Crypto 101: What is a centralised exchange (CEX)?
Your beginner’s guide to trading on a centralised exchange.
Centralised exchanges are platforms that are set up and owned by an intermediary for buyers and sellers to conduct their transactions. This intermediary governs and oversees the services and transactions on the exchange. It has the authority to regulate and control the entire exchange.
From a cryptocurrency trading standpoint, it decides the types of services and cryptocurrency pairs that should be made available for its users, the transactions that should be cleared, the people who are allowed to use its services, and the limits that should be put in place for each user.
Picture this: Two siblings exchange their belongings with each other in accordance with the rules (timing, permitted products, location of the exchange, etc) set by their mother. In this case, the siblings are the participants, and the mother is the intermediary.
You may be wondering — why are we even talking about CEX when many argue that the whole point about cryptocurrencies is a move towards decentralised finance (DeFi) and removing intermediaries who are given too much power?
Before we dismiss CEX completely, do note that trading through CEX is currently the most common method people use to trade cryptocurrencies. There are more than 300 CEX in operation at this point.
Top 5 CEX listed on Coinmarketcap according to their scores:
Why do people still use centralised exchanges to trade in cryptocurrencies?
There are several reasons why many people still use CEX to trade in cryptocurrencies despite the movement towards DeFi brought by this asset class:
Ease of use
The general population is more familiar with using a service that is offered by an intermediary. It gives them comfort that there is someone accountable for the quality of the service provided. These intermediaries will try to attract as many users as possible as trading volume is directly correlated to their profit. As such, they are incentivised to design platforms that are easy to use and mimic what the general population is already used to in their trading activities in traditional finance.
An interface for those trading in traditional finance is used to:
An even easier interface for those who have no trading experience at all:
Fees
At the time of writing, it costs around USD $100 to do a transaction between USDT and Ethereum on a decentralised exchange (Uniswap). For the same transaction on Binance, the transaction cost is USD $0.015 (0.15%). You may be wondering the reason for the big difference in trading fees and why CEX can sometimes be much cheaper.
We first need to understand how the transactions on centralised exchanges are executed. The transactions on centralised exchanges are executed “off the chain”. This means that when a user buys US$100 worth of Ethereum on a CEX, this transaction is not broadcasted on the Ethereum blockchain and there is no need for validators to validate this transaction.
This transaction is only recorded in the exchange’s own ledger or sidechain. Without the need for validators, the fees involved in executing a transaction are only those charged by the intermediary to include the transaction in their own ledger. Therefore, this fee is controlled entirely by the intermediary. This is also the reason why some hardcore supporters of DeFi remark that the cryptocurrencies bought on centralised exchanges do not truly belong to the buyer.
On the other hand, the transaction fee for decentralised exchanges is dependent on the congestion of the network. This means that when there are more transactions, the network is more congested, and the transaction fee will be higher.
Depending on the network, there may be instances where the transaction fee on decentralised exchanges is much cheaper than that of centralised exchanges. However, these instances are not common for transactions on the Ethereum network, which is one of the most popular networks.
Trust
There are many people who want to have an intermediary whom they can hold accountable when things go wrong. Centralised exchanges are also increasingly regulated by different regulators in the jurisdictions they operate in and many people (especially those in developed countries) actually trust and want the government to regulate these intermediaries.
With an intermediary governing the exchange, these users are hopeful in terms of the accountability, security, and customer protection these intermediaries provide.
CEX provide users with digital cryptocurrency wallets and the ownership of the private keys of the wallets are held by the exchange. They also serve as the custodian of the private keys (no ownership). Most reputable CEX also invests heavily to ensure that your private keys are held securely in a cold wallet which reduces the risk of a hack.
However, this does not mean that centralised exchanges are completely safe from any attacks. While most intermediaries constantly improve the security of the exchange as much as possible, it can still be compromised. There are also people who feel that the intermediary, especially established ones, will compensate them if the exchange suffers any attacks. Do note that while that is possible, there is no guarantee that any intermediary will provide any compensation for any attacks.
Is CEX the way to go then?
Assuming you get past the factors on ownership and authority power described above, you also have to consider the accessibility and availability associated with using CEX: the CEX that is available to you (depending on where you reside) and the cryptocurrency pair that you want to trade in.
Many centralised exchanges only allow users residing in certain locations to use their services. In addition, CEX typically only list cryptocurrencies with substantial trading volume on their exchange. Therefore, if you are looking to trade a cryptocurrency with a small market capitalization and low trading volume (which is often the case for new cryptocurrencies), it may not be available on the CEX you have access to and you will have to trade on decentralised exchanges.
There are cases where selected special projects may choose to do a fundraising event administered by CEX (Initial Exchange Offering). This means that the cryptocurrency will first be launched on the CEX.
The ease of use, fees involved, and reliability of the exchange are important long-term considerations that you definitely have to evaluate before you put all your money into any CEX account.
Where possible, it is not a bad idea to have more than one CEX account from a diversification perspective as these centralised exchanges may change their rules at any time (controlling power of the intermediary). For example, Binance implemented a prohibition order that prohibits Singapore users from trading cryptocurrency on their main platform with a one month notice in September 2021.
Concluding Tip: Know the best way to fund the CEX account
To use a centralised exchange, you have to load your account with the fiat or cryptocurrency you want to trade. Different exchanges have different methods of transferring these assets; such as swift transfers, or peer-to-peer transfers. There are also exchanges that accept credit card payments.
However, credit card payments are often the most expensive in terms of fees. It is important to check the most cost-efficient and safest way to transfer assets (including cash) into the account for trading as these fees will eat into your profit over time.
Happy trading and DYODD!
Text by Yong Xin Kwek
