Learn about the benefits and the risks of CEX and DEX, and how Hybrid Exchange models are likely to change the way we trade crypto.
Exchanges are a vital part of the crypto ecosystem. They allow the purchase and sale of tokens between different market participants and act as on-off ramps between the Crypto and Fiat world. In their purest form, Exchanges are marketplaces where buyers and sellers meet, agree on prices, and trade one asset for another.
While exchanges are usually heavily regulated in traditional financial markets, this is not always the case in crypto. Having little to no regulatory requirements in conjunction with the rise of blockchain technology, Crypto Exchanges have emerged in vast forms and numbers.
The concept of a crypto exchange is not vastly different from traditional currency exchanges. However, there are a few key differences, and understanding these differences is vital for beginners and professionals alike. In this article, we will explore some of the typical traits of traditional and crypto exchanges, their functionalities, and the risks and benefits they provide.
What is Crypto Exchange, and how does it differ from its traditional counterparts?
A crypto exchange allows holders of different crypto assets to meet and exchange their funds for a small fee. Crypto exchanges are very similar to Foreign Exchange (FX) markets. One of the key differences is; however that traded assets (cryptocurrencies) are decentralized by nature and thus not issued and governed by a central authority like the USD or EUR, for example.
As a result, crypto exchanges do not operate under the same rules and regulations as traditional exchanges. This “gray” field of regulation led to various approaches to setting up and operating crypto exchanges.
Let’s take a look at the two most common categories; Centralized Exchanges (CEX) and Decentralized Exchanges (DEX)
Centralized Exchanges (CEX)
If you have ever tried to buy cryptocurrencies, you most likely have come across a Centralized Crypto Exchange. The word “centralized” refers to the fact that the exchange acts as a middleman between buyers and sellers.
Centralized Exchanges are regulated legal entities that act as a centralized market for cryptocurrencies. They operate via an order book, similar to traditional financial exchanges.
Benefits of Centralized Exchanges
Ease of Use
The main benefit of a CEX it’s that they are straightforward to access and use. CEXs are usually built and maintained by large, established corporations. They have an easy-to-use user interface (UI) and cater to beginners and professionals alike.
Dedicated support teams take care of customer requests, and many provide educational material.
Signing up to a Central Exchange usually requires some sort of identification and the completion of a “know-your-customer” (KYC) procedure. And while this might be a bit cumbersome, it is no different from traditional financial markets and aims to protect the participants.
On-Off Ramp
Centralized Exchanges are the single most crucial gateway between crypto and traditional fiat currencies. Many CEXs offer the ability to transfer fiat currency from and to a user’s account, thus linking the two worlds.
Liquidity
Due to their ease of use, CEXs attract many customers, which in turn translates to higher liquidity of crypto assets available for trading. This is crucial since better liquidity means better pricing and more market efficiency for everyone.
More Features
Besides just acting as a marketplace, CEXs often offer a vast array of additional services such as staking, margin & derivatives trading, lending, and in some cases, even crypto-based credit cards.
Drawbacks of Centralized Exchanges
Custody of Assets
CEXs require participants to deposit their assets under custody. On the bright side, this means that users do not have to worry about how and where to store their coins. However, holding cryptos under CEXs custody implies that they control the authority over all deposited assets. The CEX is in charge of the crypto wallets, including the private keys. While this is convenient for regaining access to your funds after losing your login credential, it also means that your assets can be at risk if the CEX centralized wallet gets attacked. In the crypto world, this problem is known as “Not your Keys, Not Your Coins.”
Security
Being centralized entities, CEXs bear the risk of a single point of failure. Although generally safe, reports of exchange hacks are not uncommon. Massive centralized exchanges have become targets in the past, often resulting in significant damage for investors.
Market Limitations
CEXs often only provide access to a specific amount of currency pairs, and most of them focus on established coins with significant liquidity and long track records. This restricts the user’s ability to trade specific tokens.
Regulations
Crypto, in general, is still having a difficult time when it comes to regulation. Commonly a CEX is a distinct legal entity that must adhere to rules and regulations. As time progresses, CEXs are forced to adapt and adjust to an ever-changing environment, and non-adherence can lead to sanctions from regulators, directly impacting participants.
