Traders' necessity for crypto exchanges to carry out trading has increased as the number of cryptocurrencies has exponentially increased in the last couple of years. These cryptocurrency exchanges allow investors to instantaneously exchange, buy, and sell cryptocurrencies.
Now the biggest question one comes across is which exchange to opt for? Should you go for Coinbase, Kraken, or Uniswap or choose from the large list of crypto exchanges?
Before answering this question, it is important to understand the difference between decentralized exchange vs centralized exchange.
Centralized cryptocurrency exchanges, as the name implies, function as a middleman between buyers and sellers. Almost all crypto transactions are conducted through centralized exchanges, which provide more trustworthiness.
How Does A Centralized Crypto Exchange Work?
Centralized exchanges are platforms that allow users to buy and sell cryptocurrencies for fiat currencies such as the US dollar or digital assets like BTC and ETH. They operate as trustworthy brokers in deals and frequently serve as custodians, keeping and safeguarding your cash.
Centralized cryptocurrency exchanges include:
- Huobi Global
Pros Of Centralized Exchange
- User-friendly interface and simple platforms
- An added layer of security and trustworthiness
Cons Of Centralized Exchange
- Highly vulnerable to hacking or cybersecurity threats
- Charges service fees
- Controlled by a centralized entity, can be shut down in theory
Decentralized exchange is a non-centralized alternative to centralized exchange in which no single entity is in charge of the assets. In contrast to traditional centralized exchanges, smart contracts and decentralized apps are used to automate transactions and trades.
This method is far safer since no security breach is possible, provided the smart contract is properly constructed.
What Does Decentralized Mean In Cryptocurrency?
Decentralized crypto exchanges vary from centralized crypto exchanges in that they allow users to keep control of their assets by running their important activities on the blockchain. So, how decentralized exchange works? Decentralized exchanges either run on an AMM (Automated market maker) or traditional order book model.
In the order book model:
- An order is placed by a token owner to swap his or her assets for another asset offered on DEX. The owner of the token determines the number of units they must sell, the token's price, and the time limit for accepting bids for the assets.
- Other users can offer bids by putting a purchase order after the selling order has been made.
- Once the sellers have chosen the time, both sides evaluate and execute all of the offers.
In the AMM Model:
- Liquidity for an asset and its swap pair are pooled in a smart contract. Those who pool funds are eligible to receive the fees generated from the swaps using this pool.
- When someone makes a swap in the pool, the balance of assets in the pool are automatically rebalanced to 50/50 value, and the price of the tokens change to reflect the new supply.
- When there is not enough liquidity in a pool, and a large swap is made, the trader will run into high slippage issues; meaning the lack of liquidity will result in above-market purchase price.
Some examples of decentralized cryptocurrency exchanges are
DEXs build on CEXs shortcomings
One of the primary aims of a decentralized exchange is to complete the transaction more quickly and cost-effective as compared to the centralized exchanges. They achieve this by removing the intermediaries that charge a cut in the form of transaction fees on the centralized exchanges.
One of the world’s largest decentralized exchanges, Uniswap, claims a “zero rent extraction.” The exchange aims to safeguard its users from paying extra costs that generate profits for the intermediaries.
As of late 2021, Uniswap was charging a 0.05 percent transaction fee while centralized exchanges such as Coinbase, Binance, and Kraken were charging 0.2 percent, 0.1 percent, and 0.2 percent respectively.
Pros Of Decentralized Exchange
- Completely private and anonymous
- No need to transfer assets to a third party
- Fees are redistributed to liquidity providers, not to a centralized entity
Cons Of Decentralized Exchange
- Trading in fiat currency is not permitted
- Risk of impermanent loss for liquidity providers
- Liquidity can be thin, making it harder to execute large orders
Centralized Vs Decentralized Cryptocurrency Exchange: A Comparison
Now that we have a clearer understanding of centralized and decentralized exchanges, let’s delve into the differences between decentralized exchange vs centralized exchange, in terms of features, security, crypto-asset diversity, liquidity, fees, and authority.
Centralized crypto exchanges have an advantage over decentralized ones in terms of functionalities. To improve your trading, you may employ margin trading, portfolio management tools, and several sophisticated order kinds.
