Author: Liu Honglin

Blockchain technology is a technology that uses cryptography and consensus mechanisms to achieve distributed storage and verification of data. There are many applications of blockchain technology, one of which is decentralized exchanges (DEX).

Decentralized exchange (DEX) is a blockchain-based digital asset trading platform that does not store user funds and personal data on servers, does not rely on third-party intermediaries, but directly facilitates the trading and transfer of digital assets through smart contracts and peer-to-peer networks. On DEX, users can directly use their own wallets for trading without transferring control of their funds to any intermediaries or custodians. This can help avoid some risks of centralized exchanges, such as hacking, platform shutdowns, and asset freezes. Additionally, DEX can also protect user privacy as they do not need to implement regulatory requirements such as KYC and AML.

Current Status of DEX

There are various types of DEX in the market, which can be classified based on the order book method and trading mechanism.

Based on the order book method, they can be divided into on-chain order book and off-chain order book. On-chain order book records all orders on the blockchain, confirmed by miners for each transaction. This method is more decentralized but also slower and more expensive. Off-chain order book hosts trade records in a centralized entity, using relayers to manage the order book. This method is faster and cheaper but more centralized.

Based on the trading mechanism, they can be classified as Automated Market Maker (AMM) and Order Matching (OM). AMM does not require an order book, instead, it uses smart contracts to form liquidity pools and automatically execute trades based on certain parameters. This mechanism simplifies the trading process but may lead to issues such as price slippage and impermanent loss. OM requires an order book and completes trades by matching buy and sell orders. This mechanism is more flexible and efficient but requires more liquidity providers and market participants.

Currently popular DEX in the market include Uniswap, SushiSwap, PancakeSwap, Curve, Balancer, which adopt the AMM mechanism and operate on public chains such as Ethereum or Binance Smart Chain; those based on the OM mechanism include 0x, Loopring, dYdX; those based on cross-chain technology include Thorchain, Ren, Polkadot; and those based on aggregator technology include 1inch, Paraswap, Matcha.

While DEX addresses the security, privacy, and sovereignty issues of centralized exchanges, it also has some shortcomings such as trading speed, liquidity, and usability. Due to the need for transactions on the blockchain, trading speed is affected by blockchain network congestion and gas fees. Additionally, the relatively lower number of users and trading volume on DEX leads to insufficient liquidity, making it difficult to meet the demands of large trades.

Firstly, the user experience and usability of DEX still need improvement. Users need to connect to DApps or install standalone DEX clients and use their own blockchain wallets for operations.

Secondly, the liquidity and trading speed of DEX are relatively low. Due to the small market share of DEX in total trading volume, it is difficult to conduct large or rare token trades. Additionally, since all trades require confirmation on the blockchain network, delays and slippage issues may occur.

Thirdly, DEX is not completely immune to government regulation and intervention. Although DEX itself does not have centralized servers or institutions, the underlying public chain network may be subject to attacks or blockades. Furthermore, DEX may also face legal actions or liability if it issues or trades tokens suspected of fraud or illegality.

Legal Risks of Starting DEXs in China

China does not welcome virtual currencies or cryptocurrency exchanges.

In September 2017, the People's Bank of China announced the ban on all domestic ICOs and cryptocurrency trading platforms, leading to the closure or relocation of many well-known CEXs. In September 2021, China further strengthened its crackdown on cryptocurrencies, prohibiting all financial activities and services related to cryptocurrencies.

In such an environment, DEXs seem to provide a workaround for Chinese cryptocurrency users to bypass government scrutiny and intervention, enabling more freedom and decentralized trading. After all, DEXs do not require user registration and real-name authentication, nor do they charge listing fees, allowing anyone to issue and trade their cryptocurrencies without barriers. However, considering the large market of domestic cryptocurrency players in China and the cost-effective nature of technical developers, a considerable number of decentralized exchange teams are still physically located in China. Therefore, for everyone, starting a decentralized exchange in China still carries high legal risks. Based on the practical experience of our Mannkin legal team, entrepreneurs need to pay attention to the following risks.

1. Legality of Virtual Currencies

According to relevant policies and judicial practices, virtual currencies do not have the attributes of legal tender in China, nor do they belong to financial products or services. Therefore, activities such as the issuance, trading, and payment of digital currencies within China may violate relevant laws and regulations. Decentralized exchanges as trading platforms for digital currencies may be suspected of engaging in illegal financial activities or money laundering, and may be subject to regulatory investigations or closures.

2. Compliance of Information Disclosure

Although decentralized exchanges do not require third-party intermediaries, they still need to provide users with necessary information, such as platform profiles, trading rules, risk warnings, and dispute resolution methods. This information should be disclosed to users truthfully, accurately, completely, and in a timely manner, otherwise it may constitute false advertising or fraudulent behavior, infringing on the legitimate rights of users. Decentralized exchanges should establish sound information disclosure systems and processes, comply with relevant laws, regulations, and industry standards, and safeguard users' right to information and choice.

3. Responsibility for Protecting User Rights

Although decentralized exchanges do not custody users' digital assets, they still need to provide a secure, stable, and fair trading environment for users. If the platform experiences technical failures, security vulnerabilities, or malicious attacks, resulting in users being unable to use the platform normally or suffering asset losses, the platform should bear corresponding compensation responsibilities or assist users in recovering losses. Decentralized exchanges should strengthen technical research and development and maintenance, enhance platform security and reliability, establish effective risk prevention and emergency response mechanisms, and safeguard user rights and market order.

4. Regulatory Issues of Cross-Border Transactions

Due to their decentralized nature, decentralized exchanges often have cross-border characteristics, meaning the platform can serve global users, and users can trade in different countries or regions. This poses certain difficulties for regulatory authorities because different countries or regions may have different attitudes and regulations regarding digital currencies, and even conflicts may exist. When conducting cross-border transactions, decentralized exchanges should comply with the laws and regulations of relevant countries or regions, respect local cultures and customs, avoid triggering political or social sensitive issues, and also pay attention to protecting their own legitimate rights, preventing unfair or unreasonable intervention or sanctions.

Mannkin Legal Recommendations

Decentralized exchange DEX is an emerging digital asset trading model with advantages such as security, privacy, and sovereignty, but it also faces challenges such as speed, liquidity, and usability. Starting a decentralized exchange business in China carries relatively high legal risks, requiring a full awareness of risks and compliance, as well as professional legal advisors and teams. At the same time, attention should be paid to the dynamic policies and market changes at home and abroad, and timely adjustments to their own development strategies and operational models should be sought to find a legal, compliant, and sustainable development path.

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