The greatest barrier to entry into the world of crypto is all the different terminology and platforms.
Seeing as you can’t do anything in crypto without a place to buy and sell your tokens, it’s probably a good idea if we make the distinction between two types of exchanges; centralised exchanges (CEXs) and decentralised exchanges (DEXs).
In this article, we will discuss the differences, pros and cons of both exchange types. Firstly, let’s go through just what each type is.
Let’s dive in!
A centralised exchange is a platform where trades are performed, it is, in essence, analogous to an insurance broker. You want insurance, the insurance company wants to sell insurance and the broker is the middle man, taking his cut for introducing both parties.
To explain how a centralised exchange works, it will help to use a different analogy.
Imagine you want to sell your car.
You take it to the car dealer and he offers to sell it for you for a cut of the profit. In order to do this, the dealer requires you to leave your car and keys in his showroom.
Potential buyers can visit the showroom and decide which car to buy (the dealer obviously has lots to choose from). If a buyer decides to buy your car, they pay the dealer and drive off into the sunset. The dealer takes his cut and (hopefully) gives you the remaining cash.
Seems simple enough right?
Well yes, this system has been around for many years and is trusted but if something happens to that showroom (maybe a theft or a fire), you’re going to lose your car and have nothing to show for it.
Also, some middleman is making money from your car sale, surely you’d get more cash if you cut out the middleman?
For this example, we will paraphrase a well known saying in crypto by stating…”not your keys, not your car”!
Are you still with us? Good.
Now let's look at decentralised exchanges.
A decentralised exchange cuts out the middle man, you retain custody of your assets and sell them, thus giving you more security and more profit.
Sounds like a no-brainer right?
To explain things a little clearer, let’s return to our car sale analogy.
In an alternate universe, another version of you also want’s to sell their car. Instead of going to the car dealer, you decide to go to a swap meet as you haven’t decided if you want to keep the cash or buy another car.
The day comes and you rock up at the swap meet, you pay a small entry fee (trading fee), park your car up, put the keys in your pocket (your keys, your car) and wait for other people to enquire about your car. As long as the swap meet has a large number of attendees (high liquidity) you’ll make that sale or car swap.
The benefit is, that you are in control of everything. If the deal isn’t right or you decide that you want to keep your car, you can just say no and leave.
This sounds much better than the centralised exchange/car dealer right?
Well, it depends on what you want to achieve. If your priority is selling the car, no matter the extra cost, maybe you go with a centralised exchange. If you want more control and choice over the outcome and don’t like the idea of leaving your car and keys with someone else, maybe a decentralised exchange works better for you.
A centralised exchange (e.g. Kucoin and Binance etc.) runs on an order book system that matches buys and sellers. They use a similar interface as stock or currency trading platforms.
For this reason, they are very popular with investors and traders.
Decentralised exchanges on the other hand are autonomous, smart contract-based trading platforms (there’s no middleman taking a cut). Users can directly swap one type of token, with another and the transaction is recorded directly on the blockchain.
The main, fundamental difference however is the issue of custody. Centralised exchanges require you to deposit your assets on their platform and, while they technically still belong to you, the CEX has control over them. Decentralised exchanges however leave you in full custody and control of your assets.
Centralised exchanges are custodial, decentralised exchanges are non-custodial.
It is well documented, that centralised are less secure than their decentralised counterparts but they do, however, have features that DEXs don’t have (yet).
Having a much higher trading volume, centralised exchanges offer seamless, quick transactions of even large, high-value trades.
Fiat on and off ramps and conversions.
Centralised exchanges enable users to buy cryptocurrency directly using their fiat currency (e.g. USD, GBP or Euro) to crypto and vice versa.
Other than swapping one crypto for another, Centralised exchanges have features such as margin and derivatives trading as well as staking, lending and borrowing products that are not available on all DEXs (however, DeFi platforms are catching up quickly here, especially Cardano)
As we mentioned earlier, the user interface that centralised exchanges use is similar to other, more established trading platforms (stocks or currency trading). This familiarity is attractive to experienced investors and traders. For newbies, many CEXs have a lite version that simplifies trading and allows an easier introduction into the crypto world.
“Not your keys, not your coins”! CEXs will have control of your assets while they are held on exchanges. Remember our car dealer analogy? Would you trust someone else with your valuables? Crypto should be kept securely in a non-custodial wallet.
Before allowing you to use their platform, CEXs are required to follow KYC (know your customer) protocols. You will usually have to provide an ID and a photo of yourself in order to trade.
On the back of the custody problem above, your assets are at risk of hackers while they are on centralised exchanges. It seems like not a day goes by without a news report of another centralised exchange hack. A quick Google search will reveal that billions of dollars of crypto have been stolen from centralised exchanges over the years.
The DeFi space is growing at a ridiculous rate and new DEXs are popping up on many blockchains (Cardano especially), this can be attributed to the desire of users to keep control over their assets and the increased understanding of the crypto world.
