Decentralized Exchange (DEX) vs. Centralized Exchange (CEX)
Part 2 of 4.
A Comparative Review of Trading Crypto Assets and the Future of On-Chain Custody
Mayhem in the cryptocurrency markets due to exchanges losing significant amounts of capital and, in some cases, all of their customer funds is a reminder to investors to evaluate the pros and cons of using decentralized versus centralized exchanges. Most likely, as an investor in cryptocurrency, your entrance into purchasing tokens will lead you to an exchange. Exchanges represent a digital marketplace where you can purchase, sell, trade, and store digital currencies. The most prominent CEXs include Coinbase, Binance, Kraken, and now-defunct FTX. On the other spectrum, some of the most popular DEXs include Uniswap, Pancake Swap, and DyDx. The mechanics of your transactions and the variety of transactions will deviate based on the type of platform you utilize.
Let’s examine a side-by-comparison of these two contrasting exchange platforms to evaluate how they operate, what differentiates them, and the benefits and risks associated with using one over the other.
Basis of Each Exchange
As the name implies, a CEX depends on a central entity or a centralized organization to exchange digital assets.
A DEX allows full custody of user funds, removing the need for third-party involvement—exchanges are peer-to-peer.
Functionality
CEXs operate in a very similar fashion to traditional stock market exchanges. Instead of stock trading, CEXs trade digital assets. To become a user, one must verify one’s identity, known as a KYC (know your customer) verification. KYC is a requirement on a CEX due in part to the exchange of fiat for digital currencies, and to some degree to governing regulations. Due to the ability to exchange fiat with digital assets, most initial purchases of cryptocurrencies take place on a CEX.
Trading on a CEX requires the user to relinquish custody of fiat or crypto funds to interact with DEX order types, such as swaps, staking, and buy/sell orders. These assets are in custody on the CEX wallet once they leave a user's wallet (otherwise known as a custodial account). The user now becomes a depositor, but does not hold the private keys to access deposited funds directly. Instead, the user has login access to "verify" assets on their platform. Because CEXs have a large amount of volume and funds under their control, trading is similar to a book order platform where orders fill quickly.
credit: cryptorobin.com
DEXs fall into two primary categories: an order book system or an automated market maker (AMM).
Order Book DEX- Cryptocurrency orders are matched between a buyer and seller in a similar fashion to a stock market exchange.
AMM- Cryptocurrency pairs (USDC/ETH) make pools of funds (liquidity pools) to exchange respective assets instantaneously. AMM DEXs were created to solve issues that arose early on.
The key defining features of any DEX are the algorithms and smart contracts that ensure orders are secure and filled. Algorithms aid in matching traders on book order platforms and setting prices of digital assets in liquidity pools for AMM platforms. Smart contracts record transactions on the blockchain for both types of DEXs and aid in balancing liquidity pools for AMM sites. In other words, these functions eliminate the need for a middleman and ensure that DEX markets can exist without a central authority. Most importantly, user funds and digital assets remain in self-custody without a KYC requirement.
credit: cryptorobin.com
User Experience
New cryptocurrency users often prefer to use a CEX as it has many similarities to traditional financial platforms such as Fidelity, Bank of America, and Vanguard. Apps that accompany CEX web pages are also very intuitive and add to the convenience of the overall platform experience. After logging into the CEX, a user can execute a trade within seconds or minutes.
It is worth noting that user experiences across CEXs vary greatly based on user location. Due to regulations, many large CEXs have US-based platform divisions separate from global divisions. Even within US platforms, state-to-state access can differ due to laws.
A DEX user must feel comfortable interacting with and connecting their wallet to the DEX platform. Once connected and a trade initiated, permission is granted/signed to allow the user’s wallet to finalize the trade contract. There is a bit of wait time to confirm a trade transaction and ensure available liquidity. This added layer of wallet interface complexity and wait time has resulted in many new crypto adopters preferring a CEX.
Keep in mind that just because a DEX does not require a KYC, anonymity is not guaranteed. Blockchains keep an immutable record, and transactions can be traced.
