Key Takeaways
- Centralized and decentralized exchanges have distinct features, advantages and disadvantages and are designed for different types of investors.
- Centralized exchanges are best suited for beginners as they are easy to use when buying, selling or trading crypto.
- Decentralized exchanges are more difficult to use but are more aligned with the principles of cryptocurrency.
- Centralized exchanges, with much higher liquidity, allow traders to transact enormous trades of up to hundreds of millions of dollars.
- Decentralized exchanges allow smaller transactions since they offer lower liquidity because of their on-chain nature.
Are you interested in joining the crypto trade bandwagon, and you’ve read about two types of cryptocurrency exchanges: Centralized exchanges vs. decentralized exchanges, and you can’t differentiate them? This guide looks into the subject to help you learn the similarities, differences, and limitations of the two types of crypto exchanges and gives you the certainty to choose the one you need to trade with self-confidence.
What’s a Crypto Exchange?
A crypto exchange is a marketplace where you can buy, sell or swap crypto coins and tokens. Centralized exchanges (CEX) are the first-generation platforms, and decentralized exchanges (DEX) are the new-generation platforms. How transactions work, and user possibilities depend on the type of exchange you use.
Centralized vs. Decentralized Exchanges: How They Work
Centralized Exchanges
Most cryptocurrency exchanges you’re familiar with are possibly centralized: Binance, Coinbase, Kraken and Gemini are some perfect examples. They’re the first choice for most traders. But why are they popular, and what’s their backbone? The answer is centralization! Centralization means trading at the platform with a centralized intermediary, with an order book where orders are recorded and validated.
All transactions happen within the exchange’s database, and user information is processed and stored on the platform’s servers. As part of Know Your Customer/Anti-Money Laundering (KYC/AML) requirements, centralized exchange users must provide personal data and bank details when signing, a move intended to deter money laundering. Most newcomers love centralized exchanges due to the simplicity of trading. You choose the coins you want, confirm the transaction, and voila! Centralized exchanges are also custodial, storing users’ funds in their wallets. The following are the critical features of centralized exchanges:
Functionality
CEXs are user-friendly and are preferred by crypto beginners, primarily because users can buy or sell crypto using fiat money. Some centralized exchanges also offer additional services like storage and leveraged trading.
Regulatory Requirements
Centralized exchanges get operating licenses from governments, which implement strict KYC/AML procedures under the law to guarantee customer safety.
Security
Some CEXs store customers’ private keys on their platforms as centralized entities. However, this makes them vulnerable to hacks and attacks. These days, most have adopted advanced security measures like cold storage and two-factor authentication (2FA) to enhance the safety of their customers’ digital assets.
Liquidity
Because of their expansive audience, centralized exchanges offer higher liquidity. Therefore, finding buyers or sellers for tokens is relatively more straightforward, which further liquidates the exchange.
Decentralized Exchanges
Decentralized exchanges are similar to centralized exchanges in several ways but have numerous substantial differences. The main difference is that there’s no central entity in a DEX, and transactions happen on a blockchain, mainly Ethereum or Binance Smart Chain. Trading is conducted using intelligent contracts and orders executed on-chain, meaning the exchange doesn’t have direct control of users’ crypto assets during the process. Decentralized exchanges also don’t interact with fiat money, and, as a result, they don’t ask for personal details, IDs, or bank details for KYC/AML compliance. Some key features of decentralized exchanges include:
Operations
Decentralized exchange networks operate a peer-to-peer system on a decentralized platform, which is a structure without entities. This system automatically allows two parties to interact and conduct direct transactions without involving employees to maintain, operate, or process transactions.
Requirements
To trade on a decentralized exchange, you don’t need KYC/AML or other verification documents; you only need DEX firmware to deal with another entity.
Security
DEX systems are more secure than CEX systems because DEX platforms don’t store customer funds and don’t ask for security protocols like email authentication or 2FA.
Volume
Since most DEX platforms are relatively new, they have lower liquidity, which translates to lower trading volumes on the exchanges.
Risks
The biggest challenge in using a decentralized exchange is the need for users to know about security-related matters to safeguard their funds. Users must also have learned how to select the best wallet suitable for their preferred tokens. Users must apply due diligence to avoid investing in new and unverified coins that could be listed on such exchanges, some of which lead to rug pull scams. Finally, there could be exploitable bugs in some smart contracts that could have escaped detailed code reviews and comprehensive audits.
