Maverick 101: Centralized Exchanges vs. Decentralized Exchanges
UPDATE 11/14/2022: This article has been edited to incorporate recent events surrounding FTX.
Welcome to Maverick 101, a regular blog series where we explain some of the fundamental concepts of DeFi, and some of the specific features of Maverick itself!
In this installment, we’re going to explain the difference between the two types of cryptocurrency exchange: centralized exchanges (CEXs) and decentralized exchanges (DEXs). If you’ve ever bought, sold, or swapped cryptocurrency, you will most likely have done it through one of these types of exchange (even if you didn’t realize it).
For some users, the distinction between a CEX and DEX may not seem that important, but there are fundamental differences in the way that each type of exchange operates. These differences are closely tied to the core values of both DeFi specifically and crypto more broadly, so it’s worth exploring them in more detail.
We’ll begin by taking a brief look at how traditional, non-crypto exchanges work, since these are basically the model for CEXs in crypto. From there we’ll move to CEXs themselves, and finally to DEXs and how they’ve facilitated the decentralization of finance. We’ll close with a look at how Maverick plans to power the DEXs of the future.
Traditional Exchanges
A traditional exchange is a centralized institution where buyers and sellers come together to trade financial instruments like stocks, bonds, and options. The most famous of these is perhaps the New York Stock Exchange (NYSE), located on Wall Street in New York City.
Exchanges like the NYSE operate on the double auction model, where buyers submit the highest prices they are willing to pay (called a bid) and sellers the lowest price at which they would sell (called an ask). The exchange then matches buyers and sellers according to their bids and asks. Trading in this manner is obviously highly competitive, as traders must bid and ask strategically if they want to complete their trades at the best price possible.
The double auction model is used for peer-to-peer trading, but some exchanges instead use something called a Central Limit Order Book (CLOB). In the CLOB model, the exchange maintains an order book of buy and sell orders (i.e., bids and asks) submitted by customers. These are called limit orders, because the customers place limits on their orders: the amount they wish to buy/sell and the price they’re willing to buy/sell at. If the conditions of an individual order cannot be met, it simply will not be filled.
The exchange matches and executes orders according to specified rules. For example, a CLOB that uses a Price Time model will grant priority to orders that offer higher buys/lower sells and then according to when each order was submitted: if it receives two buy orders with the same price, it will fill them in chronological order; if it receives two buy orders and the second one has a higher price, it will fill the second one first.
Since there is no direct peer-to-peer trading involved, a CLOB commonly relies on market makers to supply liquidity for trades. Market makers are usually large institutions who are prepared to supply a selection of limit orders to the book for matching against the incoming bids and asks from customers. The market makers are essentially agreeing to take the long or short sides of whatever orders are required, and are generally compensated through profits realized through the spread established by the market.
The spread (also called the bid-ask spread) refers to the difference between the highest bid price and lowest ask price (i.e., the highest price a buyer is willing to pay for an asset and the lowest price a seller will accept). Generally, to complete a trade on a CLOB a buyer/seller will have to “cross the spread” (i.e., pay more or receive a lower price), giving the exchange (and thus the market maker) the advantageous side of a trade. Exchanges are motivated to maintain a spread at all times in order to compensate market makers.
For example, a trader might come to a CLOB hoping to buy 50 shares of stock XYZ at a cost of $100 each (their bid). They discover that 50 shares are being offered for sale at a price of $100.20 (the ask). In this case, the spread would be defined as $.20 ($100.20 — $100). In order to receive their trade, the trader would have to up their bid to match the ask, crossing the spread and giving the book the benefit of the difference. For a total of 50 shares, this difference would be $10 (50 x $.20)–a tidy profit for the exchange!
Why are people comfortable paying the spread? These exchanges carry the weight of tradition, and many of the most prestigious and valuable companies therefore want to be listed on them. Traditional exchanges are also regulated by the SEC, which gives many traders the assurance that the prices are fair and they can trust the parties they are dealing with. Finally, the exchanges themselves enforce their own rules to guarantee the quality of the instruments they trade (e.g., to be listed on NYSE a company’s stock must be worth at least $4).
Many of these value propositions stand in stark contrast to the ethos of cryptocurrency, which for many users is attractive because of the lack of regulation and decreased role of institutional power. In the world of crypto, we’d refer to traditional exchanges as “trustful,” because traders are required to put their trust in the market makers and managers to act as responsible and ethical middle-men.
Centralized Exchanges
It was perhaps natural that the first crypto exchanges evolved from the models of traditional finance. Although the advent of Bitcoin promised a future of trustless and permissionless finance, mass adoption of cryptocurrency has been aided by the creation of institutions that users feel comfortable trusting with their money.
As of 2022, three of the biggest CEXs were Binance, Coinbase, and FTX. In November, 2022, FTX would halt all trading amidst a liquidity crunch and accusations of mismanagement and malfeasance. We’ll get into the significance of that event later in this article. For now, it’s worth noting that all three of these exchanges expended significant money and effort in order to establish name recognition beyond the borders of crypto (Coinbase and FTX even ran ads during the 2022 Superbowl!).
Some of the earliest exchanges basically existed to help people swap fiat currency for Bitcoin (and vice versa); notable examples include Mt. Gox in Tokyo and BitInstant in New York. Customers traded with the exchange, at prices set by the exchange (which would profit by setting its own spread).
These exchanges would also often store customers’ Bitcoin holdings. For some users, this is a good solution, since they do not want the responsibility and stress of managing their own digital wallet securely. But much like with a traditional exchange, they were choosing to trust the centralized exchange, which led to problems when these exchanges were hacked or chose to suspend withdrawals (both of which happened with Mt. Gox and would later happen with FTX).
