Bitcoin (BTC), the world’s first cryptocurrency, was launched in 2009. Since then, cryptocurrencies have come a long way to be recognized as an asset class. At its peak, the crypto market’s total market cap went up to three trillion dollars. Also, despite the ongoing crypto winter, it is still above 800 billion dollars as of December’22. It is an excellent milestone, considering the cryptos are just over a decade old.
Multiple factors are responsible for the skyrocketing crypto adoption, and crypto exchanges are definitely one of them. They are a gateway for the retail masses to enter the crypto sphere. There are broadly two types of exchanges — CEX and DEX. CEX stands for Centralized Exchange, while DEX stands for Decentralized Exchange.
While the primary function of both types of exchanges is to enable the buying and selling of cryptocurrencies, it’s essential to understand how they differ in their working to determine which one is best for you.
What Is a CEX?
Centralized Exchange (CEX) might sound like a generic term. But in this context, it refers to crypto exchanges that serve as intermediaries between traders/investors, allowing them to buy and sell cryptocurrencies.
A CEX is wholly owned and controlled by a single entity. It’s responsible for maintaining user funds and executing trades. Thus, the users must trust the entity while placing the trade orders.
Some well-known CEXs include Binance, Coinbase, Kraken, and KuCoin.
How Does a CEX (Centralized Exchange) Function?
A CEX operates similarly to a traditional stock exchange but deals in digital assets instead of stocks.
You can buy and sell company shares on a stock exchange. Likewise, a CEX allows users to trade cryptocurrencies at real-time values.
1. Verification process
CEXs often have stringent Know-Your-Customer (KYC) requirements.
To become a registered user, one might have to provide name identity, address proof, and sometimes biometric verifications. Thus, it may not be convenient for those looking to trade anonymously.
After registering, the user gets their login credentials to access their account and start trading.
2. Fund custody
When a trade happens on a CEX, it is usually the exchange that holds buyers’ funds and the seller’s cryptos to make the trade happen. Instead of directly dealing with a buyer/seller, you are dealing with an entity. While this can be very useful when trying to avoid fraudsters, it requires you to trust the exchange.
Also, most retail users usually leave their assets and funds on the exchanges, thereby, giving custody of their funds to the platform. That’s not to say that you can’t transfer your funds to a privately held wallet.
3. Order book model
Any centralized exchange (like Binance) uses the ‘order book’ model to handle the transactions.
An order book is an electronic record comprising a list of buy and sell orders from traders. The order contains the quantity and price of the asset they want to buy or sell. When a buyer quotes a buy order to purchase an asset, the exchange finds a matching sell order to execute the trade.
But, this approach is not without its challenges. There is something called the ‘Bid-Ask Spread.’
‘Bid’ and ‘Ask’ refers to the price quoted by the buyer and the seller, respectively, for an asset. The difference between the bid and ask price is called the bid-ask spread.
Usually, the buyers look for the lowest price, and the sellers look for the highest price. They might not quickly agree on a single value. As a result, the difference between the two prices might increase, indicating a wider bid-ask spread.
What Is a DEX?
Decentralized Exchange (DEX) is a term exclusive to the crypto space. As the name suggests, DEX operates as a decentralized network and isn’t owned by a single entity or authority. It is a peer-to-peer marketplace to trade or exchange cryptocurrencies without the help of any intermediary.
Regarding functionalities, DEXs offer a much more comprehensive range of trading options than CEXs. It allows people to trade cryptos, earn savings interest over crypto, insure against risks, loan funds, speculate prices using derivatives, etc.
Well-known DEXs include Maker, UniSwap, PancakeSwap, and Compound.
How Does a DEX (Decentralized Exchange) Function?
Decentralized exchanges are gaining traction in the crypto space. They offer users a secure environment for trading digital assets since it removes your dependency on a centralized entity.
1. Verification process
Unlike a CEX, a DEX does not require users to submit personal information for verification purposes. As a result, these exchanges are much more anonymous, making them popular among those seeking greater privacy in their trading activities.
2. Fund custody
DEX follows a self-custody regime as the user owns the private keys to their assets. It helps them to have complete ownership of their investments.
3. Blockchain technology
To know how a DEX works, it’s essential to understand its underlying infrastructure – blockchain.
