Decentralized exchanges permit people to invest in exchanging crypto tokens directly among themselves. The article explains the complete landscape of this exchange type for informational purposes. Let’s dive into the panorama of the decentralized exchange beginning with the understanding of the term.
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What are Crypto Exchanges?
Simply put, cryptocurrency exchanges are platforms that allow you to buy and sell digital assets such as cryptocurrencies.
On these platforms, you can trade bitcoin or convert your fiat currency into another altcoin such as Ethereum, Solana, or any other cryptocurrency of your choice by paying some trading fees and exchange fees.
The two most common types of cryptocurrency exchanges include centralized exchanges and decentralized exchanges.
What is a Centralized Exchange (CEX)?
The term ‘centralized’ in centralized crypto exchange hints towards the fact that an intermediary or a third party is involved.
Like the example of a bank setup where a person puts his trust in a bank account for the money, both the buyers and sellers in the crypto exchange agree to put their trust in a third party to deal with and handle their investments, and crypto assets.
In fact, the users do not even fully own digital wallets on the exchange.
What are the reasons for advocating Centralized Exchanges?
Monitoring and security, along with protection for conducting the transactions entirely & safely are the main reasons why some cryptocurrency traders advocate for centralized exchanges. These crypto exchanges also provide active traders with the required and trusted trading partners by using their distributed network of users.
How do Centralized Crypto Exchanges function?
Crypto trading on centralized exchanges is sometimes a days-long lengthy process. As soon as someone decides to buy crypto or exchange Bitcoin or any other currency, he/she needs to approach centralized exchanges like Coinbase or Binance. These are the two best cryptocurrency exchanges. Other crypto exchanges include KuCoin, Kraken, BitYard, and eToro.
Identity verification is a major part of getting started on centralized crypto exchanges. The best crypto exchanges like Binance and Coinbase ask users to verify their identity before they trade crypto. This is crucial to prevent any criminal activities. Once the verification is done, the centralized crypto exchanges allow users to deposit fees through a debit card or wire transfer.
Funds can also be deposited as cryptocurrencies like Ethereum or Bitcoin. Please note that this process may sometimes take longer than expected (unlike truly decentralized exchanges).
Once the account is verified & funds are deposited, the crypto exchanges will show up the price according to the order book of people selling and buying at distinct amounts allowing users to make a transaction by paying off trading fees beforehand.
After a successful transaction, the crypto assets will be shown in your account. However, you do not technically hold these. It is because you have entrusted the central authority of the custodian for the chosen crypto exchange.
That is why any activity you do occurs within the centralized exchange. These exchanges store and monitor cryptocurrency in a digital wallet.
It ensures the safeguard of people’s holdings who might face loss in digital currency simply forgetting the key to the wallet.
However, the trading fee varies from platform to platform. While some trading platforms charge low trading fees, others may charge significantly higher trading fees.
Crypto traders usually prefer exchanges that offer a good selection of listed coins, low withdrawal fees, and secure trading services.
Advanced traders often use multiple exchanges for different coins and transfer all their crypto holdings into a cold wallet for added security.
Advantages of a Centralized Exchange (CEX)
1. Intuitive User Interface
Centralized cryptocurrency exchanges often make it easy for beginner crypto investors to invest in digital assets. At the same time, they also advanced trading by offering tools for more experienced traders.
On the other hand, carrying out peer-to-peer transactions can be difficult. All that you have to do on centralized cryptocurrency exchanges is log into their accounts, deposit funds using fiat currency, and purchase their preferred coins.
Similarly, these cryptocurrency exchanges also make it very easy to sell cryptocurrency on the go.
Centralized cryptocurrency exchanges can be quite reliable. They often offer strong security so that the digital assets of users remain safe. Furthermore, users get to enjoy a high level of comfort as these exchanges provide an integrated crypto wallet for crypto transactions.
This is one of the biggest benefits of centralized cryptocurrency exchanges. You can leverage your investment as these cryptocurrency exchanges allow margin trading. This means that crypto investors can enjoy high profits. However, they can also face greater losses.
Disadvantages of a Centralized Exchange (CEX)
1. Security Risks
Regardless of high security, centralized cryptocurrency exchanges are always at risk of getting hacked or breach. Centralized cryptocurrency exchanges are backed up by companies that hold their customers’ funds.
Typically, most crypto exchanges like Binance and Coinbase hold billions of dollars worth of digital currencies, which makes them a prime target of cyber criminals and hackers.
For instance, Mt. Gox, one of the most popular cryptocurrency exchanges of all time ended up collapsing after losing digital currencies worth 850,000 bitcoins in a case of cyber-theft.
2. High Transaction Fees
Trading fees on crypto transactions are yet another major concern with centralized cryptocurrency exchanges. Other than that, you can expect to pay other forms of crypto exchange fees such as inactivity fees, service charges, and a lot more.
Normally, centralized exchanges charge high trading fees in return for all the advanced trading services and ease that they offer to users.
3. Fraud risk
Regardless of how legitimate a company is, centralized entities always carry an inherent risk of fraud. Cryptocurrency exchanges are no different in this regard.
Since these companies hold billions of dollars worth of digital assets, centralized exchanges can fail or end up committing fraud. In either of these cases, users can get stripped of all their digital assets.
What is a Decentralized Exchange (DEX)?
Decentralized exchange is one of the three current types of crypto exchanges, namely decentralized finance or DEX, Centralized or CEX, and Hybrid exchange.
