Recent market events have sparked discussions online as to whether you should trade on centralized or decentralized exchanges. Those who suffered due to FTX’s bankruptcy look for private, non-custodial, and permissionless alternatives. But those having suffered DeFi exploits are also running away from their own respective home.
The old guard suggests that exchanges such as Binance and Coinbase are still safe, and that their liquidity is unmatched by any DeFi platform. On the other hand, DeFi proponents argue that self-custody is king, and that you shouldn’t trust anyone apart from yourself. So which side is right, if any?
Today’s article walks you through the differences between centralized exchanges and decentralized exchanges. You’ll learn how the two work and discover the pros and cons of each option. So let’s start by revisiting the old guard first: CEXs.
A centralized exchange (CEX) is a trading and investing platform run by a centralized entity, usually a licensed company with registered headquarters. CEXs represent the entry point for anyone’s brand new crypto journey – not only because of their fiat gateways, but due to their ease of use as well.
Prominent CEXs include Binance, Coinbase, Kraken, and Bybit – among others. These exchanges come with interfaces and applications suitable for beginners. Apart from being user-friendly, they also offer more liquidity. I’d even consider that they offer a sense of safety due to being licensed and regulated, but FTX proved that’s not necessarily always true.
Opening an account on a CEX is simple. All you need is an email and some documents that prove your identity – you need the latter for KYC. Know Your Customer (KYC) is a crucial CEX onboarding process that helps fight money laundering, terrorist financing, and identity theft. The level of KYC data you provide determines withdrawal limits, which features you can use, and many other facets of investing on CEXs.
Centralized exchanges offer various financial products and services. However, their offering is often limited by regulatory frameworks. Some CEXs might not offer all their services to customers from certain regions due to conflicting regulations. One such example includes French futures traders who are barred from using Binance.
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A decentralized exchange is a crypto exchange run by smart contracts, which are coded by blockchain programmers. Decentralized exchanges are, like any other dApp, fully decentralized, public, and pseudoanonymous for investors.
Decentralized exchanges are open to everyone, no matter who they are and where they come from. A farmer from North Korea has the same opportunities and benefits as an executive from New York. There is no criteria nor requirements for using a decentralized exchange. All you need is an internet connection and a computer or mobile device.
DEXs can operate in multiple ways, but their most popular algorithm is the Automated Market Maker (AMM) model. AMMs are a way to distribute liquidity between liquidity providers and traders by storing liquidity on smart contracts. Smart contracts will automatically execute trades based on the liquidity supply that resides within a liquidity pool (LP).
Some DEXs might even have classic order books that CEXs traditionally used. Orderbook-based DEXs operate by storing orders outside of a blockchain, but executing orders on a blockchain using smart contracts. Certain exchanges also operate as DEX aggregators and collect liquidity throughout DeFi for investors to use.
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There are big differences between centralized and decentralized exchanges. The following sections discuss each important aspect of using an exchange, including: ease of use, liquidity, custody, and security.
Centralized exchanges (CEX) and decentralized exchanges (DEX) have different levels of ease of use, which can be a significant factor for some users.
CEXs are generally easier to use than DEXs, as they have a more traditional user interface and typically offer a wider range of features and services. Users can easily deposit and withdraw funds, place orders, and access market data, all through a simple web or mobile interface. In addition, CEXs often offer customer support, which can be helpful for users who are new to trading or have questions about the platform.
DEXs, on the other hand, can be more complex to use, especially for users who are new to cryptocurrency trading. DEXs often require users to have a basic understanding of how to interact with smart contracts and use a decentralized wallet, which can be intimidating for some people. In addition, DEXs may not have the same level of features and services as CEXs, which can make them less user-friendly for some users.
Overall, the ease of use of an exchange will depend on the individual user's needs and preferences. Some users may prefer the simplicity and convenience of a CEX, while others may be willing to put in the extra effort to use a DEX in order to have more control over their assets.
It’s also important to note that certain CEXs have insurance and protect customers in the event of exchange events. Investors of all skill levels can use their user interfaces without spending too much time figuring them out.
Centralized exchanges and decentralized exchanges have different liquidity characteristics.
Liquidity refers to the ease with which a particular asset can be bought or sold on a market, as well as the size of the orders that can be filled without significantly affecting the price of the asset. A market with high liquidity is one where orders can be filled quickly and at prices that are close to the current market price.
On CEXs, liquidity is typically high because they hold a large amount of assets in their own wallets, which can be used to fill orders from users. In addition, CEXs often have a large number of users and a wide range of trading pairs, which can also contribute to high liquidity.
