Cryptocurrency is one of the best inventions of the 21st century. Today, it seems impossible to imagine a life without this innovation. As the crypto space continues to witness more and more interest from people, it is important to discuss one of the major pillars on which it stands, and that is, Centralised and decentralised exchanges.
As we’ll see later, an exchange may be centralised or decentralised. Centralised exchanges require adequate information about their users for effective operation. They mandate standard identity verification, also known as “know-your-customer (KYC)”, which helps to confirm the identity of a customer in order to prevent illegal activities, such as money laundering or tax evasion.
Creating an account on centralized platforms without going through the KYC process will restrict your account until you verify it. The restrictions will also limit your ability to transact or even deposit crypto into your account.
What is a Centralised Exchange (CEX)?
A centralised exchange involves a central authority that controls, validates and handles digital assets and transactions. They are similar to traditional financial institutions as they facilitate trades by maintaining an order book between users.
CEXs aggregate and match orders between users to execute trade. This is done by issuing an IOU (refers to account receivables) to the trader while taking custody of the assets deposited. The exchanges then maintain these IOUs in their networks and track as every user’s IOUs changes ownership.
In a research conducted this month, CEXs were found at the top of the chart for the top 100 cryptocurrency exchanges in the world. This is no doubt associated with the benefits centralized exchanges offer, like: more liquidity, speed, cost efficiency, security, and regulatory assurance, which are helpful for day traders, crypto investors, and institutional clients.
Examples of CEXs:
However, they are not without their cons. The transparency issue experienced with traditional financial institutions is also one major turnoff in CEXs. Since they do not reveal their operations to the users, it paves the way for undetectable activities such as price manipulation.
Also, the transactional operations of CEXs holding users’ assets until withdrawal make it a lucrative target for hackers, both from outside or within the organization. Another disadvantage of CEXs is their subjectiveness to government censorship. The government can seize users’ funds, freeze their accounts, or even force the exchanges to release their customers’ information.
To avoid these limitations, there is a need for a decentralized alternative, which has led to the exponential growth of many decentralized exchanges. Asides from protecting users from regulatory burdens, DEXs also offer low transaction fees. So what are DEXs and how do they work?
What is a Decentralised Exchange (DEX)?
Decentralized exchanges fulfill the goal of decentralization by eliminating middlemen or central authority. This cuts down or removes transaction fees, since there is no third-party involvement in the transaction’s operations.
This legacy protects DEX users from incurring additional costs used to generate profits for the intermediaries in CEXs. In 2021, Uniswap, a top DEX, charged a 0.05% transaction fee on a $100,000 trade while CEXs like Binance, Coinbase, and Kraken were charging 0.1%, 0.2%, and 0.3% respectively.
“Automated Market Maker” protocols determine prices of assets in DEXs. An example of the protocol is the “constant product” mechanism which determines prices according to DEXs total reserve of individual assets. Therefore, the DEXs reserve remains in relative balance–if any asset becomes scarce, it becomes expensive. This allows a fair distribution of such assets.
Examples of DEXs:
Though DEXs seem a better choice than CEX, they face a problem of liquidity cost compensation for their liquidity providers. This problem is referred to as “Impermanent loss.” Impermanent loss happens when liquidity providers are unable to withdraw the exact value of tokens contributed to the pool. As trades occur on DEXs, the ratio of different tokens (I.e. Token pairs like USDT/$FTM) change to adjust the wider market prices, causing the pool to have more of the token losing value to adjust the market prices.
This implies that the liquidity provider will either withdraw more of the token that lost value or less of the one that gained value. This means they will end up withdrawing less of their deposited assets. DEXs also struggle with providing large liquidity when working with large investors. This causes the problem of slippage—unplanned additional costs impacted by large orders.
How to use DEXs
Trading using DEXs is as straightforward as trading on CEXs but with a tweak. To trade cryptocurrencies on DEX, you have to select the cryptocurrency you hold and the one you wish to swap it to. The trade order can be to buy or sell, depending on the crypto you hold. Once the smart contract validates the transaction, the trade will be executed and your assets will be transferred.
How do DEXs operate during a trade?
Whenever a token holder places an order to exchange assets for any available asset on a DEX, there is a need to specify the number of assets they wish to sell and at what cost. They also need to include when the assets will be available for bidding (sell order). The corresponding buyer submits a bid (buy order) once the order is complete. Finally, both the seller and the buyer review and accept the bid, thereby executing the trade.
The crypto trading ecosystem relies heavily on both the centralized and decentralized exchanges, and in the future, users will determine the type of crypto exchanges they wish to use based on the features they offer. Since both are not without their merits and demerits, selecting a suitable exchange is a factor of your investment choice.