A Decentralized Exchange (DEX) is a crypto exchange that allows buyers/sellers to find each other and trade their crypto assets without the intervention of a middle man. Thus, unlike a centralized exchange, the DEX users do not need to hand over the custody of their assets. As a result, the custody risk to traders’ assets is minimized.
The four core elements of a decentralized exchange development are:
- Concept Implementation
- Counterparty discovery
- Order matching Algorithm
- Transaction settlement protocol
1. Concept Implementation
A decentralized exchange holds no power over users’ funds and the users conduct direct trades on it. However, to overcome the lack of trust between the users, a DEX uses different methods. Some implementation techniques used by DEXs are:
- Escrow agent: An escrow agent is a third-party guarantor who controls the exchange of assets on a DEX.
- Smart Contract Escrow: Trusting a third-party as a facilitator of exchanging funds might involve commissions and chances of third-party having malicious intents. To overcome these issues, some DEXs implement smart contract escrow.
- Atomic Swaps: An atomic swap is a protocol developed to facilitate the exchange of cryptocurrencies using cryptography. Atomic swaps can be conducted off-chain or between different blockchains. An atomic swap requires both sender and receiver to acknowledge the receipt of funds using a hash function within a specified timeframe, thus it helps remove the counterparty risk.
2. Counterparty Discovery
A centralized exchange requires traders to submit their orders to help them find the interested party. Thus, the centralized exchanges end up creating order books where orders are matched automatically using different protocols.
A decentralized crypto exchange also has order books. However, these may exist on-chain or off-chain.
- On-chain order books
These order books are hosted on a distributed ledger.
1) If the order book is public, anyone can submit their order.
2) Members of the network help validate and process all of the submitted orders.
3) Anyone can host and access a copy of the order book.
4) As soon as two matching orders are found, the trade is executed and settled automatically.
This kind of order book is less prone to risks of centralization or restriction. Thus, they support the trustless operations of a decentralized exchange.
- Off-chain order books
Order books hosted by third parties are known as off-chain order books. Here, the third-party facilitates order matching. As a result, issues associated with centralization like restricted view and submit access to the order book might rise.
DEXs, where the underlying blockchain is not very efficient, tend to choose off-chain order book over on-chain order book. This is because the off-chain order books take off a load of constant order updates from the blockchain.
3. Order Matching Algorithms
An order matching algorithm makes or breaks the performance of an exchange. That’s because it helps pair the buy and sell orders. An efficient algorithm ensures the DEX is easy to use, provides the fair exchange rates and minimizes the order fulfilment time.
4. Transaction Settlement protocol
On-Chain settlement of transactions ensures that traders can have access to their trade settlement transactions. A DEX can choose to use different combinations of order books and settlements.
- On-chain order books and settlements
This combination offers optimum privacy and security to users. However, this makes a DEX slow, expensive to use, liquidity suffers and the DEX cannot operate with other DEX.
- Off-chain order books with on-chain settlement
In this setup, the order books are maintained by a third-party. This kind of set up ensures the exchange is able to have higher-liquidity and offer a robust infrastructure.
Hurdles in the path of building and running a successful Decentralized Exchange:
With the rise of decentralized finance, the demand for DEXs is soaring. However, building and operating a successful DEX also has its own set of challenges. Only experienced companies offering decentralized exchange development services can help you build a successful DEX. Here is the list of the challenges:
- On-chain order books use the resources of the blockchain and impact the throughput of the DEX.
- With more users coming to the DEX, the order matching waiting times increases.
- Currently, DEXs are not capable of supporting many cryptocurrencies. This is because blockchain interoperability is still a challenge.
- If a DEX leads to trade collisions, the transaction fees will be very high.
- Existing DEXs suffer due to low liquidity.
- If a DEX is functioning on a slow order matching algorithm, the users might flee.
- Fiat currency support like a centralized exchange is a challenge for decentralized exchanges.
- DEXs developed are usually not user-friendly and tend to scare users away from centralized exchanges.
If you are planning for decentralized exchange development, Antier Solutions can help. We leverage our technical prowess and blockchain expertise to build high-performance decentralized exchange platforms that provide a world-class user experience.
Connect with our subject matter experts to share your needs for decentralized exchange development.