What Are The Differences Between A Centralized Exchange And A Decentralized Exchange?

Over the years the crypto space has witnessed an explosion in popularity. As it inches ever closer to mainstream adoption, the framework for the DeFi ecosystem continues to evolve significantly.

Blockchain technology is the underlying foundation of the crypto industry and new applications are being explored daily. This in turn has led to advancements in pre-existing use cases, and a prime example of this is exchange platforms.

For a long time, centralized exchanges (CEXes) have been the go-to platforms for traders and investors looking to carry out transactions in digital currency. However, over the past few years, alternative platforms known as decentralized exchanges (DEXes) have begun to gain traction.

For a better insight into the innovative nature of the crypto space and blockchain technology, let’s take a look at these exchange platforms, what they are, how they work, and the differences between them.

What are Centralized Exchanges (CEXes)?

Centralized exchanges are extremely popular in the crypto space and process a large majority of all crypto transactions. The world’s largest CEX is Binance.

They are third-party online platforms that facilitate the trading of digital assets. A centralized exchange can be described as a marketplace governed by a central entity that functions as an intermediary between buyers and sellers of cryptocurrency.

Centralized exchanges often require individuals to register to use their services. Additionally, to complete the process of signing up they might have to undergo KYC (Know-Your-Customer) verification after which their accounts are authenticated. The new users link their bank accounts and following that they can begin trading depending on their choice of assets and the platform’s supported cryptocurrencies.

CEXes typically function as custodians over users’ crypto holdings and facilitate fiat to crypto transactions and vice versa. To process transactions, they make use of the order book model, and the exchange plays the role of a middleman. Individuals trading digital assets for varying prices are placed on the order book and the CEX matches potential buyers and sellers whose set prices for a particular asset are the same.

What are Decentralized Exchanges (DEXes)?

Decentralized exchanges are platforms where traders can buy and sell digital currencies without the need for a centralized authority. They facilitate peer-to-peer transactions which means that users can send digital currencies directly from their wallets with the use of smart contracts, programs on a blockchain that are executed only when predetermined conditions are met.

DEXes typically implement either of the following 2 mechanisms:

● Decentralized Order Books

● Automated Market Makers

Decentralized Order Books

In the order book method, the exchange maintains an assemblage of open orders from traders who have sent in their estimated prices for certain virtual assets. The smart contract matches orders from buyers and sellers, pairs the requests and then both parties review and complete the transaction.

The whole process takes place on the blockchain, traders have to write each order on the order book. The exchange uses nodes to keep tabs on all orders and miners verify each transaction before it is added to the blockchain, meaning the order will not be completed until it has been validated. An example of a platform that uses this system is Polarity exchange.

Some DEXes use on-chain order books and are truly decentralized, however, DEXes also implement off-chain order books, in this case the exchange is only partially decentralized. A centralized entity hosts the order book but the actual trading is peer-to-peer.

Automated Market Makers (AMMs)

The automated market maker approach is an algorithm or a protocol that erases the role of a list or the need to match buyers and sellers. Traders can swiftly buy or sell tokens through a liquidity pool of various digital assets. The pool of funds carries out transactions based on certain conditions. One exchange that implements this model is Uniswap.

AMMs function with the principle of demand and supply. Each time a user buys a certain currency the pool gradually raises the cost of the currency, on the other hand, each time a user sells a particular token its price is gradually reduced. The system is based on smart contracts thus it is fully automated meaning there is no risk from external or counterparties.

One of the biggest problems faced by the DEX model is its failure to attain liquidity levels as high as those of CEXes. Centralized exchanges have high amounts of capital while DEXes depend on active traders for liquidity. However, automated market makers rely on liquidity providers (LPs) or market makers to supply the liquidity. LPs are users that supply a liquidity pool with cryptocurrencies by staking their assets and in return. LPs make profits on their investment. Liquidity providers help facilitate trade on AMMs with their investment and for this they receive a percentage of each transaction depending on the amount they have staked.

Let’s briefly discuss the differences between these models.

Security

Centralized exchanges are prone to security issues such as hacks and breaches because user funds are in the custody of a third party which makes them vulnerable to attacks and human error.

A good example of this is the Mt. Gox debacle from June 2011 when a hacker used a compromised computer from the platform to transfer Bitcoin to himself, causing the price of BTC to plummet from $32 to one cent.

Decentralized order books and AMMs are far more secure seeing as each transaction is first verified by a group of validators before it is completed. Additionally, the records cannot be altered or tampered with because they are on the blockchain and the mechanism for transfer is audited via the public disclosure of the smart contract through the blockchain. Order books, even in centralized exchanges are transparent and in DEXes, this feature is heightened.

It is important to note that a DEX is only as secure as its smart contract. In 2018, decentralized exchange Bancor was hacked while certain upgrades were being made to the smart contract and the hacker made off with 24,984 Ethereum. Smart contracts are written by humans and they can be flawed so it is essential for platforms to have a robust smart contract.

Regulation

A CEX regulates itself and can be subject to government regulation because it is governed by a central authority. DEXes are either partially controlled by centralized entities or fully decentralized and this makes imposing regulations a very complex affair.

While decentralization is a huge selling point it also comes with its disadvantages. With a centralized platform, the risk falls on to the platform but in a DEX, users may have to bear the risks.

Fees

Centralized exchanges usually feature a standard commission which could be a percentage of each transaction, the exact amount depends on the platform itself. With AMMs or the decentralized order book, the fees vary and are often much lower than CEXes, however, traders have to pay fees as well. Depending on the blockchain network hosting the platform,these fees could be quite cheap or even more expensive than a CEX.

Verification

DEXes allow for anonymity but centralized exchanges typically require users to complete a KYC verification process.

Asset Options

Centralized exchanges carry cryptocurrencies based on certain conditions, such as security, regulation, or trading volume. Additionally, they facilitate fiat-crypto transactions.

Most DEXes do not support fiat payments, however, it is possible to list all kinds of digital currencies on a decentralized exchange platform. This is once more a double-sided feature as it is possible to lose money by purchasing assets with very little value.

Conclusion

Automated market makers solve the liquidity problem faced by DEXes and while decentralized exchanges provide privacy and allow users to be in charge of their funds, a centralized exchange is a good place to start if you are trading cryptocurrencies for the first time.

Additionally, CEXes are generally quicker than decentralized platforms as those can be slower due to network delays like block times. As shown above, the varying models for exchange platforms each have their pros and cons and cater to the needs of users which in turn are different. Eventually, it all comes down to what works for you as you make your crypto investments.