KEY TAKEAWAYS:
— DEX stands for Decentralized exchange while CEX stands for centralized exchange. They both refer to platforms where crypto users can exchange, buy and sell cryptocurrency, seamlessly.
— CEX offers benefits like guaranteed liquidity, exchanging crypto to fiat, ease of use, have entail concerns about security, lack of user complete ownership and lack of anonymity.
— DEX offer complete ownership of coins and control of private keys, the possibility of governance tokens and complete anonymity but can be more complex to learn and use for beginners, do not allow fiat payments can have limited liquidity.
— DEX or CEX – which one benefits your own crypto needs? Here, we help you assess.
What’s a Crypto exchange?
Crypto is constantly evolving and changing. It is a space of consistent innovation where developers are continually inventing solutions to problems and finding ways to take the era of digital finance to a more sophisticated level. A good example of this evolution in the world of crypto can be seen in the generations of cryptocurrency exchange. There are two types of cryptocurrency exchange, namely the first generation centralized platforms, and the more recent swathe of decentralized exchanges (all the juicy details are just below).
Just like stock exchanges exist as a means for people to buy and sell assets in the form of shares and derivatives, cryptocurrency exchanges are a crypto marketplace where people get to buy and sell blockchain-based coins and tokens. But exactly how your transaction works – and the possibilities for you the user on each platform – depends on the type of exchange you’re using.
Let’s take a look at the two generations of crypto exchange, exploring how they work, key differences and limitations and what they offer users – so you can decide for yourself which one you need and start trading with confidence.
Centralized Exchanges – and their Benefits
This type of exchange platform is created and owned by a centralized organization that acts as an intermediary matching buyers and sellers. Notable centralized exchanges include Coinbase, Binance, Kraken, and Gemini, to mention but a few that you might already be familiar with.
A few other features define centralized exchanges, let’s take a look at the main ones.
CEXs are Custodial
One of the key defining features of centralized exchanges is that they are custodial. What does this mean? It means that when you want to trade on a CEX, you keep your funds in a wallet tied to the exchange itself, instead of in your own wallet. What’s important is that the exchange keeps the private keys to the wallet, not you – instead, you get login details for the platform.
On the surface level, this has some benefits, especially for new users who are just getting a hang of the complexities of crypto: safely managing your private keys is one of the most significant concerns for crypto holders, so using an exchange that handles the burden, leaving you to focus on trading, might seem pretty appealing.
Liquidity
Centralized exchanges are highly liquid. They facilitate trades by centrally matching “buy” and “sell” orders from users, otherwise known as an “order book” system. This means liquidity is a function of the number of buy and sell orders on the books and, with most people’s first steps into crypto taking place on a centralized exchange, their order volumes are necessarily higher than their decentralized counterparts. This system is further bolstered by the fact that centralized exchanges can offer incentives to large-volume traders who provide liquidity to their order books.
Companies like Binance, for example, have recorded over $30 billion daily from transactions, and because the trading figures are so high, you’re likely to always find liquidity for the trade you need.
Ease of Use
Centralized exchanges also tend to be associated with ease of use, which is not surprising; for most crypto users, a central exchange is where they make their very first purchase of crypto using their credit card – otherwise known as “on-ramping” into crypto.
With these exchanges being the very first thing people see when they buy their first crypto, it stands to reason that they need a clear, user-friendly interface, something CEXs have a reputation for.
Know your Customer Onboarding
And finally, with global norms shifting to accept crypto is here to stay, so exchanges have made concerted efforts to ensure coins and tokens can’t be used to launder money. So before you begin trading on a centralized exchange, you’ll need to produce documents confirming your ID and sometimes your address to coordinate with these measures.
Limitations of Centralized Exchanges
As with all good things, there are also some compromises to consider. Here are some of the limitations of using a centralized exchange – a few of which spurred the innovation that drove their decentralized counterparts.
Ownership and security
As you know, a centralized exchange requires you to keep your funds in the exchange’s own wallet, whose keys are managed by the platform. Sure, this relieves you of the burden of managing your private keys – but at what cost?
Remember: not your keys, not your coins.
Letting the exchange manage the key for your wallet means whatever assets you keep in the wallet are not truly yours. And this is not just a question of ownership, but also has security implications; by leaving your funds within an infrastructure other than your own wallet, you’re relying on the security standards of another that entity. If the exchange gets hacked or phished, or even goes out of business, your coins will be gone too.
So in short, how can centralized exchanges be conceptualized? They are a compromise, where users forfeit their control and ownership of their coins for the ease and convenience of the platform.
Barriers to Entry
As with any centralized entity, one of the key disadvantages of CEXs is their barriers to entry, set by the exchange itself. This can take a couple of forms: you may be looking to trade a particular coin, but can’t find it because the exchange has (for its own reasons) chosen not to integrate that coin; or maybe you live in a country where certain services of the exchange are off-limits. The point in either case is that, with the decision making power of the exchange centralised, users are limited to the access granted by the platform.
Fewer Options and Opportunities
And since this type of exchange has decision making power over which coins and tokens to include, options might not always reflect what users want to see and interact with, and likely won’t give users any early bird advantage on new projects. A prime example is NFTs, which, despite being a popular trading commodity, are only just being integrated on Binance and Coinbase.
Vulnerable to Sanctions
Since CEXs exist as a distinct legal entity, they’re susceptible to sanctions and limitations from states – and as we’ve seen in China and Iran, not all states are crypto lovers. Remember we discussed giving custody of your keys to the exchange? With a CEX so easily shut down or limited by external authorities, you might not feel so bright and breezy about leaving your funds in their custody after all.
Decentralized Exchanges – the next generation crypto exchange
OK! So now you’ve made friends with CEX, it’s time to get up close and personal with DEXs.