At its core, a DEX is powered by blockchain technology. It acts as an immutable public ledger for all transactions on the platform. These transactions happen on-chain and are verified by the decentralized network before getting stored on the blockchain.
In addition, most DEXs leverage smart contracts to facilitate trades. Smart contracts are computer codes that automatically execute orders when certain conditions are met. For example, when two parties agree to swap their tokens, the smart contract will execute the trade on behalf of both parties when conditions around payments are met. Unlike CEX, smart contracts eliminate the need for intermediaries like Binance to facilitate transactions.
4. Liquidity pool
While CEXs use the order book model, DEXs rely on ‘liquidity pools.’
A liquidity pool is a pool of crowdsourced funds locked into a smart contract to provide liquidity for a DEX. There is no intermediary or central authority to run the DEX. Thus, unlike traditional markets, users transact against the liquidity in a smart contract rather than with other users.
Three fundamental building blocks are helping the liquidity pool work seamlessly — Liquidity Providers, Liquidity Provider Tokens, and Automated Market Makers.
- Liquidity Providers (LPs): LPs are individuals who use their crypto assets to provide liquidity to a pool. The most common assets deposited in liquidity pools include ETH, BNB, USDT, USDC, DAI, etc.
- Liquidity Provider Tokens (LPTs): When LPs deposit funds in a pool, they receive liquidity provider tokens (LPTs) representing their contribution. It can be later utilized to earn financial incentives.
- Automated Market Maker (AMM): AMMs are algorithms that use mathematical formulas to set token prices and maintain high liquidity. AMMs ensure that the pool preserves liquidity by increasing the price of an asset as demand increases and vice versa.
Exchanges like Sushiswap and Uniswap use AMMs, where liquidity providers deposit two cryptos of equal proportion to the pool (For example, ETH and BAT). In comparison, some protocols (like Balancer) can hold up to eight assets in a single liquidity pool.
5. Incentive structures
In the order book model, liquidity is maintained/made by buyers and sellers of an asset. And the one providing liquidity i:e, sellers, are usually offered a rebate on the maker fee while buyers are exempted from such rebates and are liable to pay the taker fees. This is because sellers add liquidity to an exchange while buyers take liquidity away.
In a liquidity pool, anyone can become a liquidity provider by depositing two or more cryptocurrencies into a pool, typically of equal proportions. As an incentive, liquidity providers receive LPTs and rewards (i.e., trading fees) proportional to their financial contribution to the pool. In addition to trading fees, they can earn incentives by staking their LPTs.
CEX Vs. DEX – Pros and Cons
Let’s examine the advantages and disadvantages of both types of exchanges.
Pros of CEX
We will first start with the positives of centralized exchanges.
1. UX/UI (User Experience/User interface)
CEXs are easy-to-use platforms with a high UX quotient, making them intuitive to interact with. Over the years, many centralized exchanges have invested heavily in user experience research and designs. It helps to improve the credibility and trust among the users toward the platform.
2. Customer service
If we were to point out one thing that puts CEXs way ahead of DEXs? It has to be ‘Customer Service.’
Well-known centralized exchanges have excellent customer support. It enhances the user experience while using the platform. Moreover, blockchain technology is still nascent, and users are still learning. Therefore, there are so many things that can go wrong while trading in crypto. Hence, a well-trained customer helpdesk can reduce the risk significantly.
3. Vetting process
Most CEXs perform extensive research on tokens they list to protect the users from ‘rug pulls.’
Rug pull is a jargon exclusive to cryptocurrency. It refers to malicious activity where developers abandon their crypto projects and run away with the investor’s funds. It is a common occurrence on DEXs.
CEXs generally have large trading volumes due to the massive number of buyers and sellers on the platform. A high liquidity level ensures that traders can execute their orders quickly.
Cons of CEX
Below are some of the not-so-good parts of the centralized exchanges.
1. Custody of assets
In the case of centralized exchanges, users have to place their assets in the custody of the platform before starting to trade. The exchange owns the keys to the fund, and users don’t have much control over it.
Thus, there is a scope for billions of dollars in loss if the exchange is vulnerable to security threats and attacks.
2. Counterparty risk
Counterparty risk refers to the scenario where one of the parties involved in a trade or transaction defaults on their contractual obligation.
