Cryptocurrencies and decentralisation have erupted over the past several years and we have seen mass global adoption for decentralised solutions from individuals, corporations and even governments.
Due to the development of blockchain technology and the movement towards a decentralised future, we are lessening the need of third parties to exchange goods. However in today’s digital economy, centralised exchanges are more widely known than decentralised exchanges and tend to be the initial choice when being introduced to crypto trading.
Centralised exchanges are proven to be vulnerable to hacks, they are holding and controlling users’ cryptocurrency, have a poor reaction to blockchain events such as hard forks, and are being met with an increase in regulatory risk from governments around the world.
So what does this mean for centralised exchanges and how do they stack up against decentralised exchanges? We take a deep dive into the pros and cons of these cryptocurrency exchange options to help you identify what type of exchange suits you best, and if you’re getting the best out of your current choice.
What is a Centralised Exchange (CEX)?
A centralised exchange acts as the middleman between a buyer and a seller. A business facilitates exchange orders and creates a venue for trades to happen through their platform, not directly on a blockchain. As this platform is operated and controlled by a third-party they are in control of security, privacy and holding your funds.
Here are some examples of centralised exchanges:
What is a Decentralised Exchange (DEX)?
Decentralised Exchanges (DEX) operate differently to centralised exchanges, as they allow users to execute peer-to-peer transactions on-chain without needing or going through a third-party. This means the user has complete control over their funds - from making transactions to maintaining security, which in turn creates a marketplace environment for buyers and sellers to connect directly to trade or swap assets. Each transaction happens directly on the blockchain, which makes every transaction verifiable by anyone.
There are two types of DEXs:
Order Book DEXs - Similar to centralised exchanges, the older generation DEXs tend to follow the order book system. This system uses an algorithm to match buy and sell orders to facilitate trade execution. You can learn more about order book systems here.
Automated Market Maker (AMM) DEX - This is a more modern system for DEXs and is more common in the current decentralised ecosystem. AMMs are a type of bonding curve based exchange and were created to address liquidity concerns around crypto exchanges. Instead of matching buyers and sellers directly, trades are executed using liquidity pools managed by the DEX’s smart contract. The liquidity pools come from users who provide assets in exchange for passive income or yield farming.
DEXs are preferred by more technologically experienced users as it enables them to have full custody over their funds as well as better security and privacy.
Here are some examples of DEXs:
Security: Custodial vs. Non-custodial
Ownership and holding of assets is one of the main features that defines centralised exchanges and DEXs.
Centralised exchanges are custodial which means if a user wants to trade on a centralised exchange the user will have to keep their funds in a wallet within the exchange itself, as opposed to their own personal wallet. This means the exchange holds the private keys to the wallet via a login wall, instead of you holding the private key or storing it on a cold wallet.
This custodial system has some benefits such as:
- Easy for beginners to get started with who are new to the complexities of crypto
- Using an exchange to hold private keys alleviates the concern of safely storing private keys yourself
On the other hand, opting for a custodial route opens up a whole new set of problems. In layman’s terms, if it’s not your keys, it’s not your crypto.
By letting exchanges hold the private keys to your wallet means the wallet is never fully owned by the user. Outside of ownership, this opens yourself up to a new set of security issues, you are trusting the exchange’s security infrastructure and their team members. If the exchange gets hacked, phished or goes out of business your wallet and coins are gone as well. This is a serious concern for users of centralised exchanges as there have been very large scale security breaches on these exchanges such as Mt. Gox, which was once the world’s largest cryptocurrency exchange before it was hacked for 850,000 bitcoins, leaving the business irreparable and its customers losing all of their money stored within the exchange.
In contrast, you have DEXs which are non-custodial systems, meaning there is no central entity that has access to your wallet. As the owner of the wallet you have sole control over what comes in and out of your wallet and who can access it.
The comparison of a custodial exchange and a non-custodial exchange is a question of security, whether you wish to trade the responsibility of self-custody, in return for leaving yourself open to risk and someone else having control of your funds. If you opt for a non-custodial route your funds will never be controlled by anyone other than you, you will have sole ownership of your funds along with the responsibility of keeping your funds secure.
Wallet security and individual ownership is becoming more and more user-friendly as there are companies out there who provide very easy to use wallet and security applications to secure your assets.
Transaction fees are different on CEXs and DEXs. Traditionally, centralised exchanges charge higher transaction fees due to using their service and the added convenience that comes along with it. Meaning, the more a user trades, the more transaction fees they pay cumulatively, this makes high volume trading expensive on CEXs.
