Cryptocurrency exchanges: Centralized vs Decentralized
With the evolving blockchain technology and cryptocurrency industry, digital assets exchanges gained rapid development. Shortly after Satoshi Nakamoto published the Bitcoin whitepaper (October 31, 2008), the necessity to exchange digital assets emerged worldwide. Stemming from this need, the first cryptocurrency exchange Mt.Gox was launched in 2010. Since then, crypto market significantly grew, giving birth to plenty of other exchanges. Among the pioneers, there were such exchanges as Bitstamp, Bitfinex, Coinbase, Kraken that now are widely known around the globe.
Currently, according to CoinMarketCap, there are more than 300 exchanges, while other data sources tell us about more than 1000 of them. Since early times, they notably improved functionality, business models and still keep developing. Thus, how crypto exchanges can be classified and how do they differ from each other?
What is crypto exchange?
Simply, a cryptocurrency exchange is a place to exchange cryptocurrencies, tokens and fiat money. Obviously, the exchanges play a key role in the ecosystem of digital assets, matching buyers and sellers of cryptocurrencies globally.
Today we can distinguish two major groups of crypto exchanges with significantly different setups:
- Centralized exchanges (CEX)
- Decentralized exchanges (DEX)
From the first view, both types offer similar services for crypto traders and investors, but it is important to point out that CEX and DEX have slightly different functions due to technical reasons, pros and cons. Before discussing them, it is essential to understand the difference between these exchange types.
Differences between centralized & decentralized exchanges
Centralized crypto exchange, in general, operates rather like any traditional exchange, such as well-known stock exchanges. It means that the users need to deposit their funds into the exchange account to start trading. Since then, the exchange becomes responsible for the users’ funds and execution of trades according to their trade orders. In this case, a “centralized” entity (an exchange) controls and manages the execution of orders and assets storage. It is an intermediary between the buyers and sellers.
To compare, a decentralized exchange has no third-party that controls trades. The exchange neither stores the users’ funds, nor manages the operations with them. Such services are defined as “non-custodian” ones. Hence, DEX makes it possible to trade directly with another party, not relying on any intermediary (peer-to-peer trading, or P2P). The exchange provides a smart-contract infrastructure to conduct the trades, but the funds are completely controlled by end-users via their wallets. It is possible due to blockchain technology that acts as a base for decentralized exchanges, allowing to conduct trades via smart contracts and atomic swaps.
Currently, centralized exchanges still handle the vast majority of trading volumes of the cryptocurrency market, but DEXes are rapidly developing at a breathtaking pace. What is better? Let’s figure it out.
Centralized vs Decentralized
There is a broad range of factors that affect usability, efficiency and security of the exchange. To compare these exchange types, we consider such issues as anonymity, security, governmental regulations, functionality, fiat opportunities, liquidity and trading fees.
Anonymity
Being similar to traditional exchanges, centralized exchanges need to stay compliant with Anti-Money Laundering Laws (AML). That is why these exchanges require the users to pass Know-Your-Customer (KYC) procedure before using an exchange (provide personal information). In this case, sometimes the onboarding process becomes indeed annoying, and also there is a risk of personal information leak, even from a well-established exchange.
On the flip side, as the name implies, decentralized exchanges have no central authority. It means that no identification process is needed to deposit, withdrawal or trade assets. Decentralization is pseudo-anonymous! Therefore, it is rather easy to start trading without KYC and any concerns about personal details leak.
Centralized: 0
Decentralized: 1
But wait. Who cares about anonymity when access to the account is lost?
In this case, the responsive customer support of a centralized exchange will restore access after simple verification steps (CEX holds your private keys).
Unfortunately, a decentralized exchange won’t be able to help you, as it has no information and does not hold your private keys. There is no “Forgot my password” button and no customer support manager. It may sound epic, but people lose fortunes this way. Anonymity is a tricky thing, hence:
Centralized: 1
Decentralized: 1
Governmental regulations
Centralized crypto exchanges have to stay compliant with governmental regulations. Sometimes, it results in limitations for some citizens. For example, the US residents can’t operate on Bitmex, one of the largest cryptocurrency futures exchanges. Also, the crypto world is yet ever-changing and unpredictable, thus, CEX can be easily shut down.
