Are Decentralized Exchanges Legal?

Cryptocurrencies like Bitcoin ($BTC) promise a decentralized future, and decentralized exchanges (DEXs) are a part of that. Peer-to-peer (P2P) token swaps are among the cheapest and most effective way to trade crypto tokens. It’s accomplished through automated smart contracts instead of a centralized middlemen like the Nasdaq or the New York Stock Exchange.

Think of decentralized exchanges as being similar to over-the-counter (OTC) in stock trading. Whether that’s a good or bad thing depends on what criteria you’re judging by. It’s cheaper and faster, but there are problems that can arise from a decentralized marketplace. Liquidity, for example, can be an issue without a centralized authority investing funds to generate profits.  

Still, DEXs are a cornerstone in the world of decentralized finance (DeFi) and can be a powerful tool in your arsenal. They allow you to directly exchange crypto without paying extra fees to a marketplace like Coinbase (NASDAQ:COIN), much less the gas fees the extra step costs on a chain like Ethereum ($ETH).

But before you transact using a DEX, it’s important to understand what’s happening under the hood.

What Makes an Exchange Decentralized?

A centralized exchange like Coinbase puts a single entity in charge of everything happening within the exchange. Think of it like shopping at Walmart (NYSE:WMT) versus a farmer’s market – everything you buy at Walmart is being bought from the house. So, Coinbase holds custody of your funds just like a bank, even though you’re the owner of the account.

Centralized accounts are heavily regulated because there’s an entity to crack down on. That entity provides customer service and ensures that all transactions are fairly handled and stringently accounted for.

A decentralized exchange, on the other hand, relies on smart contracts to remove the intermediary. Users trade directly from their wallets and are responsible for their own security and custody. They then deposit their funds that are wrapped in a smart contract and can be traded across the network.

These DEXes run on top of other smart contract platforms, and there are three main types:

• automated market makers,
• order books, and
• DEX aggregators.

Each operates somewhat differently, and different parts of any given exchange may still be somewhat centralized.

The difference between centralized exchanges and decentralized ones is so stark that it’s natural to ask the question: is a DEX legal?

Are Decentralized Exchanges Legal?

The legality of DEXs is as varied as crypto assets themselves. In the United States, some exchanges are banned in the state of New York, among others. Popular exchanges are increasingly under a microscope by regulators like the Securities and Exchange Commission (SEC) looking for compliance, transparency, and other investor relations hot topics.

In some cases, DEXs remain the only way for you to obtain certain cryptocurrency tokens, like Monero and Dash, which can’t be listed on government-approved exchanges. And these exchanges let retail and institutional investors stake their holdings into liquidity pools to earn commissions on trades that would normally go to brokerage firms.

There is a risk in trading on these exchanges though – you don’t have the same protections you’re provided by a centralized exchange. And that’s just one of many reasons some crypto investors still prefer to pay for a centralized exchange.

Why Some Investors Prefer Centralized Exchanges

Centralized exchanges do provide services and benefits for the fees they charge. For one thing, they remove all the friction of trading to help onboard new users. A user-friendly interface lowers the bar and makes it easier for a platform to scale and expand, thus bringing in more revenues and fueling growth.

Losing your private crypto keys is very easy to do, and it’s estimated that around 20 percent of all bitcoins are already lost. Centralized exchanges can be easier to log into vs a private wallet, which may be lost forever if you don’t have the keys to unlock it.

And centralized exchanges are much faster because they maintain their own liquidity pool. Human intervention can often lead to a more secure environment for more conservative investors. Although it’s arguable whether barring access to certain coins is truly protecting investors from fraud.

Thus, a portion of the crypto community will always prefer a DEX.

Best Decentralized Exchanges

The main benefits of using a DEX are increased security and anonymity. Transactions are harder to trace, and you don’t need to be involved in criminal activity to not want your finances broadcast to the world. Additionally, a DEX is viewed as a lower target for hackers, as there’s no centralized token pool to steal.

If you’re seeking a DEX, here are three popular marketplaces to consider.

1. Uniswap

Uniswap is an Ethereum-based DEX protocol that facilitates easy ERC-20 token swaps as an automated market maker with mathematical formulas determining price. It helps exchange tokens off-chain, without the need to pay Ethereum’s high gas fees. The platform is generally regarded as safe, and it has its own proprietary Uniswap token.

The $UNI token is available on various centralized marketplaces, including Coinbase, Gemini, and Binance. Its price has more than doubled over the past twelve months, and that resulted in the token amassing a market capitalization of over $11 billion.

2. PancakeSwap

Like Uniswap, PancakeSwap is a legitimate DEX protocol that acts as an automated market maker. Instead of Ethereum, however, it operates on the Binance Smart Chain. This helps exchange a different set of trading pairs funded by its automated liquidity pools. Pancake also issues its own proprietary $CAKE token for users.

Although it’s on the rise, PancakeSwap still lacks the liquidity of Uniswap for most popular tokens. These smaller liquidity pools mean it can take longer to execute a trade. Although it’s generally considered safe, it’s important to point out a $200 million flash loan exploit that took place on sister platform PancakeBunny.

3. Sushiswap

Sushiswap is another DEX that utilizes automated market maker algorithms to determine pricing. In fact, it’s simply a Uniswap fork that changes the tokenomics to be more community focused. Whereas Uniswap rewards all the exchange fees to liquidity providers, SushiSwap also pays a portion to hodlers of its $SUSHI token.

The fees paid are ultimately the same (0.3 percent of transactions), but by giving a portion to token holders incentivizes users to hodl their supply. This could be a beneficial investment opportunity if you understand enough about what you’re doing to fund a liquidity pool and hold SUSHI.

Decentralized Crypto Exchanges: The Bottom Line

Although convenient centralized exchanges like Coinbase and Binance exist, some users prefer to trade without their bells and whistles. The crypto industry originated with an ideal to decentralize finance, and a DEX does that by removing the intermediary and drastically lowering fees.

These financial tools make it easier to trade crypto and let you buy and sell crypto assets that may not be supported by regulated markets. But regulatory heat continues to surround these markets. While they may not be as vulnerable to hacks as centralized exchanges, there is still risk involved in a DEX.

Still, this useful financial tool has a bright future in the world of crypto and beyond.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.