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With the current crypto sector booming, it is essential for such platforms to exist where cryptocurrencies can be traded. Exchanges have been popping up thick and fast ever since we were introduced to the concept of a cryptocurrency. Here, we will look into the two types of exchanges, centralized and decentralized, and compare them on different criteria. The prominence of crypto assets can be realised by this:
“Today’s average middle-schooler will have had 5+ years of interacting with crypto assets at some intellectual, emotional, or financial level before they get their first credit card or learn what a credit score is.” – JP Morgan Employee on Twitter
The upsides of a Centralized exchange (CEX)
The significance of a CEX can be understood from the word centralized, which means to be governed by an institution, a body that handles all the inner workings of the exchange. Trusting someone else to handle your money is an important part, and perhaps the driving force behind a centralized crypto exchange. CEX has a lower barrier to entry for first time investors as it enables buying crypto with fiat and withdrawing the gains back to fiat using payment integrations by banks/service providers.
The advantages of centralized exchanges are as listed:
- No pressure on customer: Being a hundred percent in control of your money is indeed a good thing, but centralized cryptocurrency exchanges take the pressure off of the customer’s head. Since you trust a third party or middleman completely with your money, working with a centralized exchange is certainly easier on the mind than managing your money by yourself.
- Easy account recovery: There have been many stories about customers potentially losing hundreds of thousands of dollars or euros, just because they lost the private keys to their hardware wallets. CEXs make it easier to recover lost access to your account, because the customer has authorized the exchange with full access to his/her account. If at all the customer needs to regain access to his/her account, the simple task of verifying his/her identity will do the job.
- Use of trusted fiat currencies: Dollars, euros and sterling are a few of the most widely accepted currencies around. A good centralized exchange is bound to provide you the ability to trade in these currencies, along with other ones, however it may be feasible to them. One thing to note is that all exchanges might not provide fiat/crypto pairings, i.e. ability to trade fiat currencies for cryptocurrencies. Some of the popular CEXs that provide this facility are Coinbase, Robinhood and Gemini.
- Liquidity: Centralized exchanges reduce the friction involved in trading by providing liquidity and convenience. The examples mentioned above (Coinbase, Gemini) are superb exchanges which provide great stability to exchange rates, also, increased volume on an exchange is always an indicator of the stability, which centralized exchanges seem to be proficient in.
The need for a decentralized exchange
Even though CEXs satisfy the needs of a major amount of customers, there exist glaring holes and drawbacks in the very concept of a centralized crypto exchange. Anonymity concerns, hacks and security issues, and other factors lead us to believe that the need for DEXs is far greater, and perhaps more fitting to the idea of a cryptocurrency, than gauged before.
One important thing to note here is that DEX’s are for seasoned traders who like to remain anonymous and at the same time may not like the fees charged by many CEXs, users cannot liquidate their assets for fiat in a DEX or can buy them vice versa.
A. Security issues
No crypto exchange is immune to hacks. According to stats, one in every 16 bitcoins gets lost and/or stolen, which defines the magnitude of the problem with CEXs quite aptly. Recent cases such as the Mt. Gox and Bitfinex hacks have led us to believe that these exchanges operating on a central mainframe can become a bullseye for hackers. People lost millions of dollars in bitcoin due to the Bitfinex and Mt. Gox hacks, which was, in a sense, easy to carry out for hackers, due to the centralized nature of the exchanges. Take out the central platform, and you have access to hundreds of thousands of dollars’ worth of data and money.
B. Anonymity concerns
When you decide to operate on a centralized exchange, your privacy is limited, since you must provide relevant details such as bank account numbers, card details and other personal data. Also, due to how these exchanges operate, tracking of transactions is incredibly easy due to the centralized nature. This is a huge vulnerability when it comes to your data and personal information.
C. Centralized nature
Arguably one of the biggest drawbacks with CEXs is the fact that they are centralized. This takes away from the very basic idea behind technologies like blockchain and currencies like bitcoin. Cryptocurrencies aim at eliminating the very idea of having to trust someone else with your money, and CEXs force us to do just that. Regulation, taxation, anonymity, security… all these are issues that exist with CEXs which defeat the very purpose of cryptocurrencies and blockchain.
How do DEXs solve the above problems?
Decentralized exchanges are everything that they promise. They attempt to counter all drawbacks of CEXs, and stay true to the ideology of blockchain and crypto being independent of any third party custodians. Running on decentralized nodes, there is no risk of taking down the entire network with just one hit. This is one of the most important security features of a DEX, making it much harder to hack than a CEX.
Privacy is no longer a myth when it comes to a DEX. Very little or no approval or details are required to create accounts and start trading on a decentralized exchange. Also, when you execute a trade, your identity is revealed only to the other party involved in the trade. Thus, your personal details are well and truly yours when you trade on a DEX. The no-regulation, no middleman factor plays an important role in giving a DEX its characteristic features.
With all problems related to a CEX seemingly being solved by a DEX, why aren’t they still globally accepted?
The problems with decentralized exchanges
There are a few underlying issues that hinder the mass adoption of decentralized exchanges. One, they fail to generate much of a trading volume, due to the on-chain orderbook. The gas costs incurred for every time an order has to be posted, modified or cancelled are too high of an overhead to incur. Also, it tends to take up significant bandwidth on the network and end up bloating the blockchain.
Two, low liquidity. This is perhaps one of the few areas where CEXs outperform DEXs, partly due to the inconvenience involved in trading on decentralized exchanges. Also, cross-chain transactions are still a long way from being realized at a globally acceptable level, since it took as long as September 2017 for the first cross chain trade to be made.
Front running can also be a major problem with decentralized exchanges, as the case of Etherdelta has shown that miners can exploit the fact that they are able to see transactions even before they are added to the blockchain, in order to capitalize on cancel orders by releasing their trades into the blockchain before yours.
For DEX’s to come in to fruition the whole world needs to function like a mesh of interconnected exchanges with shared liquidity as well as everyday transactions need to be done using crypto assets than fiat which would make fiat look outdated and hence completely eliminate the barrier to entry problem as of today. Important thing to remember is that If DEX’s performance can be scaled using layer 2 solutions like 0x protocol, shared liquidity/order book concepts, zk-snarks and atomic swaps then one day we can see the differences shortening.
The final word would be, that DEXs certainly have the potential to beat CEXs at all games possible. They stay true to the very foundational idea of the blockchain that they work on, but a few underlying issues hinder their global acceptance. Will the CEX v/s DEX war ever end? We’ll find out soon.