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What’s the Difference between Centralized and Decentralized Exchanges?

 Difference between Centralized and Decentralized Exchanges?.

DEX, CEX, Centralized and Decentralized Exchanges?




If you are planning to buy or sell crypto, your first port of call will likely be an exchange. These are digital markets where most crypto trading takes place. You've probably heard of them: Binance, Kraken, Uniswap, etc. Most are centralized exchanges and use a similar business model to traditional institutions such as the New York Stock Exchange. But a growing number of decentralized exchanges are radically rethinking the way they work.


1) DEXs and CEX.

Decentralized exchanges (DEX) have emerged over the past five years to challenge established centralized exchanges (CEX). In short, DEXs aim to offer lower transaction fees, allow users to hold their own assets directly, and avoid certain regulatory burdens. On the other hand, they face the cost of compensating their liquidity providers for a certain type of risk called "permanent loss".
CEXs also offer their own perks. They often offer more liquidity and stronger regulatory safeguards, which can be particularly important to institutional clients. All this is explained below.

DEXs aim to trade faster and cheaper than their centralized counterparts. They do this by removing brokers who receive discounts on transaction fees from CEX. The 2018 whitepaper of Uniswap, the world's largest DEX, declares "zero rent extraction". It aims to protect its users from the additional costs of generating profits for brokers managing CEX. Bancor, which launched in 2017 and describes itself as the first DEX, advocates a decentralized approach as follows:

  • “Liquidity on traditional asset exchanges has historically been provided by a small handful of professional trading firms with authorized access and specialized tools. This means that liquidity will be able to withdraw assets during seasonal fluctuations and users need it the most.
  • In late 2021, DEX leader Uniswap was charging 0.05% transaction fees for a $100,000 transaction sampled by global accounting firm KPMG. CEX Binance, Coinbase, and Kraken charged 0.1%, 0.2%, and 0.2%, respectively.
  • DEXs use "automated market maker" protocols to set asset prices without a central body managing transactions. A common approach is the "fixed product" mechanism, which sets the prices offered based on the ratio of the DEX's total reserves to each of the relevant assets. This has the advantage of tending to keep reserves in relative equilibrium: if an asset becomes rare, it becomes extremely expensive.
  • However, DEXs still tend to offer roughly the same prices for assets as CEXs. This is because watchful traders or bots can quickly take advantage of any price discrepancies through arbitrage. If there is very little ETH in a particular pool, it should allow traders to sell ETH in the pool at a higher price than the larger market indicates. Traders can easily profit from it by buying from the larger market and selling it to the pool. By doing this, the volume of the pool will increase and reduce the price offered until it matches the larger market.

2) Problems that DEXs are facing.


No matter how smooth this system is, it poses a risk to the liquidity providers behind the pool. The risk is called permanent loss. Liquidity providers have the right to withdraw a portion of the pool value they have contributed, not the exact number of tokens they have deposited. He could not promise all sellers their full tokens as the proportion of different coins held in the pool changes as transactions take place. occur But as the rate adjusts to reflect current prices in the broader market, the pool will gradually contain more of any tokens that have depreciated, and vice versa.

This means that a liquidity provider will tend to attract more of the depreciating token and less of the depreciating, compared to initial assets. As a result, they will be poorer than if they kept their assets privately. In practice, DEXs typically compensate liquidity providers through transaction fees. But that means charging higher fees than they would otherwise need.


3) Custodial and non-custodial.


Another part of the exchange between DEXs and CEXs is whether users choose to hold their own crypto directly or entrust it to the exchange. CEXs often require users to store assets before trading.

Owning your assets yourself supports the ideal of autonomy that permeates the crypto industry. You have full and exclusive control. On the other hand, private keys can be lost or destroyed without due care, causing associated assets to become unrecoverable. Welshman James Howells accidentally trashed a hard drive in 2013 and lost access to 7,500 bitcoins believed to be worth over $330 million in February 2022. He repeatedly and unsuccessfully appealed to the local council to let him dig his grave.


4) Decentralized Exchanges regulations.


The growing popularity of DEXs may, in part, reflect their success in overcoming some regulatory hurdles. The company that creates the DEX refrains from acting as a financial intermediary or counterparty and does not have to meet Know Your Customer (KYC) or Anti-Money Laundering (AML) standards as it operates autonomously. ShapeShift was a CEX until its CEO said the company had lost 95% of its users as a result of the KYC measures it had to enforce in 2018. In 2021 Shapeshift turned decisively to ignore this issue and became a DEX.

5) Pool liquidity.


DEXs can be more difficult than CEXs when dealing with larger investors. First, because they are not yet able to compete with larger CEXs in size, they cannot offer that much liquidity. When faced with insufficient liquidity, large orders may face unexpected additional costs called "slippage". Additionally, institutional investors face their own money laundering and other regulatory hurdles and may have a hard time dealing with exchanges that do not comply with similar requirements.

Sergej Kunz, the co-founder of DEX liquidity aggregator 1inch Network, noted last year that banks and hedge funds have been slow to engage in decentralized finance (DeFi) due to their own barriers. Despite being a DEX, his company now plans to launch a compatible product called the 1-inch Pro specifically to appeal to these customers.
New aggregation protocols such as 1 inch have emerged, especially to help large traders avoid liquidity problems when using DEXs. 1inch raised $12 million in 2020 in a funding round led by Pantera Capital.

The rise of aggregators essentially means users can access DEX and CEX liquidity at the same time. Being itself a DEX, the DiversiFi protocol aggregates liquidity from both types of exchanges to help its users close larger trades more efficiently. This helps traders avoid the costs of proving that an exchange's liquidity is too weak for their orders.

When it comes to deciding which type of exchange to use, it comes down to two things: if you're primarily concerned with ease of use and aren't comfortable with full control of your own wallet, a CEX is probably your best bet. joyful. If lower fees and better control over your own funds are most important to you, then a DEX is the way to go.
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