Centralized Exchange (CEX) vs Decentralized Exchange (DEX): What are the Differences?
July 6, 2021
Building Blocks of DeFi
With new decentralized finance platforms across different blockchains, crypto holders may be wondering what are the differences between a DEX and a CEX? Which one should you choose, and why? DeFi is still in its infancy, and these questions are important in order to understand the innovations of this new industry.
A Centralized Exchange (CEX) is probably familiar to readers who have used platforms such as Binance, Coinbase, Kraken, FTX, Kucoin, etc. In contrast to these major CEXs, a Decentralized Exchange (DEX) is a platform where smart contract applications operate in a decentralized and immutable manner with minimal trust in centralized authorities.
Centralized Exchanges Explained
A centralized exchange is essentially a platform that allows a user to buy and sell assets through a private entity. They are the most widely used platforms for purchasing cryptocurrency and are often initially more user-friendly than decentralized exchanges (DEXs). The centralized exchange, Gemini, describes CEXs as “platforms which facilitate the buying and selling of cryptocurrency, either for fiat currencies, like the US dollar or between digital assets, like BTC and ETH.
How does a CEX work?
CEXs function as trusted intermediaries in trades and often act as custodians by storing and protecting your funds. Leading exchanges facilitate every aspect of the digital asset trading experience: from security to fair market pricing to regulatory compliance, consumer protection, and access to various digital assets. As of September 2020, 95% of digital asset trades are executed through centralized exchanges, which represents approximately $228 billion USD a month.”
Depending on the centralized exchange, a customer can be offered a wide variety of cryptocurrencies to choose from. This allows consumers to gain easier access to a diverse set of investments. Centralized exchanges are also user-friendly in that the purchasing and selling of cryptocurrencies is usually much more intuitive. Centralized exchanges often offer off-ramping to fiat currency, while many decentralized exchanges do not offer this feature.
Many centralized exchanges require consumers to provide documentation, identification and sensitive financial and personal information in order to use their platform. This is known as KYC (know your customer) and is often necessary for regulatory compliance within respective jurisdictions.
Decentralized Exchanges Explained
Decentralized exchanges offer an important alternative to centralized exchanges in that they do not require KYC in order to interact with the exchange. A decentralized exchange, or a DEX, can be described as “a peer-to-peer marketplace where users can trade cryptocurrencies in a non-custodial manner without the need for an intermediary to facilitate the transfer and custody of funds.”
How does a DEX work?
Many DEXs will offer a way to connect your private crypto wallet to their platform, and that will allow you to swap a specific cryptocurrency for another. DEXs also offer much more privacy than CEXs and often provide the user with an opportunity to purchase specific cryptocurrencies that might be much newer. DEXs are commonly associated with specific blockchains, and because of this, they allow the consumer to purchase that particular blockchain’s native assets. Smart contracts also aid the exchange in reducing the counterparty risk by transferring the assets between the two parties in a single transaction.
Pros and Cons of CEX and DEX
Pros of CEX
**(+) **Centralized Exchanges generally administer market-making services. This means they provide both buying and selling liquidity for users to exchange their tokens and coins. In DeFi, not every liquidity pool is substantial, so users can face high slippages due to a lack of liquidity. Slippage is a term that can be defined as “the difference between the expected price of a trade and the price at which the trade is executed.”
Power of Centralized Structure
(+) Centralized exchanges are faster by design because funds do not need to be moved across a blockchain. Transactions are fulfilled by simply exchanging the funds' information internally on the CEX. Therefore, as a centralized entity, it can provide faster transactions. With CEXs, one does not need to worry about losing access to their assets if they lose their login password. In this instance, a user can easily request a password reset from the CEX. However, if an individual loses the private keys to their private crypto wallet, the assets can not be recovered.
(+) Fees can be cheaper on a CEX. As mentioned earlier, a user's funds stay in a CEX wallet where they can execute all kinds of exchange activities without the need to incur basic blockchain costs. Therefore, a CEX can provide fixed and relatively cheaper fees in contrast to current DeFi platforms such as Uniswap, where swapping fees for small volumes can take up to hundreds of dollars. It is important to note, however, that this is changing on certain blockchains. On Ergo and Cardano, for example, fees are very low and can even be lower than certain CEXs. Certain CEXs also have high fees if one is attempting to off-ramp and cash out to a fiat currency. However, it does depend heavily on which CEX one uses, as fees vary depending on the platform.