As CEX is the custodian of the user’s asset, the scope for counterparty risk is high. The FTX debacle is an excellent example to know about the implications of counterparty risk.
3. KYC process
A CEX puts the user through the painful process of adding KYC documents. Whereas a DEX just asks the users to connect to a crypto wallet. Also, CEX is not ideal for those who want privacy and anonymity.
Pros of DEX
Like CEX, DEX also has its set of benefits and drawbacks. First, we will look into the pros.
The traditional finance ecosystem is generally sub-optimal in developing countries. Hence, DEX can be an excellent tool for financial inclusion in these regions.
2. Control to users
Unlike CEXs, DEXs don’t control investors’ funds, as only users have private keys to their assets. It also significantly reduces counterparty risks.
3. High number of tokens
A CEX typically charges a hefty fee from the project team to list their tokens. This might prevent some great projects from reaching users. On the other hand, a DEX has a low entry barrier, thus giving users the benefit of having access to a wide variety of tokens.
Other obvious benefits include anonymity and privacy due to the absence of the KYC process.
Cons of DEX
As the entire DEX ecosystem is just a few years old, it’s not without drawbacks.
1. Bugs in smart contracts
At a fundamental level, smart contracts are nothing but computer codes. Like any computer code, smart contracts are also vulnerable to attacks in case of bugs.
2. Limited validation
The fact that DEXs have such a low barrier of entry for crypto projects makes them prone to scamsters. Often, many scam coins enter the ecosystem, looting millions of dollars of investors’ money. Some of the well-known scam coins include Bitconnect, Pincoin, and SQUID.
3. Network congestion
DEXs depend on blockchain technology. Thus the exchanges can be slow and prone to network congestion.
4. Low liquidity
Except for some of the well-established DEXs like Uniswap and PancakeSwap, many DEXs are new and nascent, lacking liquidity to cater to the user’s demands.
5. Impermanent loss
Impermanent loss is something exclusive to decentralized exchanges. It is a monetary loss experienced by liquidity providers when the price of the tokens in the liquidity pool fluctuates.
Other limitations include the lack of user-friendly interfaces and customer support.
CEX Vs. DEX – Key Differences
Below is a quick snapshot of the differences between a centralized and decentralized exchange.
|Parameters||Centralized Exchange (CEX)||Decentralized Exchange (DEX)|
|Governance||Centralized governance||Relies on smart contracts for its functioning|
|Custody of Assets||User assets are held by CEX||Users maintain full control over the assets|
|KYC Requirement||Traders are required to disclose personal information due to KYC requirement||Traders can remain anonymous as no personal information is required|
|UX/UI||Easy to use and beginner friendly||Highly complex|
|Regulation||High regulatory scrutiny||Largely unregulated|
|Fees||Expensive as third parties are engaged in the process||Cost-effective|
|Risk Factors||Counterparty risk; exposed to hacks||Impermanent loss; bugs in smart contract|
|Examples||Binance, Coinbase, Kraken, and KuCoin||Sushiswap, PancakeSwap, Binance DEX, and Loopring Exchange|
Now you might be thinking, what suits you better? CEX or DEX.
It all boils down to one thing — Do you trust people or technology?
The critical difference between centralized and decentralized exchanges is the choice between trusting institutions or technology to run financial services.
If it’s people, the centralized exchanges are for you. If you choose technology, decentralized exchanges are the way to go.
Therefore, traders should carefully consider their needs and preferences before deciding which type of exchange best suits them.
1. Why is a DEX preferred over CEX?
Decentralized exchanges are gaining traction in the crypto space. Unlike a CEX, a DEX does not require users to submit personal information for verification purposes. As a result, these exchanges are much more anonymous, making them popular among those seeking greater privacy in their trading activities. Another advantage is that DEX gives full control to the users over their assets. It is not the case with CEXs.
2. Do you pay taxes on a decentralized exchange?
The Indian crypto tax law imposes a 30% tax rate on the income from the transfer of digital assets. In theory, one can avoid crypto taxes by using DEXs since you can’t withdraw in fiat via a DEX. But investors would have to convert their crypto gains into fiat at some point in time to utilize it. This would expose them to the crypto tax.