“Not your keys, not your coins” is the phrase that echoes around the crypto world. DEXs are non-custodial; they don't require users to give up control of their private keys in order to trade. DEXs interact with a user's private wallet (such as Daedelus or Yoroi on Cardano) via smart contracts. Centralised exchanges all require you to give up custody of your assets…erm…no thanks!!
Smart contracts record every transaction directly onto the blockchain, so buyers and sellers don’t need to rely on a third party (like a CEX) to ensure their transactions are secure; as DEXs don’t hold your funds, they are less likely to be targeted by hackers.
Diversity of Market.
As of November 2021, coinmarketcap.com lists over 8200 different cryptocurrencies, most of which are only accessible on decentralised exchanges because P2P transactions can occur without having high trading volumes. Centralised exchanges control which tokens they will list and, as we said earlier, CEXs work better with higher trading volumes, so they generally only list tokens with a high enough volume of transactions.
DEX users are not usually required to complete KYC (know your customer) and AML (anti-money laundering) protocols. This is a result of the DEXs not being liable for your assets because you retain custody of them.
DEXs run on self-executing smart contracts, eliminating the need for a penny-pinching middleman (e.g. a centralised exchange). While fees on DEXs do fluctuate, they remain far lower than the fees on CEXs.
NFT and DeFi products.
With the launch of smart contracts, DEXs can do more than just swap tokens. Financial services like lending and borrowing can be bolted onto a DEX, as can NFT art and gaming products.
While the following can be considered disadvantages, most, if not all, are a result of the infancy of the DEX industry and will become less and less of a problem as the arena matures. Depending on the blockchain the DEX is built upon (Cardano especially), some of the following disadvantages have already been fixed!
A DEX is only as good as the blockchain it is built upon, therefore it is bound by the same scalability issues as the host blockchain. As adoption rises, so does the volume of transactions. If the host blockchain struggles to handle the volume, transaction times and fees go up. We have seen this recently with skyrocketing congestion and gas fees on the Ethereum network. Third-generation blockchains like Cardano, are able to handle a much higher volume of transactions and with upgrades like Hydra, Cardano will be able to scale even more while still retaining decentralisation and security.
Early DEXs were often clunky and difficult to navigate, however, today’s DEXs are much more user friendly. DEXs like Cardax aim to make the user experience much more fluid and logical.
User Learning Curve.
The number of novel concepts that a new DEX user must get to grips with is a barrier to entry. Whether it’s the jargon or the ability to transfer funds from wallet to wallet etc, many DEXs and blockchains are pumping out academy style learning material (exactly like this article in Cardax’s academy!) to help new crypto investors make the leap without issue.
Liquidity is always an issue, especially with newer DEXs or trading pairs, however, the uptake of the entire DeFi space over the last few years has been nothing short of remarkable. Currently, there is around US$100 billion locked in DeFi. This will only increase over the next few years, so the liquidity problem is a beaten dragon.
Currency on and off-ramps.
In order to invest in crypto and start using decentralised exchanges, you need to be able to get your fiat currency (USD, GBP and Euro etc.) onto the system somehow. Currently, support for fiat on and offramps is limited and difficult for new users to manage. However, like the other “disadvantages”, time will fix it. This may be by using new stablecoin technology (like Djed) or the ability to buy crypto directly from the token issuers. Either way, if DEXs continue to progress at the same incredible rate as they have been, it won’t be a problem for long.
Compared with traditional financial markets, the crypto market is still in its infancy. With this infancy comes price volatility. This is a risk on any type of exchange, however, there are risks that are unique to each exchange type.
Vulnerability to hacking. As we mentioned earlier centralised exchanges have lost billions of dollars to hackers and given that they have control over your assets, this is a big risk!
Data breaches. Because centralised exchanges require you to verify your ID (KYC), your personal data is stored with them, if an exchange platform has a data breach, your data may be stolen and used for identity theft.
The mercy of financial regulations. Centralisation requires adherence to regulatory bodies. These regulations can change very quickly and may result in you temporarily (or even permanently) losing your assets.
You are in charge. While this is brilliant in terms of controlling your own assets, it also brings an inherent risk. Losing your wallet’s recovery phrase and therefore access to your funds permanently. Keep recovery phrases in a VERY safe place!
Poorly written smart contracts. A DEX is only as secure as the smart contracts it uses. Several early DEXs had vulnerabilities that were exploited by thieves. Stick to DEXs built on secure blockchains with strong smart contacts (like Cardax on Cardano for example!).
Both types of exchanges have their place in the crypto world. It is common for investors or traders to use both types, however, the domination of the market by centralised exchanges is been greatly reduced by the increase of decentralised exchanges available and will continue to do so as DEXs improve, offering more DeFi products, anonymity and financial freedom to users.
As always, do your own research, make sensible decisions and always remember “Not your keys, not your coins”.