Decentralized Exchanges – How to Start a DEX

One might assume that if a DEX is not governed by anyone in particular and gives its customers free rein in trading operations, it will not need a legal permit. This is not necessarily true. Assessing the need for a license starts with defining the business model of your future startup.

While some decentralized exchanges are crypto-only, which means that they allow customers to connect their wallets and use cryptocurrencies for trading directly from there, others can offer more flexible solutions, such as on-ramping for the trading process. On-ramping involves exchanging fiat currencies for digital ones to further use them on a DEX.

The involvement of fiat in a Decentralized Exchange is a prerequisite for licensing in its own right.

Liquidity is an aspect of huge importance in the stability of a DEX. Since decentralized exchanges connect traders directly to liquidity pools, without stable liquidity, it would be impossible to perform successful trading operations. A good example of the importance of liquidity is on-ramp services: a Decentralized Exchange that offers on-ramping must be able to find the liquidity to provide all customers with crypto in exchange for fiat.

Multiple factors contribute to stable liquidity. It is often managed by ensuring a sufficient number of trading pairs supported by the platform. For this purpose, it is important to evaluate which crypto trading pairs are the most popular among customers. Besides, do not forget about market making, which is the concept of active selling and buying cryptocurrencies that helps provide and support liquidity. This process can be facilitated by using Automated Market Makers (AMMs), the decentralized protocols that rely on algorithms to ensure direct and effortless crypto trading and sufficient liquidity.

Decentralized exchanges do not hold custody over their clients’ funds. Instead, traders connect their crypto wallets to the platform and use them directly for trading after obtaining an individual private key. The process usually takes less than a minute and does not require any additional information from the trader whatsoever. Once a user wants to trade cryptocurrency, the DEX connects them to a corresponding liquidity pool.

An important technical aspect of this process is connecting crypto wallets. As a future owner of a Decentralized Exchange, you must think in advance of the crypto wallets that your platform will support. As a rule, it would be wise to concentrate on the most widely used ones, the crypto wallets that have gained client trust around the world and in the country with your particular targeted market. For instance, you could consider Metamask, a wallet that is tremendously popular among seasoned crypto traders.

If a Decentralized Exchange has no central authority, then who draws policies and makes changes? Most often, a Decentralized Autonomous Organization (DAO) is behind the decision-making process.

A trading platform can either create its own DAO before launch or enter a partnership with an already existing DAO. In this way, it will obtain a decentralized legal structure based on a set of smart contracts, in which traders will participate by purchasing DAO’s governance tokens.

In most cases, a DEX platform will not require a license. However, it depends on the business model and technical subtleties of a particular project. One of the defining elements is the addition of on-ramp trading. If you plan to implement on-ramping within your Decentralized Exchange, then it will most likely require a crypto license. That license is also required for the subsequent custodial services provided on your exchange if you will detain the funds of your customers.

From the legal perspective, it means dealing with all the preparatory procedures and meeting the requirements of a regulatory authority. LegalBison’s know-how allows us to effectively analyze the most suitable regulator for a particular DEX project. Contact us with your project plan and the legal experts will draft a legal opinion or memorandum specifying the licensing needs for each aspect of your Decentralized Exchange.

With the need for a license comes a meticulous process of meeting AML-CFT and due diligence requirements. For AML-CFT compliance, most regulators require licensees to draft an adequate compliance program, as well as assign a responsible AML officer. LegalBison excels at ensuring AML compliance for clients, taking up all the necessary paperwork, and providing compliance trading for key shareholders.

In addition, the due diligence process is an integral part of the compliance procedure. For on-ramping, it is essential to provide a banking gateway, and banks tend to verify their clients before accepting transactions. In the case of a Decentralized Exchange, the KYC process will be the platform’s responsibility, as required by the majority of regulatory authorities.