2.6.0. Two Types of User Interfaces
The crypto user interfaces are the exchanges, the aggregators, and the lending platforms. As the Crypto Market grows, two kinds of exchanges have emerged - Centralized and Decentralized Exchanges. Table 6 summarizes the differences between these two exchanges.
(1). Centralized Exchanges
Centralized exchanges are the first kind of user interfaces; they originated with the birth of Bitcoin, the first crypto to be invented. In a centralized exchange, the buyer and the seller of the crypto meet to trade in cryptos or crypto-fiat currencies under the coordination of a third party, a central figure, who lays out the conditions for transaction.
Centralized exchanges have been discussed in the lessons of Grades 4 and 5 of the Primary SOC.
Normally, in a centralized exchange, when you want to send, receive, buy or sell a crypto:
• the prices of the currencies are displayed in an Order Book in the exchange
•the private key of your wallet is held by the exchange, which means that when you want to withdraw your crypto, the exchange will have to sign the transaction on your behalf.
This means you will need to trust the exchange to do the right thing. But such right thing is sometimes not done.
Occasionally, front running occurs in centralized exchanges.
Front running is a practice in which an insider is aware of a pending transaction and uses that privileged information to place a trade before the transaction is processed. The front runner, therefore, benefits from information not known to the public. Generally speaking, this is illegal.
Thus, trust has been a major challenge in centralized exchanges.
(2). Decentralized Exchanges
Because of the problem of trust with centralized exchanges and with the birth of the Ethereum blockchain in 2015, developers started to experiment with new ideas to produce new models for exchanges.
The stages of growth of these new models are as follows:
(a). Order Book on Blockchain
Instead of keeping the Order Book that contained the selling/buying price offers of users on the exchange, from 2016 some developers decided to build exchanges that would rather keep the Order Books on blockchains. By this action, no third-party would be in charge of transactions.
Such a user-interface model in which the Order Book is kept on a blockchain is known as Semi-Decentralized Exchange. Exchanges that utilized this model include Oasis and the 0x.
(b). Automated Market Makers
By 2018, a new idea to completely get rid of the Order Book was developed. That is, instead of providing an Order Book, a model was developed in which users were encouraged to supply their cryptos on blockchains so that anyone can easily transact with the cryptos.
To encourage users to keep their cryptos on the blockchain, the users receive a small percentage of profit from every transaction that involve their cryptos.
Such users who provided their cryptos for the transactions on the blockchain are called Liquidity Providers (LP).
By this method, there is no need to have any central party to supervise and interfere with transactions and no need for Order Books.
This user-interface model is known as Automated Market Makers (AMM). That is, it is automated and the Liquidity Providers are the makers (creators or producers) of the market.
AMM is a fully decentralized model that has two main benefits:
• it is trustless, that is, no more problems with trust
• it is permissionless, that is, does not require any KYC (know your customer) documentation or any other form of permission.
Today, decentralized exchanges use the AMM model. Because transactions are carried out on the blockchain, decentralized exchanges reduce the risk of theft, prevent price manipulation or faked trading volume, and offer more anonymous transactions than centralized exchanges.
2.6.1. Two Challenges with Decentralized Exchanges
The challenges with the decentralized exchanges (often abbreviated as Dex) are twofold:
(1). Irreversibility
Since there is no human agent involved in the transaction process, if you accidentally enter a wrong wallet address, wrong prices, or any other mistake, the transaction cannot be reversed and you will suffer a loss.
(2). Non-Custodial Wallet
Because it is decentralized, it means both the public and private keys of your wallet are in your control. Thus, the security of your funds is in your hands. This places an enormous responsibility in your hands to tighten security around your wallets in order to prevent unauthorized access. If you are careless, you may pay for it with scammers taking advantage of that carelessness to steal your funds.