To compare, DEX is not that dependent on governmental regulations, therefore, is free of the legislative limitations and more likely to survive if centralized crypto exchanges are shut down.
Centralized: 1
Decentralized: 2
Security
Security issues are closely related to the control of the assets. Centralized exchanges are responsible for the customers’ funds and keep their private keys. It means that the users of CEX rely on the exchange’s security system. And this is where a custody risk appears.
Custody risk is the risk of any troubles happening to the funds of the client while a custodian (in our case, it is a crypto exchange) is in charge of them.
Among possible reasons for a loss, there are technical errors, poor administration, the exchange insolvency, or any fraudulent activities — from the part of custodian or external ones (hacker attack). Unfortunately, these troubles are not a rare thing in the young crypto industry. Among the prime examples, there is Mt. Gox that lost 744,408 BTC in 2014, or Bitfinex with 119,756 BTC stolen in 2016. The refunds for the hack attack victims are possible, however, are not ensured.
That is why, among the most essential issues to consider while choosing a CEX there are its security level and transparency.
In contrast to CEX, DEX is not that vulnerable for hacker attacks, as the funds are stored in the customer’s own wallet, and the only person responsible for the funds is the customer itself. However, even though the hackers attack crypto exchanges more often, your wallet can be hacked as well. What is more, you may simply lose your private key and, consequently, access to your funds (this happens more often).
Centralized: 1
Decentralized: 3
Functionality
In terms of functionality, CEX has certain advantages. By holding users' digital assets, centralized exchanges can easily manage the customers’ trades and provide various types of orders. Besides, automated trading is possible at centralized exchange, as well as margin and futures trading. With an array of opportunities and instruments for trading, CEX might be more appealing to the customers.
As for decentralized exchanges, the list of functions is not that long. However, take into account that DEX is younger than CEX. It means that the new solutions may be yet to come. Anyway:
Centralized: 2
Decentralized: 3
Fiat-to-crypto exchange
Some centralized cryptocurrency exchanges offer fiat trading pairs and an opportunity to buy crypto with a bank card. Obviously, it adds popularity to CEX from the part of both — professional traders and newbies.
As for the DEX, the fiat-to-crypto exchange is not available yet at this kind of infrastructure.
Centralized: 3
Decentralized: 3
Liquidity & Speed
Liquidity describes how swiftly it is possible to buy or sell a certain amount of an asset. The higher liquidity is, the quicker you can exchange large sums of an asset.
Liquidity is one of the chief reasons why CEX still holds the edge in popularity over DEX. With a broader functionality and audience, less time needed for executing a transaction, and also market-making opportunities, CEX manages to ensure better liquidity and trading volumes than DEX.
At the same time, the majority of DEXes have significantly lower liquidity than the centralized ones. For decentralized exchanges, the order matching takes more time due to the exchange infrastructure, lack of trading automation and lower popularity, in comparison to CEXes.
Lower level of liquidity in comparison with some centralized exchanges often results in lower speed of transactions and sharp price differences for the assets.
Centralized: 4
Decentralized: 3
Note that the liquidity depends on the crypto exchange characteristics (scale of the user base, age, functionality and so on). Therefore, not every CEX is liquid. Do your own research!
Fees
Centralized exchanges generally charge a fee in a percentage of every executed trading order. The fees depend on the exchange, but usually, CEX fees can be higher than the ones of decentralized exchanges (in case if DEX charges only gas for the execution of contracts).
Centralized: 4
Decentralized: 4
Thus, what is better? There is no clear answer. Although this is not the whole list of the issues to compare, it can be concluded that each type of digital exchange has advantages and limitations.
Moreover, the crypto industry is still maturing, improving both types of exchanges and giving birth to new trading platforms and solutions.
What type of exchange to use is up to you, your preferences, goals, and level of experience in crypto. However, there are some substantial issues to pay attention to while choosing an exchange. It will be a topic of our next article.
Stay tuned for updates!
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