In comparison DEXs are able to have cheaper transactions by cutting out the intermediary. Trading peer-to-peer means the direct route to exchanging assets is much shorter, thus allowing users to reap the benefits of cheaper transactions. New DEX versions like Uniswap v3 have low transaction fees as discussed in our earlier blog post.
Privacy is another key difference between CEXs and DEXs. Majority if not all CEXs have know-your-customer (KYC) procedures in place, a user must submit personal data before being able to use the platform or to make withdrawal and deposits. Exchange access or features will be disabled until completed.
To trade on a DEX it is not required for the user to submit any KYC data, offering more privacy and anonymity. Keeping your personal data secure and protected is a major advantage, however, although DEXs don’t require you to submit your personal data, you will have to comply with KYC at some point in time to purchase your crypto.
Centralised exchanges are controlled by a business entity that governs which tokens are listed, the registration process and regulates activity on the exchange.
DEXs, especially many AMM based exchanges offer their users governance tokens to democratise the control of the platform, as well as using the token as an incentive for providing liquidity. This adds a democratic process for the DEXs ecosystem and allows users to participate in the decision making process for the exchange.
Regulation has and will continue to be a key theme within the cryptocurrency sector, this is even more apparent when looking at exchanges. As financial and legal entities, CEXs are subject to regulation from their local governments, meaning centralised exchanges are susceptible to sanctions and limitations from the state. If a country decides to push against cryptocurrency as a whole, they could shut down centralised exchanges and as you do not hold the private keys to the exchange it may leave your funds in the state's custody.
DEXs are subject to less or in some cases no regulation and due to the peer-to-peer exchanges, DEXs prevent market manipulation, which protects users and the industry from fake trading and wash trading.
The liquidity battle between CEXs and DEXs have been back and forth over the past few years. Traditionally CEXs are known to have more liquidity, based on the amount of institutional investors and larger entities trading on centralised providers. For example the largest centralised exchange, Binance, reports 24-hour trading volume of $15 billion+ (as of 2 August 2022) and with such high trading volumes means you are very likely to find trade liquidity you need.
However with the DeFi boom and AMM, the liquidity on DEXs have grown tremendously. Unlike CEXs where they have a centralised process of deciding which tokens and trading pairs are listed, DEXs have flexibility in which tokens are tradable and users are free to find tokens or projects they are interested in and begin trading. This opens the cryptocurrency market wide open to trade basically any token, as long as the user is willing to research tokens and projects they are interested in.
Centralised exchanges give traditional finance investors and beginners a familiar, friendly way of trading cryptocurrencies. CEXs have a signup process, familiar account dashboard (accessible via password login) and easy to use trading UI that anyone can get started with and begin trading digital assets. However as CEXs are a regulated platform this also creates a barrier to entry itself. Signing up to the exchange will require multiple forms to be filled, providing personal data and KYC verification, in some cases, KYC verification can take multiple days to complete. You will also have to research if the trading pair you are looking for is available to trade on that platform. All of this is dependent on if the country you are in allows trading on CEXs.
DEXs are less user-friendly for the uninitiated and require a level of education and learning to begin trading. A user will need to set up a wallet outside of the DEX and will need to know the basics of sending and receiving assets via a blockchain. Until recently many DEXs have a more complicated UI that is built for more experienced users, however this is starting to change to match the same simplicity as CEXs. Once you understand how to create, secure and transfer using a crypto wallet, you will be able to begin trading on DEXs.
What should I choose?
Even though centralised exchanges and decentralised exchanges both serve the same purpose, they are both vastly different in features and properties. With CEXs, it gives a platform for new users to enter crypto, focus on trading without needing to worry about having industry knowledge or learning how to set up wallets and make transactions, however this comes at a price. DEXs offers freedom in trading, better payoffs and opportunities but requires knowledge and technical understanding.
The crypto landscape is ever changing and evolving, with new technology and innovation always emerging, it is unwise to put all of your eggs in one basket at this stage. With a little learning, you can immerse yourself in everything the industry and especially decentralised solutions have to offer, you will be able to access more technical methods and exciting projects that are at the forefront of technology.
If you are interested in learning more about decentralised markets, read our article on the world’s most efficient market.
About Trading Strategy
Trading Strategy is an algorithmic trading protocol for decentralised markets, enabling automated trading directly on blockchains. Learn more about Trading Strategy in the introduction post.
Join Trading Strategy community Discord to discuss decentralised finance, technical analysis and algorithmic trading.