This article will give a comprehensive explanation of centralized and decentralized exchanges, their advantages and disadvantages, and how they vary. Finally, we will discuss where we see the industry going and what traders should think about before trading on either.
Understanding Centralized crypto exchanges
Users can trade one cryptocurrency for another on cryptocurrency exchanges. Centralized exchanges (CEX) are cryptocurrency exchanges that serve as intermediaries between buyers and sellers. They are called centralized because they are administered by a firm with centralized decision-making power.
Trading on a Centralized Exchange (CEX)
A user must first sign up and authenticate their account before they may trade on a CEX. If they have cryptocurrency, they may deposit it into an exchange wallet, which credits their account and allows them to trade. If not, potential traders can use fiat on-ramps to buy cryptocurrency using credit cards, bank transfers, and other methods.
Order books are used for all trading on centralized exchanges. CEXs provide traders with a variety of order types, including limit orders and stop orders.
CEX imposes liquidity criteria on listed cryptocurrencies and tokens in order to offer competitive spreads. CEX has advanced, high-speed matching engines that match customers’ orders in milliseconds, allowing for a more seamless experience and minimizing price volatility during volatile market periods.
Advantages of a CEX
Because of the simplicity of access, security, and order management, CEX now facilitates more than 75% of trading volume, making them a more resilient solution for institutions with large volume requirements. CEXs have the following advantages:
1. High Liquidity and Volume
Centralized exchanges provide more liquid markets and give institutions an appealing setting for their trading due to market makers and speedy trade execution.
2. Fiat Support
Allow traders to buy cryptocurrencies with local fiat currency and provide off-ramps to fiat.
3. User Experience and Support
Provide client service, including user-friendly interfaces that assist traders with any questions they may have.
4. Wide Variety of Supported Assets and Instruments
Centralized exchanges may accommodate a variety of native cryptocurrencies and make cross-currency trading simple since they operate as the authority confirming transactions on their platform.
Disadvantages of a Centralized Exchange (CEX)
Despite the aforementioned benefits, the physical location of dealers affects the value of a centralized exchange. Additional disadvantages include:
1. Prone to hacking
Centralized exchanges are a prime target for hackers, like other centralized services. Despite best efforts, CEXs occasionally become hacked. For instance, crypto.com lost $35 million in October 2022.
2. Lack of transparency
Public access to the movement of money through centralized exchanges is limited. Users occasionally wait until after receiving their transfer before obtaining their transaction hash, even when withdrawing.
Decentralized exchanges are the greatest place to start for anyone seeking for an alternative to centralized exchanges and for traders wishing to learn more about the DeFi ecosystem.
3. Requires trust
Users that deposit into centralized exchanges give away custody of their cryptocurrency assets, making it impossible for dealers to retain complete control over their holdings.
Understanding Decentralized Exchanges
Smart contracts on public blockchains such as Ethereum or Solana power decentralized exchanges. The earliest decentralized exchanges were based on order books and the concept of enabling trading between peers.
This is known as an Orderbook DEX, and order books can be hosted on-chain or off-chain. Off-chain order books are not really decentralized since they rely on third parties to manage orders.
Orderbook on the chain DEXs has also failed to become widespread, owing to the lack of liquidity and the time it took for orders to be filled.
With the launch of Uniswap’s Automated Market Maker algorithms, DeFi and decentralized exchanges began to grow.
Automated Market Makers (AMMs) and Liquidity Pools
AMMs have become the primary means for traders to exchange tokens on DEX. Users trade peer-to-pool rather than peer-to-peer.
Automated Market Makers are algorithms that determine the price of an asset using a mathematical formula and the supply of tokens in a DEX’s liquidity pools.
Users that add tokens to so-called liquidity pools earn a percentage of transaction fees and sometimes airdrops of native tokens in exchange for providing liquidity on DEXs. The greater the number of tokens in a pool, the more liquid it is.
Because the price is established by a mathematical formula, it may differ from the price at which assets trade outside of the pool. This is known as impermanent loss, and it represents a circumstance in which a user puts tokens into a liquidity pool where they trade below market value.
Advantages of a DEX
With its novel methodology of allowing trade without intermediaries, DEXs provide a slew of benefits.
1. Non-custodial
Users have complete control over their funds on a DEX. They use their crypto wallet to connect to a DEX, and any transaction must be signed and confirmed before it can be performed. This means that users never give up custody, which is consistent with the concept of crypto self-sovereignty.
2. Transparency
When trading on a DEX, traders have the ability to audit all transactions. This provides an entirely new degree of information into a token’s trading history and methods for measuring performance.
3. Permissionless
DEX is accessible to everyone with an internet connection. They make no distinction based on the location of the trader.
4. Censorship resistance
Transactions cannot be censored since the protocols are decentralized.
Disadvantages of a CEX
Trading volumes on DEX lag behind those on centralized exchanges. This is due to a number of drawbacks that contribute to reduced adoption.
1. Limited token supported
Because DEXs are constructed on-chain, they can only handle tokens that are native to the chain they operate on. For example, Ethereum-based DEXs will handle ERC-20 tokens, but a trader may find it difficult to convert native Bitcoin to Ether.
2. Impermanent Loss
While it is preferable for tokens in pools to eventually trade in line with the overall market price, the temporary loss can sometimes become a permanent loss. As a result, liquidity suppliers are discouraged from deploying capital through DEX, lowering total liquidity.
3. Hacks and Bugs
DEXs are only as secure as the programming that powers them. They can be hacked if the code is poorly written or has errors.
4. User Experience
The procedures for using decentralized exchanges may be less straightforward than those familiar with TradFi. Trades may take longer to complete and be more costly depending on the underlying blockchain, adding to the friction in user journeys.
Conclusion
Users can trade digital assets through both centralized and decentralized exchanges. They do this in very different ways, with one processing and confirming all transactions through centralized servers and the other as a permissionless smart contract.