Unlike other businesses, it is a place where users can swap the desired crypto token with their peers without the involvement of any intermediary.
So, these crypto exchanges allow users to buy crypto securely without the hustle of signups and the exhausting wait for days. But, how does it all work?
Centralized and decentralized exchanges are related. To have an accurate understanding of a decentralized crypto exchange, one needs to know centralized exchanges sufficiently. For this purpose, we’ll quickly be reviewing the definition and functioning of centralized exchanges first.
How does trade work on Decentralized Exchange?
A decentralized crypto exchange dismisses the involvement of the third person (exchanges) in a centralized exchange and introduces a new notion to crypto exchanges.
Taking a different approach, it employs automatically executed smart controls for facilitating the trade of digital assets among individuals without taking hold of them in real life.
These crypto exchanges often pave the way for instantaneous trades to happen at the best prices. So, DEX is based on a non-custodial framework that puts you in charge of managing a digital wallet that you own and the private keys.
DEX trading without taking control of coins
Decentralized margin trading handles all of this intelligently with the help of effective mechanisms.
Order books, aggregations tools, and liquidity providers are the most well-known Defi mechanisms. Various decentralized platforms employ these mechanisms to facilitate trading.
Similar to a centralized crypto exchange, decentralized exchanges also operate on order books. However, its order books are entirely decentralized. For each digital asset, these order books put together all the currently available buy and sell offers.
The variation of the different prices reveals the credibility of the order book and the corresponding crypto market price. DEXs handle order books in two different ways.
On-Chain order book
In this, each transaction is noted onto a blockchain. It includes the request to buy crypto or deny a purchase in addition to the original price. This chain helps but can make the purchase more expensive and steady by putting everything on the blockchain.
Off-Chain order book
It does not write each transaction on the blockchain. Instead, the off-chain order book only accesses the final transaction there. As all the other orders are not kept a record of, it can sometimes lead to a chain of security issues. However, it remains less costly and steady.
Some first-generation decentralized sites or apps that employ order books are Tomo DEX, dYdX, Binance DEX, Nash Exchange & Vitex.
Swaps are the instantaneous trades executed between the user’s digital wallet. These are the liquidity pool protocols used to find out the pricing of any asset. This process came to be known as a swap for its peer-to-peer and instantaneous nature.
2nd generation of decentralized exchanges uses liquidity pool protocols or works by swapping assets, i.e., tokens. Following are some of the dex platform in the market which uses swaps.
At Uniswap, automated market makers, one can swap any 2 Ethereum assets, be it a token, without any hindrance on the top of the fundamental liquidity pool. It allows a larger audience to easily buy and sell digital assets.
It is also a liquidity pool. But unlike others, Dodo makes use of its algorithm of Proactive Market Maker to able to provide the required liquidity. Some other DEXs include Curve, SushiSwap, and Kyber.
Decentralized crypto exchange with its dynamic approach employs various mechanisms and protocols. For instance, gnosis protocol. It provides increased autonomy and security.
However, their use is also observed to be the cause of disjointed liquidity over different DEX platforms. It discourages ring trades or institutional investors who are more inclined to buy and sell crypto in a larger trading volume.
To counter this problem, DEX aggregators successfully develop tools that merge asset liquidity pools for both types of crypto exchanges. Following are two crypto exchange aggregators.
It results in higher liquidity across decentralized and as well as centralized crypto exchanges. DiverisFi employs Starware to remove the front running problem.
2. 1-inch Exchange
It strengthens liquidity pools to ensure low slippage on orders based on large volumes by aggregating the liquidity of different decentralized exchanges. Ultimately, traders can buy and sell at the best possible best price on these crypto exchanges.
It is one of the great boons for which people shift to decentralized exchanges. These crypto exchanges provide the required privacy as it does not take hold of the user’s tokens, unlike centralized exchanges.
2. Various Options
There are a lot of options that you can explore and make use of in the index market. These include trading tokens without involving any financial institution or even a bank account.
3. Decreased Risk
As you own the keys to your private wallets, you are at a lesser risk of hacks. Also, you can do cryptocurrency trading without any break, which is required in the maintenance span of a centralized crypto exchange.
Many of the decentralized exchanges require tokens of the Ethereum network to work like a looping exchange. The trader needs an extra step of conversions before they can trade. The trading fees, of course, are set by the market.
2. Only cryptocurrency assets
Decentralized exchanges are limited to only cryptocurrency assets. So, owning a cryptocurrency asset or token is crucial to be to use a decentralized exchange.
3. Lack of customer service
Decentralized exchanges do not have a central entity backing them up. This means that you will not find any customer support. If you run into issues, you will have to figure the solutions out yourself. In short, you are responsible for all your transactions. Also, decentralized cryptocurrency exchanges do not allow you to create a crypto exchange account. So, they do not offer customer service.
Although centralized exchanges own the leading position in the market, the decentralized crypto exchange is also fast approaching people with its peculiar perks. While CEX is an authorized exchange type to buy and sell your tokens, DEX is a non-custodial trading site.
The choice between centralized or decentralized cryptocurrency exchanges primarily depends on the users and their preferences. Some crypto traders might prefer the user-friendliness and advanced futures trading tools centralized exchanges offer.
On the other hand, some users may prefer the privacy and quick-swapping of digital assets offered by decentralized exchanges.