What exactly is a decentralised exchange? Like a CEX, the purpose of a decentralised exchange is to allow you to trade your crypto assets. But the structure of this type of exchange is fundamentally different.
There are two main types of DEX: order-book based, and automated market makers.
Order Book DEXs
Like centralized exchanges, the older generation of DEXs tend to operate using a decentralized version of an order book system. You might already know some Order Book DEXs, such as LoopRing, Gnosis Protocol or IDEX – all of these use an algorithm (instead of a central platform) to find and route the trades between individual users, and smart contracts record the exchanges on the blockchain to reflect the coins and tokens that are moving between buyers and sellers.
In other words, there is a market – but no one is in the middle selling for you, only an algorithm. This is how the service remains decentralized.
Automated Market Maker DEXs
Automated Market Maker DEXs are also known as AMM DEXs and tend to embody the more recent swathe of exchanges. They were developed as a response to a key problem that is prevalent in crypto exchanges – lack of liquidity. You might already be familiar with some of those protocols – SushiSwap, Uniswap and Compound are just a few of the most prevalent.
Instead of matching buyers and sellers, the trades on AMM DEXs are carried out using liquidity pools managed by the DEX’s own smart contract. The liquidity is sourced from users who either give their coins or tokens (in trading pairs) in exchange for passive income or, if they’re taking a more calculated approach, as part of a broader yield farming strategy.
The exchange itself sets the price of trades between coins automatically, depending on the supply and demand for those assets. This is done through an algorithm that is constantly rebalancing to reflect changes in liquidity and is not necessarily in synch with the rest of the market – this, incidentally, is a prime opportunity for eagle-eyed traders to make yield through arbitrage. If you’re interested in knowing how that works, check out our deep dive on AMMs.
Benefits of Decentralized Exchanges
Self-Custody
This is the beauty-you! Since a DEX does not exist as a central entity, there is no platform to put funds into – instead, you simply connect the DEX to your existing wallet, using your own private keys to manage your funds.
So unlike a CEX, using a DEX might not necessarily relieve users from the burden of self custody – but the pay off is that your coins will never be controlled by anyone but you.
The question of self-custody is also becoming easier as the ecosystem evolves. With Ledger’s growing list of integrations now including decentralized exchanges such as Paraswap, using a DEX for swapping while managing the specifics of self-custody can still be a seamless experience, coupling clear signing and ease of use from within Ledger’s own ecosystem, with the absolute security of cold storage.
No KYC or Onboarding Data
Since DEXs have no interaction with fiat money, they don’t need to be KYC compliant – this means you won’t be asked for ID to begin using one. The good side of this is that your privacy is respected and your details are not porously left on the digital network for just anyone to tap or hack. This is definitely a good thing.
But don’t get too carried away with ideas about anonymity! Although your the DEX doesn’t require tour data and your DEX trades won’t be tied to your identity, everyone has to comply with Know Your Customer measures somewhere when they first buy crypto – so ultimately, every trade floating around in the blockchain ecosystem can be related back to the money’s real world owner.
Wider Range of Crypto
Since the selection of coins and tokens on a DEX is not limited to the agenda of a central entity, users are more or less free to find the projects they’re interested in and start getting involved. One of the best parts of this is the ability to be an early adopter in up and coming projects you managed to get some alpha on – so for traders who don’t mind doing the research on new projects, a DEX is probably the first place they’ll go when placing their chips on the table.
Distributed Governance
Many AMM based DEXs are offering their users governance tokens, both to further democratize the control of the platform and as an reward for providing liquidity. This allows users to participate in the decision-making processes and future of the exchange. This is an increasingly relevant consideration as more and more DEXs choose to fully distribute their management to users.
Compromises with DEXs
More complicate interface
Unlike CEXs, DEXs tend to be less friendly to new users. The interface can be harder to navigate and understand for less experienced users, for example.
No Fiat On-Ramping
And unlike their centralized counterparts, decentralized exchanges do not accept payment in fiat – in other words, they won’t be anyone’s first step into crypto.
Liquidity, Slippage and Slow Trades
Liquidity is a big issue for decentralized exchanges and both the order book and automated market maker systems have their limitations. For order book exchanges, a lack of available trading partners might result in a slow trade time – and slippage – for you. Meanwhile, AMMs offering poor rewards for their liquidity providers might also find themselves with a deficit. So this is something to be considered by you the user when embarking on your DEX adventure.
Total Freedom Means Total Responsibility
Self-custody may well put you in the driver’s seat but remember – it also leaves you to deal with the storage and security of your exchange assets. You can’t simply leave them on the exchange once you’re done, so making sure your crypto wallet is both compatible with the service and immune to risks will be key to your experience.
Do your own Research!
Although DEXs allow users to trade freely while retaining complete control of their assets, the downside is that such a lot of freedom necessarily brings extra responsibility. Since any coin can be listed on a decentralized exchange, it is even more important to do your own research to ensure the authenticity of the project you’re buying into.
Blind Signing
And with DEX transactions powered by the omnipresent smart contract – the details of which often can’t always be displayed when you sign – taking steps to understand the risks and how to minimise them is essential.
DEX or CEX – which one do you need?
So there you have it – a short overview of the two major types of crypto exchange. With CEX, new users can make their first steps into crypto, focus on trading and leave all the other aspects of the exchange to the company in charge. But this comes at a price: However, DEXs offer more freedom and potentially better pay offs for users and opportunities – although they may require a more knowledgeable user. Which suits you more?
Crypto can be a confusing place to be but a little reading can change that! The beauty of crypto is that it’s constantly evolving, finding solutions to the tensions faced by its users and striving to offer more. With a little learning, you can take full advantage of what the industry has to offer – not just for your wallet, but for your life.