Despite these drawbacks, CEXs have proved immensely popular, with Binance boasting a $25 billion 24 hour trading volume at time of writing. The attraction of these large exchanges is the same as the NYSE: name recognition, security, and trustworthiness.
Binance, Coinbase, and FTX are (or were) established brands, backed by huge investors, and able to offer guarantees for their customers’ holdings. You can use a conventional bank account or credit card to make purchases on these exchanges, lowering the barrier to entry, and the exchange will store your crypto holdings for you. The exchanges are also selective in which tokens they will list, which enhances their prestige for both customers and projects. In return for all of this, they make money through a combination of spreads and transaction fees.
Of course, the very features that attract so many users to CEXs are the same things that make them distasteful to others. This primarily boils down to a large institutional player occupying the position of middle-man for cryptocurrency trading. This gives the institution a lot of power: not only to extract fees from customers, but also to control which projects can have access to their markets.
“Not your keys, not your Bitcoin.” — Andreas Antonopoulos
Many crypto traders are also not comfortable with the custodial nature of CEXs; that is, they want to hold on to their own money, and not pay a premium to withdraw it. The concern here is less that the exchange will be hacked and more that they might choose to suspend trading or withdrawals, in response to pressure from government or industry (as we saw with Robinhood and GME). This line of thought is neatly captured in the slogan “not your keys, not your coins” (paraphrased from blockchain advocate Andreas Antonopoulos).
The sudden collapse of FTX in November, 2022, revealed the actual risk customers may be taking by leaving their holdings on a CEX. Revelations about how FTX and its sister company, Alameda Research, were being run led to a loss of faith in its token, FTT, and concerns that FTX itself lacked the funds required to meet its obligations (Coindesk has a good timeline of relevant events).
Despite FTX’s size, reputation, and promises of customer security, it could not fulfill customer demands in the ensuing bank-run and soon had to pause all withdrawals. FTX customers, from large institutions to average investors, were left unable to access their funds and unsure if they will ever be able to recover them. What does seem to be clear is that customers had no way of knowing what FTX was doing with their money, and it has been reported that as much as $10 billion of customer funds were transferred from the exchange to support Alameda.
Much like a traditional exchange, a CEX is a fundamentally trustful enterprise: users are putting trust in the CEX to behave transparently and responsibly as it facilitates trading activity. FTX provided a salutary lesson in what can happen when a CEX does not meet its end of this bargain.
While CEXs have been essential to the rapid growth of crypto-based finance, a truly trustless economy needs another type of solution.
Decentralized Exchanges
What is decentralized about a decentralized exchange? A DEX basically removes all the middle-men from trading, replacing them with smart contracts that operate transparently, autonomously, and agnostically on the blockchain. Traders are not required to put their trust in individuals or institutions. Instead, they interact with the smart contract, which executes trades according to algorithmic rules.
At the core of most DEXs is a type of smart contract called an Automated Market Maker (AMM). The AMM takes over the role of the traditional CLOB and its manager. Instead of matching limit orders one by one, the AMM sets prices algorithmically and executes trades automatically. We did a deep dive on AMMs in a previous Maverick 101 post, where we examined more of the mathematical logic that dictates how they price and execute trades.
The market maker from the CLOB becomes a liquidity provider for the AMM: they supply liquidity to be used to facilitate trading, but they don’t set limits on its use as they would in a CLOB model.
Nevertheless, the liquidity provider can still be understood as agreeing to take the long or short side of customer trades, as needed: for example, in constant product AMMs a liquidity provider usually deposits equal amounts of both assets in a trading pair into a pool, and is thus agreeing to provide liquidity to both buyers and sellers. In return, they expect to receive profits drawn from transaction fees paid by customers in their use of the AMM.
The value of a DEX is that there is no human or organizational intermediary establishing spreads between bids and asks. Instead pricing is done by the smart contract code that is the AMM. The AMM can be transparent about pricing and fees, and most smart contracts are open-source and available for external audit and verification. This openness enables customers to trade directly with the smart contract in a trustless fashion, without concern for the motivation or interests of the counterparty.
Most DEXs are also non-custodial, meaning that users connect their own wallet to the contract in order to make their trades, and thus always maintain control of their own funds, which are exchanged instantly with the AMM contract. They do not have to worry about the exchange losing funds or limiting access to their deposits at any time.
Maverick and the Next-Generation DEX
While DEXs are clearly the foundation of a DeFi future, there remain some issues. Key amongst them is liquidity, as many DEXs besides Uniswap have had difficulty reaching TVL that competes with CEXs. Also, despite the promise of permissionless finance facilitated by DEXs, there is still generally a tight control maintained on token listings.
Maverick aims to fix both these problems with its next-gen AMM technology, which enables the rapid and secure boot-strapping of liquidity for new markets through its intelligent liquidity-shifting mechanisms. A Maverick AMM is capable of facilitating low-risk, liquid markets for mid-cap and long-tail tokens without the need for market makers or other intermediaries. Our vision is that Maverick will provide the infrastructure for DEXs to match the trading volume of CEXs, and provide users with more options for trading their crypto assets.
Interested in learning more about the difference between traditional finance, CEXs, and DEXs? In the second episode of our Maverick Twitter Space, we gathered a group of DeFi experts from Pantera Capital, Coral DeFi, Liquity Protocol, and Maverick itself to take a deeper dive on questions related to this article. You can listen to it here!
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