[DEX Series #4] Centralized vs. Decentralized Exchange

In the previous articles of the DEX Series, we have explored the determiners of assets, trading and exchange, and the issue of governance.

This episode brings you a perspective on the benefits of decentralized exchanges in comparison to the centralized ones.

Marketplaces and platforms for crypto goods were established and sustained on the same principles of trading as those known to man since the most traditional markets and stock exchanges, e.g. NYSE (New York Stock Exchange).

The blockchain technology triggered the riotous theory of individual independence, decentralized systematization and omission of the middle man. It became logical to reconsider the classical way of trading with crypto assets.

Below you can read all about the enrichment that decentralized exchanges brought to the user experience of the trading process, comparing it to the experience on centralized platforms.

The answer is: a decentralized exchange

No matter a coin or a token, we exchange the majority of them in the pool of exchanges — that remains centralized (e.g. Binance) which means that the main notion of blockchain as a distributed ledger is not fully adapted.

Centralized exchanges continue to work like every other traditional institution — the profit still comes before the prosperity of the community, there are still possibilities of risks (lack of access, support, abuse cases etc.) which additionally undermine the community’s trust.

Decentralized exchanges (e.g. Waves Dex) provide an answer to the challenges of centralized platforms, gradually becoming a more impressive player in the mainstream.

Centralized exchange — traditional hierarchy of a classic marketplace

A centralized way of running the marketplace does not vary much from other traditional marketplaces — companies still have power over users, the goods that were traded, and related data, meanwhile providing them with the platform with a medley of exchangeable assets and ample network.

Their business model and other handlings with business are founded on a set of terms and conditions which work as a legal base and protect the interest of the business entity over the interest of its users. Once the users agree with stipulated terms of involvement, there is not much maneuvering space for their alteration or ambiguous interpretation if a user feels misled or deceived.

Some of the issues that come with transactions on a centralized exchange are:

1. An inclination to security issues: Since they are running on a central or a single server and having a single point of entry (centralized asset account), they are also more vulnerable to targeted attacks. Several centralized exchanges like Zaif, Binance, and CoinCheck have suffered hacks recently (either attacking their APIs, hot wallets, etc.) and ended up losing hundreds of millions USD.
2. Reduced independence of asset management for users: Dependency on the platform reduces the autonomy of asset management for users. Once they deposit funds or execute orders, the funds are in the hands of the platform until withdrawal.
3. High expense: Apart from server fees (raising with the traffic), and much like a traditional business, centralized exchanges face high overhead costs to cover their employees, security requirements, maintenance, and taxes. These expenditures are usually covered by user fees incurred during trading.
4. Platform clogging: central server provides a determined computing power which could result in delays or even temporary closing of the platform due to clogging. Also, centralized platforms can read the orders, and even use them to their benefit to conduct trading based on insider information.

Once we apply a decentralized approach to these processes, users can leverage many benefits for them and their assets.

Decentralized exchange — Everything from anonymity to dependability

When the principles of the blockchain are applied, there are no longer any signs of any kind of pecking order — only a model of same-level exchanges, operational and validation processes, run in the blockchain.

Terms and conditions are no longer a trust mechanism in DEXes — automatization of smart contracts, reliable and impermeable infrastructure of blockchain are the main cases here. The power of trading goods hangs in the balance of users who own them.

1. Attack-proof: No central point means increased reliability by default (higher uptime due to distributed nature), but also significantly higher security, as it is nearly impossible to issue an attack on the distributed network of private servers. This precludes individuals, organizations or even governments to intervene, ensuring a more democratic use of technology for the benefit of all. With the absence of a central authority, which gives users permission to exercise transactions, a decentralized exchange facilitates a permissionless ecosystem, increasing users’ autonomy. Given the increasingly stronger regulatory pressure from governments, the direct nature of trading relationships on decentralized exchanges is becoming increasingly important also as a deterrent against censorship.
2. Goods and data in users’ hands: In a decentralized exchange, the proverbial middle-man is no longer an indispensable part of the process. As no central authority holds control of the traded assets, the trading entities (buyers and sellers) directly facilitate one-to-one deals. The trading entities actually own the traded assets by keeping them in their wallets, which is especially important, as users do not have to relinquish the control over their assets to anybody and these cannot be arbitrarily withdrawn. This tighter user-centered control lives up to the “not your keys, not your coins” principle, which basically means that any assets stored off the actual exchange mean less risk. They also ensure anonymity as the personal information of the trading counterparties remains protected within their respective wallets.
3. Cheaper trading: Since the transaction fees usually imposed by a central authority are not always incurred in the decentralized exchanges, the latter can also be cheaper. DEXes can still charge fees to cover gas, but they are usually lower compared to centralized that need to cover operational overhead expenditures.
4. Faster traffic: By abolishing a third party intervention, transactions between trading parties are done instantly, provided all the parameters work and the transaction is authorized. Instead of having to rely on centralized software or a middleman confirming a transaction, such operations are done automatically through the code of a decentralized transaction.

CEX vs. DEX face to face

Is the future decentralized?

Decentralized exchanges aim to create a future-proof environment, where digital assets are managed in a manner that it delivers on the promise of diminished abuse and reduced risk and unhindered trust — a kind of trust, crucial for communities to develop and flourish.

That said, decentralized exchanges also have some downsides compared to centralized, for example, atomic swaps are (mostly) not possible cross-chain yet. Also, the user experience is often less pleasant and slower on DEXes, since order matching has to be ensured first which could take a bit longer than merely updating some figures on a centralized exchange database. These traits are the price a user pays for leveraging increased security when using a decentralized exchange.

Decentralized exchanges will furthermore be facing several challenges as the ecosystem evolves. Regulations, liquidity, exchange rates, KYC/AML, etc. will be parameters determining the functionalities and adoption of DEXes.

But so far, much progress in bringing the trading of crypto closer to the user has been achieved and has already set the ground for what is to be the future of trading.

Decentralized exchanges are paving the path towards a broader inclusion and trading customization. One of such platforms is also our decentralized SwapMarket, coming soon to all NFT traders.

For more on the topic of a decentralized way of trading assets, please check our other episodes of the DEX Series:

DEX Series #1: Tags and IDs
DEX Series #2: Trading and exchange
DEX Series #3: Governance and control distribution of exchanges
DEX Series #5: Academia
DEX Series #6: Crypto-collectibles

This article originally appeared on the 0xcert website and has been replicated here with express permission by 0xcert.