any type of asset on any type of platform. The focus is now on Web3 users who are placing their stakes on complete decentralization – a selling point that is inherent to all DEXs.
Opportunity Breakers
Decentralized exchanges that exist today have a hard time attracting users with any options other than their decentralized characteristics. The interfaces are still far from resembling the quality of centralized exchanges, which have capitalized significantly in the time since their inception on expanding their scopes of services. Few DEXs can boast of having multiple services or platforms, such as NFT marketplaces, DeFi services, lending and borrowing facilities, and other features all within the scope of a single hub.
Most importantly, DEXs are not very decentralized either, since they comply with the same KYC principles as centralized exchanges. Though this is a necessary measure to prevent money laundering and the financing of terrorist activities, users see this factor as a major breach of their privacy and personal data. The upside is that DEXs do not have centralized storage of user funds, reducing the risk of hacking, and give traders complete anonymity during their operations.
True DEXs require users only to have a username and starting capital to start trading. But that does not stop financial surveillance from being in place on DEXs. The Financial Crimes Enforcement Network or FinCEN, obligates businesses, financial institutions, and exchanges to report suspicious transactions to law enforcement under the Suspicious Activity Reports or SARs:
“Under FinCEN regulations, a person is exempt from money transmitter status if the person only provides the delivery, communication, or network access services used by a money transmitter to support money transmission services. Consistent with this exemption, if a [convertible virtual currency] trading platform only provides a forum where buyers and sellers of [convertible virtual currency] post their bids and offers (with or without automatic matching of counterparties), and the parties themselves settle any matched transactions through an outside venue (either through individual wallets or other wallets not hosted by the trading platform), the trading platform does not qualify as a money transmitter under FinCEN regulations.”
In essence, DEXs act only as platforms that facilitate peer-to-peer transactions and are exempt from the regulation if they are merely trading between each other. This acts as a powerful advantage in favor of DEXs for users seeking true privacy and an escape from oversight. However, such exemption does not mean that DEXs and users are free from all oversight and all of their operations are released from surveillance.
Since surveillance, regulation and laws were put in place to protect investors, their main object of attention are securities. As such, users who trade assets deemed securities on DEXs will have to be careful. The main hurdle is that the definition of a security in the cryptocurrency space is still moot. The sole guidance is that tokens that promise profit in the future to their holders are securities. As such, practice dictates that a DEX that only facilitates the trade of non-security assets is not subject to regulations and laws regarding securities.
The Future
A DEX is more than just a hub for facilitating the peer-to-peer transactions of users who wish to remain anonymous. It is the true embodiment of the blockchain and its principles. With Web3 growing and expanding into an increasing number of everyday life aspects, it is possible that only DEXs will be able to survive in such a fully automated, blockchain-based, and decentralized environment.
Since Web3 entails complete privacy and a peer-to-peer approach to financial matters with protection of personal data, the DEX fits the description of an ideal venue for such a narrative. However, only time will tell if the functionality of DEXs and their development into user-focused and user experience oriented platforms will be able to guarantee their dominance. DEXs are facing stiff competition, since centralized exchanges have a head start in the scaling, user experience, interface, and service range domains.