Customers of decentralized crypto exchanges, on the other hand, have access to a restricted number of order types and do not have access to margin trading (or equivalent services). Perhaps when more advanced decentralized systems enter the market, they will provide more functionalities.
There are very few scams at a centralized exchange. People purchase unknown currencies and lose their whole investment when the project turns out to be a hoax, and crooks flee with millions of dollars in cryptocurrency.
Similarly, the centralized exchange holds your personal safety, also known as your wallet. This means you may ask the exchange to reset your password if you forget it.
However, if you're tricked on the decentralized exchange, there's no way to get your money back. Also, because you own your wallet, you won't be able to change your password if you forget your seed phrase (a series of random words given to you while setting up your wallet).
Crypto Asset Diversity
As of 2021, there are over 4,000 unique cryptocurrencies on the market.
To be listed on a CEX, an asset must meet the following criteria:
- Security criteria
- Trading activity
- Regulatory requirements
And on decentralized exchange? You can list anything on a DEX. This means you'll take on more risk, but it also means you'll be able to trade new, in-demand assets. Simply put, if you do not carry out thorough research, you might end up with worthless assets!
One of the biggest drawbacks of decentralized exchanges is that it has failed to achieve liquidity levels comparable to centralized exchanges. Some DEXs have recently introduced a new liquidity mechanism to solve this issue: Automated Market Makers (AMMs).
Despite its enormous value proposition, the AMM model does not substitute centralized order books' accuracy and performance with centralized liquidity.
The majority of cryptocurrency traders are concerned with trading charges.
A white-label DEX works similarly to a CEX in that it charges a percentage of the cost for each transaction, but a centralized exchange works like a per trade fee!
As a result, when a transaction is ready to be put on a decentralized exchange, you must pay a gas cost in order for your trade to be confirmed via blockchain, which can be expensive depending on the chain.
One thing that works in the favor of centralized exchanges is speed. They are faster than decentralized exchanges. While a centralized exchange takes 10 seconds on average to finish a transaction, a decentralized exchange takes 15 seconds to match and execute the order.
In terms of usability, centralized exchanges have the upper hand. They are very easy to use as compared to decentralized exchanges. By entrusting transactions to an intermediary and paying a small fee, users get easy access to their money (such as ATMs and debit cards). Also, there are tools at their disposal such as online banking apps that help them visualize their assets with visually appealing platforms.
Another advantage of DEX bitcoin is that the user retains control of his or her assets. In a CEX, the exchange retains entire possession of the currency. Holding off on the key exchange, on the other hand, might result in a speedier execution because the user is not required to give access. However, this might lead to crypto thefts!
You've got a real-life illustration of this. The majority of the $713 million stolen in 2018 came from the Coincheck Exchange breach.
Cryptocurrency and its facilitators have always been surrounded by regulatory challenges. On top of that, decentralized exchanges have been a subject of debate for compliance. This is where centralized exchanges have an advantage over decentralized exchanges as they abide by the regulations and are compliant with the local regulatory bodies. Centralized exchanges maintain a KYC database as well as use software to make sure the trades are totally free of loopholes.
The government licenses and regulates the majority of the centralized exchanges. Crypto exchanges may be prohibited in certain countries – for instance, China, South Korea, India, and Russia – thus it is in CEX's best interests to abide by the regulations.
Governments and regulators, on the contrary, have no influence on decentralized exchanges. They just cannot be turned off. That is their greatest advantage, but it also comes with a number of drawbacks; customer support is not on their side.
Decentralized Exchange Vs Centralized Exchange: Summary
Here's a basic breakdown of the differences between centralized vs decentralized cryptocurrency exchange:
Final Verdict: Centralized Vs Decentralized Cryptocurrency Exchange
Although a centralized exchange is more user-friendly and potentially safer, a decentralized exchange is a revolutionary innovation that will most likely become the industry standard in the future.
When trading bitcoin and other crypto assets, though, you're more concerned with making money today or tomorrow than with what will happen in ten years.
In terms of short-term advantages, CEXs provide a safe entry into the world of crypto trading, but DEXs is a riskier environment with larger rewards if you play the game well.
The bottom line is that you should do both. Also, keep in mind the golden rule of crypto trading: never invest money you can't afford to lose.