Centralized vs. Decentralized Exchanges
As a leading provider of business accounts for digital assets in the industry, partnering with top-tier crypto exchanges like Bitstamp and FTX, we often discuss how the landscape of exchanges will evolve.
This article will provide a holistic overview of centralized and decentralized exchanges, their benefits and drawbacks, and how they differ. To conclude, we will share our thoughts on where we see the industry moving and what traders should consider before trading on either.
Reach out to our team to discuss different exchange types and how BCB enables digital asset businesses.
What is a centralized crypto exchange?
Crypto exchanges are platforms that enable users to trade one cryptocurrency for another. Centralized exchanges (CEX) are crypto exchanges that act as intermediaries between buyers and sellers. They are called centralized because a company with centralized decision-making power runs them.
Trading on a CEX
Before a user can trade on a CEX, they must sign up and verify their account. If they own crypto, they can deposit to an exchange wallet which credits their account, ready for trading. . If not, prospective traders can use fiat on-ramps to purchase crypto with credit cards, bank transfers, and more.
All trading on centralized exchanges happens through orderbooks. CEXs offer traders various order types, including limit orders, stop orders.
In order to offer competitive spreads CEX place liquidity requirements for market makers on listed cryptocurrencies and tokens. CEX have sophisticated, high-speed matching engines that match users’ orders in miliseconds, facilitating a smooth experience, and minimising price swings during volatile market periods.
Advantages of a CEX
Currently, more than 75% of trading volume is facilitated through CEX due to ease of accessibility, security and order management, making them a more robust choice for institutions with high volume requirements. CEX benefits include:
Offer traders ways to purchase cryptocurrencies with local fiat currencies support off-ramps to fiat.
High liquidity and volume
Thanks to market makers, and fast execution of trades, centralized exchanges have more liquid markets and offer especially institutions an attractive playground for their trades.
Wide variety of supported assets and instruments
Centralized exchanges, as the authority validating transactions on their platform, can support various native cryptocurrencies, making it easy to trade cross currencies.
User experience and support
Centralized exchanges offer customer support including intuitive interfaces that help traders with any questions they may have.
Disadvantages of CEX’s
Despite the advantages above, centralized exchange value also depends on the physical location of traders. Other disadvantages include:
When depositing into centralized exchanges, users give up custody of their cryptocurrencies removing the ability of traders to maintain ultimate control of their assets.
Single point of failure
Like all centralized platforms, centralized exchanges are an attractive target for hackers. Sometimes, despite best efforts, CEX get hacked. Earlier this year, crypto.com lost $35 million
Lack of transparency
Money flows through centralized exchanges aren’t fully visible to the public. Sometimes, even when withdrawing, users will not receive their transaction hash until after receiving their transfer.
For those looking for an alternative to centralized exchanges and traders wanting to dive deeper into the DeFi ecosystem, decentralized exchanges are the best place to start.
Decentralized exchanges run as smart contracts on public blockchains like Ethereum or Solana. The first iterations of decentralized exchanges were based on orderbooks and the idea of facilitating trades between peers. This type of DEX is called an Orderbook DEX, where orderbooks can be hosted on-chain or off-chain., ff-chain orderbooks place reliance on third parties to manage orders making these not truly decentralized.
On-chain orderbook DEXs didn’t become mainstream either, mainly because users quickly realized the lack of liquidity and the time it took for orders to fill.
Defi and decentralized exchanges started to flourish with the introduction of Automated Market Maker algorithms by Uniswap.
Automated Market Makers (AMMs) and Liquidity Pools
AMMs have become the primary way traders can swap tokens in DEX. Instead of trading peer-to-peer, users trade peer-to-pool.
Automated Market Makers are algorithms that set the price of an asset based on a mathematical formula and the supply of tokens available in a DEX’s liquidity pools.
Liquidity on DEXs is provided by users that add tokens to so-called liquidity pools and receive a share of transaction fees and sometimes airdrops of native tokens in return. The more tokens in a pool, the more liquid it is.
Because price is determined through a mathematical formula, it can deviate from the price assets are trading outside of the pool. This phenomenon is referred to as impermanent loss and describes a situation where a user deposits tokens into a liquidity pool where they trade below market price.
Advantages of DEX
There are a host of advantages DEXs offer with their innovative model of facilitating trading without intermediaries.
On a DEX, users are in control of their funds at all times. They connect to a DEX with their crypto wallet, and any transaction has to be signed and confirmed before it’s executed. This means users never give up custody aligning with the idea of crypto self-sovereignty.
Anyone with an internet connection can access DEX. They do not discriminate by trader location.
When trading on a DEX, traders can audit all transactions. This offers a whole new level of insight into a tokens trading history and ways to measure success.
As decentralized protocols, there no parties can censor transactions.
Disadvantages of DEXs
DEX trading volumes trail behind those of centralized exchanges. That’s because they come with a set of disadvantages that contribute to lower adoption.
While the ideal is for tokens in pools to eventually trade in tandem with overall market price, more often than not, impermanent loss can become permanent loss. Therefore liquidity providers are disincentivized from deploying their capital through DEX, reducing overall liquidity.
The processes for using decentralized exchanges can be less intuitive than those people are used to from TradFi. Depending on the underlying blockchain, trades may take longer to execute and can be expensive, further contributing to friction in user journeys.
Token support limited
Since DEXs are built on-chain, they are limited to offering support for tokens that are native to the chain they run on. For example, Ethereum-based DEXs will support ERC-20 tokens, but a trader may not be able to swap from native Bitcoin to Ether on easily.
Hacks and Bugs
DEXs are only as secure as their code. If the code is badly written or contains bugs, exploits can happen.
Centralized and decentralized exchanges both exist to enable users to trade digital assets. They do so in very different ways, one by handling and verifying all transactions through centralized servers, while the other running as a permissionless smart contract.
Centralization vs. Decentralization
To conclude, both platforms have their benefits and downsides. There is no one approach that fits every need.
At BCB, we work with businesses across the blockchain and Fintech sectors that offer both centralised and decentralised services and products.
Reach out to our team to further discuss our views on exchanges and how we enable leading exchanges to access to payment rails, and multi-currency transaction business solutions.