Centralised Exchange Vs. Decentralised Exchange
There are two major types of crypto exchange, and each has its benefits and drawbacks. Before you start using any of them, however, you need to understand the differences between these exchanges and determine which is right for you.
What is a Crypto Exchange?
A crypto exchange is a platform where you can trade, i.e., buy or sell crypto assets. A crypto exchange is similar to a stock exchange where you can purchase and sell shares and derivatives. However, in the case of crypto exchange, the platform is strictly for trading digital assets such as blockchain-based coins and tokens.
What is a Centralised Exchange?
A centralised exchange is a type of exchange created and owned by a third party. Centralised exchanges (CEX) facilitate trades between users using an order book model, a collection of buy and sell orders posted by individual traders. The orders refer to requests to buy or sell a particular cryptocurrency at a specific price. The CEX aggregates orders and executes the corresponding buy and sell orders. Popular centralised crypto exchanges include Binance and Coinbase.
A centralised exchange (CEX) is similar to traditional brokers in a way. You deposit your assets into the central wallet of the CEX just like you deposit your money with your stockbroker. In most cases, a centralised crypto exchange would require that you verify your personal information (KYC) before you can use the platform.
Pros of a CEX
- Highly Liquid
CEXs operate on the order book system, which has to do with facilitating trade by matching sellers with buyers. These exchanges usually have users making specific orders, mainly influenced by market trends. As a result, several users are always buying or selling an asset in demand, which encourages high liquidity.
- Cross-chain compatibility
CEXs enable the exchange of tokens between different blockchain networks. For Example, on a CEX you can exchange ETH for BNB.
- Easy to Use
When compared with decentralised exchanges, CEXs are easier to use. It’s one of the reasons newbies make their first crypto purchase using a CEX. It makes sense for these platforms to have a user-friendly interface to ensure that beginners are not confused.
Cons of a CEX
- Owned by a Third-Party
With CEXs, a third-party centralised organisation owns the wallet where you keep your crypto assets. Since ownership isn’t vested in you, it’s also not your responsibility to keep the assets secured. That means you’ll have to depend on the security system of the CEX, which is more prone to attacks by hackers.
- Limited Access to Early Projects
CEXs sometimes do not give access to early projects. There may be cases where you’ll be interested in trading a particular asset, but it wouldn’t be available on the platform.
- Regulatory Sanctions
CEXs are legal entities that are subject to applicable laws. In some cases, the government may sanction them if they fall short on some compliance issues. These sanctions may include shutting down the exchanges or limiting their operations.
What is a Decentralised Exchange?
A decentralised exchange (DEX) allows direct cryptocurrency transactions between users without any intermediary. Most DEXs operate on an Automated Market Marker (AMM) model. There are a few older DEXs that use the order book model, but for the purpose of this article, we will be discussing AMM DEXs. Automated Market Maker DEXs (AMM DEXs) automatically set the price of trades between tokens or coins depending on the supply and demand for the token or coin, based on a liquidity pool.
They allow digital assets to be traded automatically by using a liquidity pool rather than a traditional market of buyers and sellers. They are more like peer-to-contract rather than peer-to-peer. A DEX doesn’t work with an order book like CEX, and the price you get for an asset you intend to buy or sell is determined by a mathematical formula. Examples of popular decentralised exchanges include Uniswap and Pancakeswap.
Pros of a DEX
- No Third-party involvement
There’s no third party involved in storing your assets. All you need to do is connect the DEX to your wallet and use your private keys to manage your funds. It gives you total control of your assets.
- More Options
The range of coins available on DEXs is wider than most CEXs have. It allows you to be an early adopter for upcoming projects (although, you should always do your research on new projects!)
- Security
DEXs appear to be more secure than CEXs. While it’s true that CEXs always have strict security procedures in place, they are still more susceptible to security attacks by hackers than DEXs.
Cons of a DEX
- Complicated User Interface
This is one of the significant downsides of DEXs, as DEXs tend to have a more complicated user interface, making it difficult for newbies to understand and navigate.
- Fewer Features
DEXs have fewer features when compared to centralised exchanges. CEXs have features like spot trading and margin trading, but most DEXs don’t support these features.
- Cross-Chain complexity
DEXs also allow for making tokens swap, but it’s a bit more complex compared to using a CEX as swaps can only work within the same blockchain network. For example, you can only swap Smart Chain tokens on Pancake swap, you cant purchase ETH on pancake since they exist on different networks.
If you want to exchange a token that doesn’t exist on the network, you’ll have to wrap it before exchanging and the process of wrapping and unwrapping makes the process more complicated.
Although, you should note that atomic swaps make this process less complicated. Through atomic swaps, you can exchange two different crypto assets on two different blockchains peer-to-peer through the use of Hash Time-Locked Contracts (HTLCs) which are codable into blockchain transactions. The way it works, if either of the parties doesn’t meet up with its obligations, the contract gets cancelled and funds are automatically returned to the owners.
Order book vs AMM
The order book model:
- In this model, a user, who has a token and wants to swap for a different asset, places an order. Such individuals decide the number of units they want to sell, the price, and the number of bids they wish to accept for assets.
- After this selling order has been created, the buyers or users can present their bids by putting forward a purchase order.
- The seller then chooses a time, and both sides evaluate and execute the offers.
The AMM Model:
- This model allows users to trade crypto assets without using the traditional market system of buyers-to-sellers.
- There are slight variations on how this works from one DEX platform to another. For instance, some DEX platforms use simple formulas to facilitate the process, while others use more complicated calculations.
- Instead of trading with another trader or reaching out to them, you work with a smart contract. This is a set of codes that “creates’’ a market for a user that is ready to trade. Systematically, trading happens between you and a smart contract. In the process, there’s no need for an order book.
- The people who add funds to the liquidity pools are liquidity providers (LP). After funding and creating the pool, the LP is rewarded for every successful trade in that trade.
- As a user, you need to find a pool. Look for an individual liquidity pool with the type of assets you want to trade. The prices you get for trading in that pool will be determined by mathematics.
Differences between a Centralised Exchange and a Decentralised Exchange
Wrap Up
Now that you know the differences between centralised and decentralised exchanges, the next question is, which exchange is suitable for you? The simple answer is “it depends on your needs and interests”. Thus, you should decide the most important features to you and make your decision based on that.
