What is a decentralized exchange? Is it a better way to trade cryptocurrency than via a centralized one? This time, we figure out the difference between a DEX and CEX, their key advantages and disadvantages, and their mechanics.
Ever since Bitcoin came along, it has promised us an alternative way to deal with our finances. The alternative way offered by blockchain technology was called ‘decentralized’, and it meant that we could get rid of the money-draining middleman and gain full control over our assets. This was a new and exciting perspective that inspired a great deal of people.
Then, consequently, all kinds of cryptocurrencies and blockchains started popping up and things got a lot more complex as people wanted to exchange their cryptocurrency for various tokens, coins, fiat currencies, and vice-versa.
And that’s how the first cryptocurrency exchanges came to be.
Centralized Exchanges (CEX)
- Suitable for anyone: advanced UI/UX
- High liquidity
- Variety of trading tools
- Fiat deposits
- Compromised security
- Compromised anonymity (KYC)
- Strict regulations, dependency on the state
Currently, the majority of people use mainstream centralized exchanges to trade their digital assets, and this, to a point, compromises the main idea behind cryptocurrency. How can this be so?
Not Your Keys, Not Your Bitcoins
Well, first of all, in order to trade on a centralized exchange, you need to create an account and deposit a certain amount of funds in either fiat or cryptocurrency. Or you can transfer funds from your blockchain wallet to the exchange. Keep in mind, they always have limits. Once you transfer the funds to the exchange, it will update your account’s balance and you can start trading. Your funds, in turn, go to the exchange’s pooled ‘coin jar’ and all your future cryptocurrency trades are basically just recordings on a registry.
But where do your funds actually end up? Centralized exchanges use your cryptocurrency (partially or entirely, depending on the platform) to maintain their ‘hot wallet’ storage. So when you want to withdraw, the exchange can take the funds out of the hot wallet and you will get your money almost immediately.
However, this is where the problem lies. These hot wallet balances are usually the all-time favorite targets of hackers. Mt. Gox and Bitfinex exchanges, as well as many other CEXs, have been hit in the past and, unfortunately, we keep seeing news about yet another cryptocurrency trading platform that has suffered heavy damage.
Now, how can anyone relax when there’s the constant fear of losing money instead of making profits via a secure exchange present?
And that’s not the entire picture.
Lack of Privacy
As we have to depend on big enterprises like Binance and co. to exchange our blockchain assets, we have to play by their rules.The authorities, more or less, regulate these centralized cryptocurrency exchanges and require them to conduct AML and KYC procedures. For users, this means that they must provide some personal info, a copy of ID, or even have a video call with the representatives of the company.
And then again, where does an exchange store this data? Right on their servers that can be potentially hacked as well.
The Bright Side of CEXs
But let’s look on the bright side. Frankly speaking, centralized exchanges are not as bad as you might think they are by now. Most of them are great for cryptocurrency and blockchain beginners and are really easy to use.
They can afford to deliver a great UI/UX and be multilingual. Centralized exchanges provide their users with advanced trading tools, high liquidity, and quick support teams. In some cases, they even provide cryptocurrency insurance coverage. Quite often, these benefits outweigh the discomfort.
Decentralized Exchanges (DEX)
- Independency from the middleman, governments, and regulators
- Advanced security
- Lack of useful trading tools and often complicated UI/UX
- Low liquidity
- No fiat payment option
Obviously, blockchain revolution devotees and other sophisticated cryptocurrency users were not too keen on sharing their personal data, private keys, and assets with random third-parties.
And that’s how decentralized exchanges on the blockchain came into existence.
What DEX is All About
A decentralized exchange, or DEX, is a p2p platform that enables cryptocurrency transactions between two users excluding third-parties. These platforms set up markets on the blockchain and provide the opportunity to exchange cryptocurrency directly between traders. In simple terms, peer-to-peer or from one blockchain wallet to another. The management process is carried out automatically or with the help of their customers.
The very definition of a decentralized exchange implies that there are no servers that store your data; all they do is help you find the right matches for your orders. You stay the sole owner of your cryptocurrency every step of the way.
Developers have come up with multiple approaches on how to organize a working DEX model on the blockchain, from off-chain order matching and on-chain settlement, to smart contracts, to various hybrid models (when decentralized exchanges are in practice only partially decentralized).
The simplest option for a decentralized exchange is to use one single blockchain in order to record cryptocurrency transactions. That’s why many of the decentralized exchanges are built on top of the Ethereum blockchain and are able to exchange the Ethereum cryptocurrency and Ethereum tokens, such as ERC20 or ERC721.
However, there is a way to execute peer-to-peer transactions between blockchains as well. This method is called cross-chain atomic swaps.
As much as we love the idea of being solely in charge of our cryptocurrency and staying anonymous, there is a downside to it.
First of all, decentralized exchanges have a not-so-flattering reputation for poor user experience and confusing interfaces. Basically, most blockchain beginners stand no chance of puzzling them out quickly. Centralized exchanges provide their customers with a whole bunch of trading tools that make the entire process of trading cryptocurrency a lot easier, which these exchanges are usually not able to deliver.
Secondly, these exchanges show low liquidity levels, and this is a crucial point for an exchange. After all, you turn to an exchange with one particular and very clear goal: to trade your cryptocurrency and if the service takes too long, you’re more likely to never use it again.
And finally, decentralized blockchain platforms cannot facilitate a fiat to cryptocurrency exchange, because at the moment it is impossible to do so without a trusted authority that keeps track of account balances. Obviously, this is another red flag for users who have only just begun their blockchain journey and hold no cryptocurrency whatsoever.
Although decentralized exchanges are still lacking the functionality, flexibility, and liquidity their centralized rivals can easily afford, they do provide us with advanced security and anonymity, which are the major pillars of the crypto space. Decentralized exchanges are clearly not for everyone. Not even every experienced trader could easily figure out how to use a decentralized exchange after he got used to the centralized alternative. Not to mention blockchain and crypto newcomers.
But frankly speaking, a lot of exchanges that proudly call themselves DEXs, in practice, turn out to be so-called hybrid models whether they store some data on their servers (not keys though!) or force you to create a cryptocurrency wallet on their blockchain. Although it compromises the security part of the deal, it may also bring in advanced functionality.
On the other hand, the blockchain industry is developing rapidly. And since anonymity and control over your own funds are the key elements of the cryptocurrency movement, it’s possible that we will soon witness how decentralized exchanges overcome their issues and set up a new standard for crypto trading.
Right now, when decentralized exchanges are still in the first stages of their development, the majority of the users still prefer their centralized rivals. Those decentralized exchanges that live up to their name are currently popular with hardcore blockchain enthusiasts.