Decentralized Exchanges (DEX)
Decentralized Exchanges are fully automated peer-to-peer (P2P) platforms solely governed by code. The idea of a DEX is to eliminate the middleman and let buyers and sellers engage directly.
The most noticeable difference to a Centralized Exchange is that a DEX only handles cryptocurrency, i.e., they do not support Fiat-Crypto trading.
Order Book DEX
An Order Book DEX works similar to a centralized exchange whereby an order book captures all open buy and sell orders and matches them accordingly. The key difference to a CEX is that an algorithm manages this order book to route the trade from one user to another without the involvement of a middleman.
However, an order book-based exchange is heavily dependent on how many open orders have been transmitted to the exchange. This poses an issue, especially for smaller exchanges or for more exotic currency pairs, since limited liquidity can result in significant slippage, volatility, and hefty price spreads.
Automated Market Maker DEX
More recently, AMM DEXs have emerged. An AMM DEX ensures liquidity by creating pre-funded pools of tokens from which pending orders are filled. These pools are filled by liquidity providers (LPs) that are willing to commit tokens to the exchange pools in return for an incentive.
The exchange then sets a price for each token pair based on supply and demand for liquidity. The shortcoming of that approach is that each AMM DEX prices assets solely based on their supply and demand and not necessarily in line with the rest of the market. As a result, there can be price discrepancies between various exchanges that can be exploited by arbitrage trading.
Let’s look at some of the key benefits and risks and discuss the most important ones in more detail.
Benefits of Decentralized Exchanges
Fully Automated, Decentralized, and Transparent
As the name suggests, DEXs have no controlling intermediary and thus fall in line with the concept of decentralizing markets and assets. Most DEXs have an open-source code, meaning the mechanics behind it are visible to everyone, and anyone can copy and develop their decentralized exchange. Full automation also means lower trading fees for participants.
Full automation also means less counterparty risk as fewer entities are involved, and all trades are instantly routed and cleared.
Having no internal database reduces vulnerability to attacks and single points of failure. This does not mean DEXs are safe!
Anonymity & Custody
Decentralized Exchanges do not require onboarding and thus no user identification. This facilitates access to a DEX. Users simply connect their wallets to the exchange platform and can trade immediately. This also means that no assets are custodied by the DEX, and the user is in complete control.
Tradable Assets
DEXs have little to no onboarding requirements for tradable assets, as long as liquidity for the said asset is provided. Thus DEXs generally offer a more significant amount of tradable coins and tokens, especially if you are looking for alt-coins, newly launched and niche tokens.
Drawbacks of Decentralized Exchanges
Do-It-Yourself (DIY)
Being in complete control also means you are fully responsible. There will be no customer service team to help you if a trade goes wrong. Your wallet is your access to the DEX, and if you lose access to your wallet, you lose access to your crypto.
For this very reason, handling DEXs require certain knowledge and are not recommended for beginners.
Reduced Functionality & Complexity
In general, a DEX is simply an asset exchange. They do not offer lending or margin trading. The UI of a DEX tends to be somewhat more complex and requires an understanding of market liquidity.
As mentioned earlier, a DEX only works with cryptocurrencies and does not support Fiat assets. This means you have to exchange your tokens for real-world currency elsewhere.
Unvetted Tokens
Listing requirements for tokens are generally low or non-existent. Anyone can list anything, and it comes down to the user to evaluate whether the traded tokens are trustworthy. Worst case, the token can be purchased but is unsellable, resulting in a total loss of assets.
Slippage and Impermanent Loss
Users have to be familiar with slippage and impermanent loss when using DEXs. Understanding these two terms is vital but would exhaust the aim of this article.
Decentralized Exchange (DEX) vs. Centralized Exchanges (CEX)
Cryptocurrency exchanges are the critical source of liquidity in the worldwide market. As it provides billions of dollars in daily trading volume. The market expands, so prominent exchange platforms are still scaling in response to the demand for digital assets, offering asset storage, new trading features, and access to a constantly growing number of digital assets.
Disintermediation is the critical idea of the blockchain community. Thus, DEXs have become widespread alongside traditional CEXs. DEXs take the other approach to trade digital assets: they work without intermediaries to clear transactions, relying instead on self-executing smart contracts to promote trading. The dynamic allows for immediate trades, usually cheaper than CEXs.
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