Unique Features
Many features (such as staking, increased liquidity, and more available trading pairs) that provided the CEX an edge in services are diminishing due to DEX platforms evolving to offer these services. And further, more risky and complex trading strategies exist on a CEX over a DEX. These include margin trading, crypto derivatives trading, exchange staking, and margin lending, among others. However, the ease of interaction is still the main benefit of a CEX, along with the availability of customer service.
A DEX will usually offer lower transaction fees on trades. Lower costs are due to the ability of DEX aggregators to “price shop” on specific chains for a requested trade pair, as well as the absence of a third-party entity profiting off a trade. Hybrid-style DEXs are making considerable gains that allow customers to utilize features (such as staking, and swaps requiring high liquidity) that were once only available through a CEX. Finally, DEXs allow users to access the world of smart contracts and DApps that provide financial services, including lending and savings products and NFT projects.
Security
As of this writing, the bookends of the crypto space timeline consist of two of the largest hacks that occurred on CEXs: Mt. Gox, which included the theft of 850,000 BTC (over 13 billion in USD value), and the liquidation/theft of at least 1 billion in USD of user deposits on FTX. Exploits to the private keys, corruption of centralized authorities, false reporting of assets held, freezing of assets/withdrawals, and leveraging user deposits are just some of the exploits seen when granting authority to a centralized entity, not to mention that many CEXs are still unregulated.
Due to reliance on smart contracts and blockchain transparency, DEXs have an edge in keeping assets secure. However, risks are not absent, as hackers can compromise a DEX or attack DeFi protocols on a DEX. The security of interacting with a DEX is only as good as the security standards a user practices while utilizing their wallet and verifying sites they are conducting business with.
An Alternative: Proof of Solvency
The beauty of cryptocurrency assets and utilizing blockchain technology is the ability to verify—not simply trust. Imagine an investment platform that is 100% verifiable, 24/7. Also imagine that users do not bear the burden of being solely responsible for custody of their funds. This investment vehicle is the best option moving forward because all investments remain on-chain. “On-chain transactions offer security and transparency since they can't be altered once they're verified and recorded on the blockchain network.” (Investopedia)
A CEX operates much like a bank in many instances, as assets that are deposited are not 100% backed at any given time, which creates a lack of solvency. Banks can get away with this to a degree, as central governing entities that back them can essentially supply an unlimited amount of liquidity if all depositors want their money back at the same time. A CEX has no such entity to bail it out if there is a call on all of its funds, and this is how a large institution like FTX collapsed by losing billions of dollars. If FTX had held its funds on-chain, it would never have been able to deceive investors into thinking the company was solvent and assets were sound.
On-Chain Index merges the positive attributes of a DEX and CEX by balancing the convenience of fund management by a third party with the security and verifiable trust of smart contracts and blockchain technology.
Takeaways
A CEX currently offers convenience based on trust in a highly unregulated and proofless space. Until more regulation and third-party platforms can ensure the verification of funds, the safest way to interact with a CEX is to conduct trade and immediately transfer funds back to a self-custodial wallet.
Using a DEX relies on verification, plus greater user knowledge and responsibility. The reward is retaining control of user assets. Self-custody and verification of blockchains are some of the most significant features of cryptocurrencies. Trading funds outside of verifiable custody relies on trust and usually immaterial gains against security and true ownership. Keep in mind that trust in CEXs has diminished due to recent events and lack of transparency, while proof is verifiable and certain with a DEX. However, loss of funds due to mismanagement of private keys is still problematic and an impediment to wider DEX adoption.
User experience and custody of assets are two of the most remarkable differences between a CEX and a DEX. When trading assets, customers must weigh risk aversion with true ownership and ease of use between these two types of exchanges. Product offerings, liquidity, and transaction times are now becoming insignificant between each platform as they evolve to attract increased user share. The next evolution requires absolute transparency in an on-chain environment—and it has arrived.
Credit: Investopedia.com
