While centralized crypto exchanges boast the benefit of regulation and KYC, decentralized exchanges stand out with a revolutionary blockchain phenomenon- smart contract. One of the game-changing blockchain applications, smart contracts help to automate the trading process in decentralized cryptocurrency exchange blockchain platform and also minimize counterparty risk. Check out more about Multibank.io.
We will discuss in detail how smart contracts work and help decentralized cryptocurrency exchange blockchain platforms. But, before that, let’s have a few words about smart contracts.
Decoding smart contracts
Smart contracts can be defined as blockchain applications that serve as self-executing digital contracts. Smart contracts, as we find them today, were first introduced by the Ethereum blockchain.
Smart contracts work based on the principles of condition programming. It implies that these digital contracts will automatically execute a transaction or an order, or an agreement, the moment some predefined conditions are met.
Benefits of smart contracts
As smart contracts are based on blockchain platforms, they automatically enjoy the revolutionary features and benefits of blockchain.
Decentralization- Smart contracts work in a decentralized “direct” environment, eliminating the presence of intermediaries.
Transparency- All data that are entered into smart contracts are always visible to all parties involved in the contract.
Immutability- As blockchain is immutable, so are smart contracts. It is more than impossible to alter and modify any kind of data that is entered into the smart contracts.
Security-Smart contracts use cutting-edge cryptographic protection to safeguard data, making the whole database impossible to hack.
Automatic execution- It’s not possible to resort to fraudulent activities if an agreement or transaction is based on smart contracts. It’s because smart contracts are self-executing contracts based on condition programming. So, the moment the pre-set conditions are fulfilled, these contracts will automatically execute the task mentioned beforehand. This way, smart contracts go a long way to prevent counterparty risks.
Decentralized exchanges and smart contracts
In centralized exchanges, the entire trading activity takes place through a custodian. It’s the custodian or the centralized authority that supervises and executes the trade, as well as, exercises control over funds.
But, decentralized exchanges work in a different way. These crypto exchanges are built upon smart contracts-compatible blockchain platforms. Unlike the CEX counterpart, these cryptocurrency exchange blockchain platforms do not depend on intermediaries to execute the transactions. Rather, these portals depend on self-enforceable smart contracts for facilitating trading and related transactions. Ethereum is the prime hub of smart contracts today. In fact, the majority of DEXs are developed on the Ethereum blockchain only.
DEX allows direct P2P trading for traders, straight from the traders’ wallets through interaction with smart contracts. In this case, your funds are never under the custody of the cryptocurrency exchange blockchain platform- rather you can protect them in your wallet, guarded by private key. The wallet must be compatible with smart contracts as otherwise you won’t be able to conduct the trade on the DEX.
AMM (Automated Market Maker)
There are different kinds of DEXs and all of them use smart contracts for facilitating trading. However, the most popular model for decentralized cryptocurrency exchange blockchain platforms is the AMM model.
The AMMs depend on the smart contracts to address the problem of liquidity plaguing the crypto exchanges for long. Now, mention must be made of “Oracles” here.
It must be mentioned here that smart contracts, no matter how powerful these are, are restricted by certain limitations. Blockchain platforms are unable to access off-chain or real-world data due to certain in-built protocols. The problem extends to smart contracts as well. Put simply, smart contracts are unable to access data from the real world on their own. This inability to access data from the external world limits their ability to function in their ultimate potential.
This is the place where Oracles come to help the smart contracts. And AMMs depend on these oracles to bring data for smart contracts so that the latter can execute the trading tasks seamlessly. The oracles bring data from various cryptocurrency exchange blockchain platforms to help AMMs define asset prices for trade.
How do smart contracts benefit DEXs?
Smart contracts are always a mighty and highly beneficial technology behind the decentralized cryptocurrency exchange blockchain platforms. Here is a brief on how the smart contracts benefit the DEXs.
Eliminates counterparty-risk
No every other person you trade with is an honest and ethical person. In fact, the number of fraud traders today is probably more than that of honest traders. What if your buyer signs out without paying after taking the assets from you? Sounds scary, right, Well, there is no dearth of such fraud traders around. This is one place where smart contracts help to protect innocent traders.
As mentioned above, smart contracts represent self-enforceable contracts. The contract might set the condition that the buyer’s money will be locked into the wallet connected to smart contracts till the trading period. So, the moment the buyer will purchase crypto from you, the smart contracts will immediately pass on the payment to the seller. This way, smart contracts prevent the risk of non-payment by buyers and help to ensure a safe and inviting trading environment.
Some experts might criticize DEXs for not following KYC protocols that are otherwise used by CEXs to weed out imposters. But, DEXs might not need KYC protocols as strongly as CEXs, thanks to the smart contracts that already help to prevent fraudulent activities.
Faster trading
Smart contracts also help to ensure faster trading on a decentralized cryptocurrency exchange blockchain platform. As you know, smart contracts follow a decentralized environment and eliminate the presence of intermediaries. It rather facilitates a direct P2P trading environment that executes trades and transactions way faster than a traditional trading platform.
Lower costs
If you compare the fees between centralized and decentralized exchanges, you will see that the latter one always charges lesser fees than that of the former. In this case too, the credit goes to smart contracts.
As smart contracts eliminate the intermediaries, these also help to offset the costs associated with involvement of middlemen. The end result is a safe trading environment at lesser fees.
