Crypto Exchanges: Decentralized vs Centralized
To buy any kind of asset, be it stocks, gold or cryptocurrencies, one needs to go through an exchange - a marketplace that ensures fair and orderly trading by listing price information on all of its products. Wholesale exchanges are rare to find, as most exchanges specialize in specific types of products. For example, NYSE trades stocks listed by both US and international companies, NYMEX lists energy and metal commodities and XTB handles foreign currency exchange. Similarly, exchanges specifically created for cryptocurrencies exist as well. Most cryptocurrency exchanges are centralized and follow a business model similar to traditional exchanges. However, the disruptive nature of cryptocurrencies has forced a radical rethinking of how these exchanges can function, bringing the concept of decentralized exchanges (DEXs) to life.
DEX vs CEX: Major differences
A Centralized Exchange (CEX) in crypto works much like any other exchange. It involves the use of a trusted middle person or a third party to help conduct transactions. Users trust the exchange with not only the safe completion of transactions, but also the successful search for trading partners through the exchange’s network of users. The exchange charges a fee for such services, which has been a tried and tested method for centuries.
Many of the earliest attempts to establish a decentralized marketplace relied on replicating the conventional order-book experience, but DEXs have now completely flipped the script. DEXs facilitate the exchange of tokens without the need for an intermediary exchange acting as a custodian for their cryptocurrencies. They have removed the need for an intermediary by using smart contracts known as automated market makers (AMMs). AMMs allow digital assets to be traded using liquidity pools rather than a traditional market of buyers and sellers. In this case, this pool is created by liquidity providers (LP).
LPs supply liquidity pools with crypto tokens, whose prices are determined by a constant mathematical formula, in exchange for a share of transaction fees and free tokens. While only High net-worth (HNW) individuals and institutions provide liquidity in traditional exchanges, with AMM, anyone can be an LP. The pool welcomes everyone because the more assets there are in the pool, the larger the trades it can support.
Over the past few years, decentralized exchanges have moved from the fringes of cryptocurrency into the mainstream. DEXs reported more than $1 trillion in trading volumes in the year 2021. While that is still a small percentage of the $14 trillion in crypto trading volume in 2021 from all channels, it was a massive 858% increase compared to 2020 DEX trading volumes, and the rate of growth significantly outpaced rival centralized exchanges. There are currently more than 35 DEXs in existence globally, including Uniswap, Kyber, and Bancor.
Advantages of DEXs
- Privacy and accessibility — CEXs require know-your-customer (KYC) details, whereas DEXs work on the basis of anonymity. DEXs are essentially permission-less environments, so such checks are not needed. This solves serious privacy and data-sharing concerns for some users, as well as accessibility issues for others by requiring only an active cryptocurrency wallet to make a transaction.
- Price — CEXs bear the cost of setting up and maintaining the infrastructure that is required to offer secured services. Conversely, DEXs, via AMMs, work on the principles of automation and self-regulation that make the price comparatively cheaper and help reduce transaction costs. In late 2021, the leading DEX, Uniswap, charged a 0.05% transaction fee while the top CEXs Binance, Coinbase, and Kraken charged 0.1%, 0.2%, and 0.2%, respectively.
- Safety — Since there is no third-party involvement, assets are much less susceptible to hacks in DEXs. Additionally, Since DEXs do not hold your private keys, hackers cannot get access to the user’s wallet. On the other hand, CEXs do not record their transactions on the blockchain, which can then lead to breaches of security and unsafe storage of information and funds. Due to this, billions of dollars have been stolen by hackers from prominent exchanges like Bitfinex and Binance over the last few years.
- Control — CEXs typically hold the private keys of the users. This may seem unimportant to many, but in the cryptographic asset space, whoever controls the private key is in total control of the asset. If users don’t have their private keys, they have no technical standing or recourse whatsoever to gain control of an asset associated with their private keys. Conversely, when using DEXs, users have full control over their wallets and funds, which is in line with the ethos of the Web3 revolution. However, control can be a double-edged sword, because if an individual loses the private keys to their wallet, the assets stored in it become unrecoverable.
- More token options — While the bulk of crypto trading today occurs on CEXs, they usually list only the biggest cryptocurrencies. CEXs have rigorous requirements that cryptocurrencies need to pass before being allowed to trade, restricting many new entrants. DEXs are much more democratic on this front and allow all newly issued tokens to be traded, as long as there is liquidity for those tokens. For example, Uniswap trades nearly four times as many tokens as Binance.
Disadvantages of DEXs
- Usability — DEXs have a reputation for not being very user-friendly. Trading on DEXs requires complex knowledge and is often not suitable for new users. They also do not support fiat currency transactions.
- Functionality — Because decentralized exchanges are new and have only recently become operable, they tend to focus on executing simple buy and sell orders. Users may find advanced trading functions such as stop losses, margin trading, and lending are unavailable on most DEXs.
- Risk of impermanent loss — DEXs introduce a major risk for the liquidity providers (LPs). LPs are entitled to withdraw the portion of the pool they contributed to, but with a caveat. They do not get back the exact tokens they put in, but instead, they get back the ratio of tokens that currently exist in the pool they contributed to. Since trades occur, the exact ratio of tokens cannot be maintained in a pool, and progressively tends to contain more of whatever token is losing value. This means that an LP will end up withdrawing more of the token that lost value and less of the one that gained value, as compared to their starting assets. Therefore, they will end up worse than if they had just held onto their assets privately. In practice, DEXs generally compensate liquidity providers through transaction fees - but if there is a very large fluctuation in price, LPs could end up losing more than they make.
- Liquidity — DEXs face more challenges when working with larger investors than CEXs. Since DEXs cannot yet compete with the largest CEXs in size, they cannot offer as much liquidity. While using DEXs, if met with insufficient liquidity, large orders can face unplanned additional costs called “slippage”, which is the price difference between when one submits a transaction and when the transaction is confirmed on the blockchain.
Future of Crypto Exchanges
Currently, the deciding factors for which type of crypto exchange to use include usability, control, and fees. For users that prioritize easy access to crypto trading over being in total control of their wallet, then a CEX is the best option. If lower fees and control over funds are of a higher priority, then the user may consider using DEXs.
However, this decision-making calculus is set to change. The blockchain ecosystem is still in its nascent stages and is constantly being updated. Uniswap is already in its 3rd version since launching in 2018. DEXs are now working on solving problems such as network congestion, high gas charges, and low capital utilization. These improvements will help make DEXs easier to use and further reduce fees, enabling a greater number of people to engage with DEXs. Additionally, many of the current drawbacks in DEXs relate to low liquidity which will resolve itself as more investors start to interact with them. DEXs have revolutionized the way assets can be traded and will require time to iron out the wrinkles currently plaguing them. One day, DEXs may become the preferred medium for not just crypto, but stocks, commodities and foreign exchange.
Disclaimer: None of the information in this blog constitutes recommendations to buy/sell any cryptocurrency or security. This is not financial advice. You should always do your own research.