Pros of DEX
(+) At the heart of Cypherpunk, the ideal is that cryptocurrency economies should provide access to a peer-to-peer economic structure that gives back financial freedom to people. Since a DEX functions in a non-custodial manner, a user can keep their funds in their private wallet and swap tokens through the DEX in any desired amount.
Custom Trading Pairs
(+) One of the most unique characteristics of a DEX is that it is an ideal place for initial coin offerings and custom trading pairs. Anyone can set up a liquidity pool in a DEX and provide liquidity for a new exchange pair. This type of platform democratizes individual participation in market-making.
(+) All DEX interactions happen on-chain, therefore anyone can check if the volume is executed on the blockchain. This is why it is impossible to create Wash Trading without encountering transaction fees. The transparency of a blockchain acts as a protection layer against malicious actors.
Cons of CEX
(-) When it comes to lower market cap coins, big holders are needed to create buy/sell liquidity in a CEX. Automated Market Making (AMM) algorithms on DEXs can be much more beneficial in providing a healthy market for early-stage projects.
(-) Wash trading occurs when exchanges manipulate transactions for the purpose of appearing to have high trade volume numbers. This false display of transactional volume is an attempt to appear attractive to prospective cryptocurrencies looking for new listings and new investors who are seeking an active trading platform. Trades on a CEX happen internally, so there is no way of tracking the transaction by an impartial party. This gives a lot of power to centralized exchanges. This highlights the benefit of using a DEX due to the transparency of blockchain explorers and the utilization of smart contracts. On Ergo, for example, every transaction can be seen on the Ergo explorer.
Power of Centralized Structure
(-) "Not Your Keys, Not Your Coins." Readers may be familiar with this phrase, and it is a reference to the intrinsic downside of storing assets on a CEX. The actions of a user happen under the auspices of a custodial service provider. Centralized exchanges implement data-keeping services of your funds but also hold your keys, which is contradictory to the principles of a P2P (peer-to-peer) financial system. To clarify, the CEX is singularly responsible for the security of the wallet that holds your assets.
Cons of DEX
(-) The non-custodial nature of a DEX means that a user can lose their funds permanently if they do not keep their private keys secure. There is no way to recover the seed phrase for a unique wallet, so in the event, a user loses or forgets their private keys, there is no way to retrieve them.
Custom Trading Pairs
(-) It should be noted that there can be adverse consequences from some custom pairs on a DEX. Since anyone can set up a liquidity pool, one common type of fraud by malevolent entities is called a "rug pull." Investors can fall victim to unexpected losses when trading and/or swapping with a new "false" token on a DEX. Malicious actors defraud investors by creating new tokens for the purposes of trading and swapping the "false" token on a DEX.
(-) Since DEX interactions happen on-chain, there are different transaction fees that need to be included for each trade. DEX platforms generally have governance and liquidity providers’ fees that can vary between 0.2-1% per transaction. On top of that, however, an additional fee must be paid to the blockchain platform since the transactions occur on-chain. However, these blockchain fee requirements can evolve through the implementation of sidechains that address scalability issues. With this being said, the fees depend on which blockchain one uses. For example, the gas fees on Ethereum can be extremely expensive, whereas on Ergo they are quite low in comparison.
(-) Since data is transparent, though, transactions can be tracked, and wallets can be easily detected. This scenario is not ideal, but a dApp like ErgoMixer provides users with a new layer of security by hiding some of the transactions on-chain.
DEX vs CEX- Key Differences
There are several vital differences between what a CEX and DEX offer. Primarily, a CEX requires KYC information, whereas a DEX is non-custodial. CEXs often allow a user to sell their cryptocurrency for fiat currency and then off-ramp that money to their bank account. DEXs seldom allow for the off-ramping of fiat currency and usually deal strictly with cryptocurrencies. CEXs can provide a user with a large, diverse set of cryptocurrencies to purchase, whereas DEXs usually offer a few cryptocurrencies and their native tokens for swapping.
Overall, there are advantages to using a CEX and a DEX, and many users use both depending on their specific needs. DEXs become much more useful when a user is participating in a specific cryptocurrency ecosystem and wants to purchase native assets. It is vital that both CEXs and DEXs are available to the public if mainstream cryptocurrency adoption is to take place because they serve as the main avenues for participation in cryptocurrency markets. It is imperative that one does ample research about the CEX platform they are using to ensure that their funds are in a safe place. It is also important to note that sufficient research into any native assets on a respective blockchain should be carried out before swapping a coin for a native asset.