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Buying or selling cryptocurrencies is really easy these days. Cryptocurrency services or products are delivered by thousands of companies that are trying to differentiate themselves by what they offer. The very basic description however divides the cryptocurrency exchanges between centralized exchanges (CEXes) and decentralized exchanges (DEXes). What are the main differences, advantages or disadvantages of both? Moreover, when is a good time to use CEX over DEX or vice versa? These will all be covered in the following article.
What are Centralized Exchanges?
The most common type of cryptocurrency exchange is a centralized exchange. This type of institution is very similar to traditional financial companies (traditional exchanges). The only difference is that it offers products and services connected to cryptocurrencies, not stocks, bonds or commodities.
Therefore, centralized exchanges have offices, employees and are traditional companies, which will be hugely different in comparison to DEXes. These types of exchanges, due to their traditional infrastructure and systems have to usually follow very strict regulations regarding KYC (know-your-customer) and AML (anti-money laundering) policies. This is often regarded as one of their disadvantages, but we will get to that later.
Advantages of Centralized Exchanges
First, let’s have a look at the advantages of centralized exchanges. Since they are essentially traditional financial companies, they have to follow strict regulations regarding the safety of the assets they store. It is very common practice for them to have strong security and cybersecurity teams abiding up to date measures and rules, leading to more secure storage of cryptocurrencies. Also, if they hold most of the cryptocurrencies in the cold storage wallets (which in most cases they should), they offer an environment that should be hard to hack.
Since these companies have to follow regulations, they can be held accountable if needed. This might seem pretty straightforward, but it will not be the case for DEXes. Moreover, they usually offer a variety of customer services and support teams that are helping customers in case it is needed, which is again one of their advantages.
Overall, centralized exchanges are usually pretty easy to use with a very simple user interface for both retail and institutional investors. Most of them even offer fiat on and off ramps, which means that users can easily transfer their funds to or from the exchange.
Disadvantages of Centralized Exchanges
As mentioned previously, strict KYC and AML policies have to be followed, which means that users of these exchanges cannot have proper privacy. Verifications connected to KYC and AML in many cases need several documents and IDs, sharing numerous personal details and information and might not be welcomed by everyone.
Most of the centralized exchanges are so-called custodial, meaning that they hold the cryptocurrencies you buy. Even though they almost always offer a withdrawal option, until you actually withdraw the cryptocurrencies out, they are in the possession of the exchange. Simply said: “Not your keys, not your coins.”
Moreover, as the past few months showed, centralized exchanges face several problems regarding their trustworthiness. As with other financial companies, investors need to trust in the third-party provider (in this case the centralized exchange). However, this might be hard when the reputation of the centralized exchanges is not the best.
For instance, in one week of April, 2 cryptocurrency exchanges in Turkey, Thodex and Vebitcoin reportedly closed their services and products and are seen as exit scams. Additionally, in February, Coinbase decided to pay a fine of 6,5 million dollars for wash trading and price manipulation, which only shows that some of the exchanges might be prone to misusing their power and is still one of the biggest flaws of centralized exchanges (Browne, 2021).
What are Decentralized Exchanges?
The concept of decentralization was popularised mainly through the creation of cryptocurrencies and still is one of the main features and characteristics of this world. When it comes to decentralized exchanges, decentralization means that the platforms are mostly run on smart contracts and are only being developed by small teams, usually not in the form of companies.
Their end goal should be, and in most cases is, the move solely to the governance of the exchanges to the hands of the token holders, who should have all the voting power over the decisions that will be made in the process of improving and running the exchange. As with CEXes, DEXes have several advantages and disadvantages that we will look at.
Advantages of Decentralized Exchanges
The biggest advantage of the DEXes in comparison to the CEXes is probably their ability to keep the privacy of the buyers (or in this case swappers). It is very common for most of the DEXes not to have any KYC and AML regulations. For some of them, you do not even have to have an account opened. Usually, it is enough for the users to only connect their wallets to the DEXes, which keeps the privacy of the buyers to themselves.
Hand in hand with the privacy feature is connected, the next advantage of the DEXes. This is the fact that the only person responsible for all of the coins or tokens is the person making the trades. This means that coins and tokens are always in your own hands and in your custody, which means that no one can stop you from trading them or no one will ask for more or better verification. Everything is solely up to you.
DEXes have also the ability to offer countless cryptocurrencies and projects. Since most of them do not have order books but are rather automated market makers that only need sufficient liquidity from liquidity pools, any coin, token or trading pair can be swapped on the DEX, if it has enough liquidity. This however is also one of its disadvantages, since there are already many scams and exit scam projects that are being traded on these exchanges, since there is no “veto rule” or supervision over the trading pairs listed.
Disadvantages of Decentralized Exchanges
As we mentioned before, the no “veto rule” means that DEXes might be full of scams and illegal projects that are trying to rob the investors. However, there are several more disadvantages of the DEXes, such as their expensive trading fees. This is mostly visible on Ethereum based DEXes, where the scaling problem is ever more present. Once the scaling is solved, the fees might get significantly lower, however, until that happens (probably with the ETH 2.0 implementation), DEXes built on ETH network will always suffer from it (Ethereum Average Transaction Fee, n.d.).
Moreover, the fact that most of the DEXes are only built on one network (such as Ethereum) assets from other blockchains can not be traded on them yet. Solutions such as wrapped assets are already used, however, these might not be the best, leading to relatively high division of the projects based on the platform they are built on.
DEXes are also without any customer support. There are several blogs or platforms where the community is very helpful, however, this does not mean that all problems can be solved there. Moreover, DEXes not only miss customer support, but they also do not have any special features such as charting or fiat onramp. This means that trading assets on DEXes might get complicated or is rather complex in comparison to CEXes.
When to use CEX and DEX?
After seeing most of the positives and negatives of both types of cryptocurrencies one might ask, when is it appropriate to use each type? The answer to that question would differ depending on the individual trader or investor, however, some basic generalisations can be made.
When you want to buy traditional coins or tokens from all different blockchains or networks, CEXes might be your best shot. Also, if you are not so familiar with cryptocurrency space, the simplicity of the CEXes might offer you some comfort in using it.
On the other hand, DEXes would be beneficial if you want to buy some low-cap gems that have just begun their trading. Moreover, DEXes are used for security and privacy reasons, so if you are very careful about your whereabouts in the “digital world,” DEXes offer better privacy than CEXes. These types of exchanges are also used for buying “gems,” small-cap tokens that are new to the cryptocurrency world and rather risky investments, but usually offer high returns.
The decision on which exchanges to use is always up to the trader or investor. However, it might be useful to have the ability to trade on both and use for instance DEXes for buying little-known gems and CEXes for buying well-established coins and tokens. In this way, one can be sure to be using the cryptocurrency world to the fullest.
Browne, R. (2021, 4 26). A second bitcoin exchange collapses in Turkey amid crackdown on cryptocurrencies. Retrieved from CNBC: https://www.cnbc.com/2021/04/26/turkish-bitcoin-exchange-vebitcoin-collapses-amid-crypto-crackdown.html
Ethereum Average Transaction Fee. (n.d.). Retrieved from Ycharts: https://ycharts.com/indicators/ethereum_average_transaction_fee#:~:text=Ethereum%20Average%20Transaction%20Fee%20is,K%25%20from%20one%20year%20ago.