CEXs vs. DEXs: Key Differences
Both centralized and decentralized exchanges have their advantages and disadvantages. The following are the main differences between centralized and decentralized exchanges:
Access
Users in the decentralized exchange ecosystem control their crypto tokens. In centralized systems, the service provider controls users’ funds and accounts. Having a third party with some control is a double-edged sword. On the one hand, if a user loses their private keys, the exchange could come in handy, and some backups could be run to enable the user to retrieve their funds. The downside, however, is that a user can lose all their funds if the centralized exchange gets hacked.
New Features
Compared to CEXs, DEXs have relatively new features that enable traders to convert one crypto to another automatically. Unfortunately, centralized exchanges may not necessarily support such additional features. Whereas you can use fiat money to buy cryptocurrency on a CEX, you can’t use fiat money to trade on a DEX. Also, decentralized exchanges don’t have unique features like limits, stop-loss, or margin trading available only on a CEX.
Regulatory Requirements
Centralized exchanges obtain operating licenses in many jurisdictions, making them more liable to follow a country’s rules and regulations. You must submit your identification documents before trading on a centralized exchange. Since decentralized exchanges run on a distributed blockchain model, they’re not bound by any legal requirements anywhere. You don’t require a single identification document before trading in a DEX.
Security
Since CEXs store users’ funds, they’re more prone to cyber-attacks than DEXs. In this regard, DEXs are a more secure platform than CEXs. On a positive note, though, since most CEXs offer custodial and cold storage of digital assets these days, they’ve started using cold wallets to ensure users’ funds are secure even if the exchange suffers an attack.
Liquidity
Centralized exchanges have a broader client base and a higher trading volume. The multiple market participants buying and selling different types of digital assets provide a constant flow of supply and demand, enabling the exchanges to maintain higher liquidity. DEXs, on the other hand, don’t have multiple users buying or selling crypto assets, resulting in a lower trade volume and liquidity owing to lower market participation.
Fees
Trading in a DEX environment draws zero or very little in fees, especially for traders who participate in multiple higher-value transactions. CEXs extract a fee for every transaction in exchange for the service rendered, but the costs are relatively low compared to what traditional operators charge.
Popularity
The decentralized exchange model for trading cryptocurrencies is still relatively new, with lower liquidity and market participation being the main drawbacks. However, the centralized exchange model is still more popular within the crypto community for trading and investment.
Anonymity or Pseudonymity
Centralized exchanges require KYC/AML details of all users to eliminate money laundering or other illicit activities. On the other hand, a decentralized exchange is simply a code that doesn’t require proof of identity. All transactions can be tracked on the blockchain, therefore providing pseudonymity.
Fiat Onboarding and Cash Out
Centralized exchanges support fiat money onboarding and cash out, meaning users can use cash to buy and sell cryptocurrencies. Decentralized exchanges, on the other hand, are hosted on blockchains and only support crypto-to-crypto transactions.
Deposit Withdrawal Control
CEXs can select which crypto assets users can withdraw or deposit at their discretion. However, DEXs almost always process any transaction.
CEX vs. DEX: What does the future hold?
The battle between CEX vs. DEX is a mixed bag! DEXs offer everything cryptocurrency was created to do: privacy, anonymity, and security. However, their greatest undoing is that they are still new and can be complicated for the average user. CEXs, on the other hand, have the numbers, with over 99% of the market cap for cryptocurrency exchanges. Additionally, most people only use decentralized exchanges to purchase altcoins.
CEX vs. DEX: What is best for you?
Since both centralized exchanges and decentralized exchanges have advantages and disadvantages, every trader must make the ultimate decision on their preferred mode of trading. However, the most prevalent trend has been for newbies to choose CEXs as they begin their investment journey and later graduate to DEXs once they have learned the ropes.
Conclusion
The decision on what type of platform you’ll choose between a CEX vs. DEX is personal, but it boils down to two essential factors: If you’re interested in an easy-to-use system and don’t want to be tied down to controlling your crypto wallet, a centralized system would be the best option for you. But, if you want anonymity, total control of your assets, paying lower fees, and a gateway to DeFi and NFTs, then a decentralized exchange is the way to go.
