As we draw closer to the public launch of the Stakenet DEX, we have planned a short series of articles highlighting the various types of cryptocurrency exchanges, with their advantages and disadvantages, and finalising with a summary of new developments in this area.
We have planned a community activity at the end of this article series, so make sure to read it thoroughly. We begin with the most common and popular type of exchange, a centralized exchange.
Centralized cryptocurrency exchanges (CEX):
Centralized exchanges (CEX) are operated by a registered business entity. This entity keeps full custody of all user funds deposited into their exchange and utilizes private servers and software to store funds, execute trades, and keep relevant records.
For a long time, a CEX was the only way to trade crypto. The first generation of CEXs opened for business around 2010. They’ve played an essential role in boosting crypto adoption by making it accessible to broader audiences. The largest exchanges today (i.e. Binance, Bitfinex, Coinbase) continue to operate as centralized exchanges.
This type of exchange is fast and capable of providing good liquidity, CEXs can handle heavy traffic and are relatively easier to set up and operate. Their role as custodians of their users’ funds requires that they adhere to tighter government regulations — which provides a certain peace of mind that might appeal to a new investor.
CEXs that are fully licensed and compliant with regulations may be eligible for certain types of insurance (i.e. FDIC) that financial institutions enjoy. If the exchange is compromised, there is a chance that customers could receive money back. Being fully compliant also enables FIAT deposits (USD, EUR, CAD, etc.) and FIAT trading options, which are not possible for decentralized exchanges (more on these later).
They operate on a time-tested model that, for better or worse, greatly increases accessibility and adoption. Bitcoin, and the cryptocurrency industry in general, owes much to the early CEXs that helped legitimize the use and trade of crypto to the degree it is today. We have come a long way from when the early bitcoin pioneers negotiated trades on online forums.
On the flip side, the centralized nature of a CEX brings with it a host of problems. Stringent regulations and KYC requirements directly oppose the spirit of a true cryptocurrency — the free, unrestricted movement of money across borders and peer to peer. Once a trader has complied with these requirements, his private data (source of funds, copies of official identification, addresses, etc.) lie at the mercy of the CEX. The vast amounts of funds held by a CEX make it an attractive target for hackers, and in cases of successful hacks, one stands to lose funds, with all personal data leaked and abused.
A CEX is only as secure as its security policies. Your funds are safe (“safu”) up until the second the exchange is hacked and all funds drained away. Here is a list of a few of the biggest hacks in crypto’s very short history:
- 2011: MTGOX ($8.5 million)
- 2014: MTGOX ($460 million), Cryptsy ($9.5 million)
- 2016: Bitfinex ($77 million)
- 2018: Coincheck ($500 million), Bitgrail ($187 million), Coinrail ($40 million), Zaif ($60 million)
- 2019: Cryptopia ($16 million), Binance ( $40 million), Upbit ($51 million)
- 2020: Kucoin ($150 million)
In most of these cases, traders and users were left with no reimbursement or recompense. Lawsuits initiated by the victims are dragged out in courts to this very day.
Decentralized Exchanges (DEXs) were developed as an answer to the shortcomings of a CEX.
Decentralized cryptocurrency exchanges (DEX):
Decentralized exchanges (DEXs) arose to match the need for a secure, permanent, immutable medium to trade assets freely and without interference or special permissions from centralized entities. In other words, DEXs extend the immutable nature of the blockchain to cover the trading mechanism.
Trading on a DEX happens by way of an “Atomic Swap”. Atomic swaps allow a direct peer-to-peer exchange of two assets, from different blockchains, without the need for a trusted intermediary.
The trade occurs on-chain. The trader never loses control (“private keys”) of his funds during the process. There is no need to trust that a centralized exchange would not freeze your funds or “exit scam”. Uptime is constant and reliable.
DEXs have been around in some shape or form for years, but it was only in 2020 that they moved out into the forefront of the exchange industry. DEXs improve significantly upon several CEX flaws, but early implementations of them were lacking and simply had too many setbacks to be competitive.
Among the biggest setbacks at traditional DEXs are: setup, accessibility, liquidity, fees and speed. If a DEX is inherently difficult to set up and has little ease-of-access, it isolates itself from the vast majority of liquidity providers and investors. Assuming there is enough liquidity to execute a trade and perform an atomic swap between two different assets, there remains the issue of high fees for takers and slow swap times for trades.
A DEX is only as capable as the blockchain it runs atop. If the blockchain hosting a DEX isn’t capable of processing high volume transactions quickly and has volatile on-chain fees, that DEX will quickly hit performance bottlenecks that prevent it from scaling with increased traffic.
If fees fluctuate when a blockchain gets congested, the DEX becomes slower and more expensive to use as traffic increases. We have seen this, especially on Ethereum DEXs like Uniswap in early 2021, when the trading fees exceeded $500 per trade.
Much like Bitcoin and Ethereum, decentralized exchanges that operate strictly on-chain have trouble scaling and keeping low fees as traffic increases.
Despite these flaws, decentralized exchanges are a significant step forward for cryptocurrency trading, and the high volumes being traded today in DEXs like Uniswap attest to the growing acceptance of DEXs among traders.
In the next article, we will talk more about different Layers and various types of DEXs — the problems most decentralized exchanges face as well as the most promising developments that seek to mitigate these issues.