Centralized vs Decentralized Exchanges

An introduction to the ultimate differentiator in today’s crypto trading venues, including pros and cons of each.

Although cryptocurrencies are currently in the midst of a volatile bear market when compared to this time last year, the overall market capitalization has climbed from less than 15 billion in 2016 to over 197 billion today. Whether the user is a retail consumer, an experienced crypto hedge fund manager, or somewhere in between, they need to choose what type of exchange on which they will trade. With over 500 exchanges that share many similarities, there is one attribute that does distinguish them: whether they are a Centralized Exchange (CEX) or a Decentralized Exchange (DEX).

Centralized Exchanges

Though decentralization is a fundamental property of blockchain technology, centralized exchanges account for a staggering 99% of cryptocurrency trading worldwide.

CEXs are operated in fashion most similar to a traditional electronic securities exchanges, like the CME or NYSE, using proprietary technology and a central management team to oversee its operations — albeit often with far less oversight and accountability. CEXs typically incorporate a friendly user-interface that connects buyers and sellers as an intermediary and derives profits from those transactions. They provide a marketplace for tokens and facilitate the buying, selling, and trade of digital currencies to other digital and sometimes fiat currencies (i.e., USD, EUR, etc.). Due in large part to regional regulatory environments, fiat gateways are far less common that crypto-to-crypto exchanges. The CEX business model allows for other customer-friendly features including stop losses, margin trading, and lending.

CEXs are operated in fashion most similar to a traditional electronic securities exchanges, like the CME or NYSE, using proprietary technology and a central management team to oversee its operations — albeit often with far less oversight and accountability.

CEXs are very convenient for new customers to open accounts and start trading crypto immediately, it also means that they are typically regulated by the government laws of the country of their incorporation and residence — worth noting, region regulation can vary wildly. Because of their often necessary adherence to those government regulations, CEXs also require that users trust them and provide their most private information (name, bank accounts, government IDs, etc.) and to effectively relinquish control of their accounts to the CEX as a third-party. These regulations are known as KYC (Know Your Customer) and AML (Anti-Money Laundering).

Transactions of digital currencies in centralized exchanges are done off-chain with the customer funds, coins, and personal data stored in an exchange wallet. The user doesn’t have the private keys, so then they technically don’t have possession of their cryptocurrency. The exchange is responsible for the security for a countless number of these wallets that are in their custody, making CEXs a significant target for hackers and thieves. A testament to this fact is that hackers have stolen over 15 billion USD over the past few years from exchanges and their users.

In spite of some of the drawbacks of centralization, these exchanges dominate the digital currency ecosystem. Their success can be attributed to positive user experience and a widely accepted business model that is comfortable for both new users and experienced traders alike. It is very likely they will continue to innovate and adopt new security and custody measures to maintain their position as the type of exchange of choice for the foreseeable future. Some of the larger centralized exchanges you may be familiar with are Coinbase, Binance, Bittrex, Huobi, and Kraken.

Decentralized Exchanges

The value proposition of a decentralized exchange holds the ideals of the blockchain movement by allowing buyers and sellers to find one another and trade directly on-chain without a third-party intermediary.

Decentralized exchanges are a relatively recent development, and through the use of smart-contracts, they aim to create a peer-to-peer trading environment. This concept is in keeping with the fundamental essence of decentralized cryptocurrencies and the blockchain itself, but has several notable drawbacks. Trading on a decentralized exchange typically requires a higher degree of technical knowledge as they lack some of the more polished user-friendly interfaces found on centralized exchanges. Trades that settle directly on-chain circumvent requiring a third-party custodian and therefore greatly reduces the risk of hacking or theft. As a result, however, executing trades is much, much slower — many orders of magnitude — as validation of transactions take time and resources on the blockchain. Although the trading is decentralized, there is some partial centralization necessary to pay the people that write the trading dApps code and the smart contracts. As a result, DEXs still charge trading fees to execute transactions.

There is much less daily trading on DEX exchanges. Having less volume makes it more difficult to find buyer and sellers to complete a trade. Right now the DEXs trade a small portion of the digital currencies, however with the increasing regulations and security issues CEXs face, along with the inherent lack of privacy, some traders believe that decentralized exchanges will become increasingly desirable in the future. A notable proponent is the creator of Ethereum, Vitalik Buterin, who’s quoted as saying, “I definitely hope centralized exchanges go burn in hell.” Some of the more well-known decentralized exchanges are: IDEX, Waves, EtherDelta, and Waves.

Which should you use?

Deciding which type of exchange to trade is still a subjective choice (or as they say, DYOR). Presently centralized exchanges are by far the most utilized within the digital currency ecosystem. However, there are important issues that need to be addressed as digital currencies continue to make traction into the mainstream. Among them is an “institutional-grade custodial solution” according to Goldman Sachs CFO, Martin Chavez. Decentralized exchanges that today are clumsy to use and have various limitations preventing their widespread adoption.

At LXDX, we’re proud of our technology. Our software was built from the ground up in highly optimized C++, is run on proprietary hardware in top tier data centers, and as a result can perform at levels not seen in today’s crypto exchange ecosystem. As a centralized exchange, security is of utmost importance to us, which is why we employ multi-level cold and hot storage solutions and utilize 23-hour trading days to allow for safe settlement of funds and new technology roll-out. We also constantly strive to be on the forefront of innovation, which is why we’re exploring non-custodial trading solutions for our users. Stay tuned to find out more about that.

What’s your preference for trading digital assets? Let us know your thoughts in Telegram.