On DEXs, liquidity is generally lower than on CEXs. This is because DEXs do not hold assets in their own wallets, but rather facilitate trades between users directly. As a result, there is a limit to the amount of liquidity that is available on a DEX at any given time, as it depends on the assets that users are willing to trade. DEXs also tend to have fewer users and fewer trading pairs compared to CEXs, which can also impact liquidity.
It's worth noting that liquidity can vary widely on both CEXs and DEXs, and there are many factors that can affect it. These include the popularity of the assets being traded, the overall demand for the assets, and the trading volume on the exchange.
For example, the total liquidity for the ETH/USDT LP is worth $22 million on Uniswap. Binance’s daily trading volume on the same trading pair was $380 million at the time of writing. The radical difference in liquidity means that CEX users deal with lower slippage when placing large orders and thus get more crypto for their money.
Trading-wise, CEXs are different from DEXs in respect to how they work. A CEX has an off-chain order book that has a list of sell and buy orders. The CEX has a market maker that moves the order book and connects buy orders with sell orders by decreasing the order book spread.
A DEX has an AMM that possesses liquidity pools for each trading pair. This liquidity pool contains a 1:1 supply ratio of two tokens. AMMs use a formula that ensures that the total dollar value of each asset always remains the same. No liquidity disbalance within an LP can take place and traders can always redeem one token by supplying another.
Centralized exchanges (CEX) and decentralized exchanges (DEX) have different approaches to custody of assets.
On CEXs, users typically deposit their assets into the exchange's wallets, and the exchange holds custody of the assets. This means that the exchange is responsible for securely storing the assets and protecting them from theft or loss.
On DEXs, users retain custody of their assets at all times. When a user wants to make a trade, they must transfer their assets to a smart contract on the blockchain, which holds the assets in escrow until the trade is completed. After the trade is completed, the assets are transferred back to the user's wallet.
The main advantage of this approach is that it allows users to retain control of their assets and reduces the risk of losses due to exchange hacks or other security breaches. However, it also means that users must take on the responsibility of securely storing their own assets, which can be challenging for some people.
CEXs require investors to store their assets on the exchange in order to trade and invest. These exchanges store customer funds on a combination of hot wallets and cold wallets. While secure on paper, recent events have shown that exchanges sometimes misuse customer funds.
DEXs are non-custodial. Investors can interact with other users on a DEX without having to deposit their funds on the exchange. Investors store funds on a private and permissionless Web3 wallet that is capable of interacting with DEXs. Token swaps take place when the investor signs a transaction on his wallet and passes his funds to the DEX.
Centralized exchanges (CEX) and decentralized exchanges (DEX) have different approaches to security, which can affect the overall security of the platform.
CEXs typically have a higher level of security compared to DEXs, as they have more resources and infrastructure in place to protect against attacks. CEXs often use a combination of hot and cold wallets, multi-sig technology, and other measures to secure user assets. In addition, CEXs are typically regulated by financial authorities, which can provide an additional layer of security for users.
However, CEXs do have a single point of failure, as the exchange itself holds custody of the assets. This means that if the exchange is hacked or suffers a security breach, user assets can be at risk. There have been several instances of CEXs being hacked and user assets being stolen, which has led to significant losses for affected users.
DEXs, on the other hand, do not hold custody of user assets and instead facilitate trades between users directly. This means that there is no central point of failure, and the risk of loss due to a security breach is significantly reduced.
However, DEXs do have other security risks to consider. For example, users must take on the responsibility of securely storing their own assets, which can be challenging for some people. In addition, DEXs may be less robust in terms of security infrastructure, as they do not have the same resources as CEXs.
Overall, both CEXs and DEXs have security risks to consider, and it's important for users to carefully evaluate the security measures in place before choosing an exchange.
In conclusion, whether to use a centralized exchange (CEX) or a decentralized exchange (DEX) will depend on the individual user's needs and priorities.
CEXs are generally easier to use and offer a wider range of features and services, including customer support and a variety of payment options. They also tend to have higher liquidity and may offer a greater selection of trading pairs. However, CEXs have a single point of failure and hold custody of user assets, which can be a security risk.
DEXs, on the other hand, do not hold custody of user assets and offer a greater degree of control and privacy for users. However, they can be more complex to use and may have lower liquidity and fewer trading pairs.
Ultimately, the decision to use a CEX or a DEX will depend on the user's specific needs and priorities. Some users may prioritize ease of use and a wide range of features, while others may prioritize security and control over their assets. It's important to carefully consider all of the pros and cons before making a decision.
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