Picking an exchange is one of the first decisions any crypto investor will have to make. In general, the choice is between a centralized and decentralized exchange. In this blog, we will look at the differences between them to help with your decision.
What is a Centralized Exchange
Centralized exchanges (CEXs) are similar to traditional banks, where users trust the bank to hold their money. A centralized exchange acts as the third party between the buyer and seller by overseeing trades and handling users’ assets.
So users trust in the exchanges’ ability to keep their assets safe and provide the liquidity to transact effectively. Thus, centralized exchanges act as liquidity providers for the tokens they support by acting as market makers.
What is a Decentralized Exchange
A decentralized exchange (DEX), on the other hand, has no third parties involved. Instead, users hold their assets and execute peer-to-peer transactions directly with each other. In DEXs, users provide liquidity among themselves through a liquidity pool mechanism. Basically, users pool their assets in a decentralized exchange’s smart contract to provide liquidity that will facilitate asset swaps between traders.
In 2022, decentralized exchanges are less popular than centralized exchanges—more on this and other differences below.
CEX vs DEX:
| Centralized Exchange | Decentralized Exchange |
|---|---|---|
Usability | CEXs generally have user-friendly platforms with easy-to-navigate user interfaces making them a great option for crypto newcomers. | DEXs may be quite difficult to understand especially for new users and have a steep learning curve. |
Regulation | Centralized exchanges are often regulated. | DEXs avoid regulation as they operate in a peer-to-peer manner. |
Liquidity | CEXs attract many active users who buy and sell assets and hence have high trading volumes. This translates to high liquidity. | Since few people use DEXs they are highly illiquid. This hinders seamless transactions which may be inconvenient for investors. |
Impermanent Loss | Not a problem for centralized exchanges. | A big problem for decentralized exchanges’ liquidity providers due to the volatile nature of cryptocurrencies. |
Security & Privacy | Security of your assets depends on that of the exchange. Doesn’t offer anonymity due to KYC and AML regulations. | Security depends on the holder of the assets. DEXs offer anonymity since they don’t comply with KYC standards. |
Usability
The first thing users will notice when interacting with a platform is the user interface. Naturally, an easy-to-use interface will encourage users to continue using the platform, and the user experience will make them stick. User experience spans from the onboarding processes to users interacting with their assets. Decentralized exchanges are easier to get started with but fail in the user interface and experience department.
On the other hand, centralized exchanges like SMART VALOR excel in making their platforms and services as user-friendly as possible. It comes with a neat interface that only takes a couple of minutes to understand.
CEXs also attract users with the availability of fiat-crypto trading pairs, which brings in an element of familiarity. This makes them a direct access point to the market for newer crypto investors.
Regulatory Concerns
DEXs can skip regulatory hurdles since they don’t comply with Know Your Customer(KYC) or Anti-Money Laundering (AML) standards. CEXs, however, have to comply with these regulations. Larger investors such as institutional investors prefer CEXs since they face regulations themselves in their space and aim to be associated with exchanges that submit to similar regulations. Smaller retail investors often appreciate the sense of security that comes with regulation.
What about Liquidity
Liquidity is one of CEXs' strongest selling points. Big exchanges have enough assets in their reserves to allow their users to make instantaneous deposits and withdrawals. Contrarily, DEXs often have limits on how much a user can spend. And since they can't offer as much liquidity as CEXs, it's hard to compete with them.
Catherine Yushina, COO at Zeus exchange, on the importance of liquidity in exchanges,
"Liquidity in crypto can be provided by crypto assets backed by traditional assets, aka by bridging crypto and fiat markets. Higher liquidity would lead to faster transactions, more stable prices and, therefore, more market participants. This would boost general public adoption of blockchain technology and crypto instruments and lead to "maturity" of the industry. While there are discussions around crypto vs. fiat worlds, crypto is more of an extension, the next evolution step for the financial market as a whole".
That said, aggregators that allow users to access liquidity in CEXs and DEXs are popping up, but as it stands, CEXs are by far the best choice when it comes to liquidity.
Impermanent Loss
Impermanent loss refers to the temporary loss incurred by DEX liquidity providers due to price changes of a trading pair. It occurs when a liquidity provider decides to withdraw their assets from the pool and register a loss which wouldn’t be the case if they’d just held on to their assets in the first place.
Consider a user who deposits assets to an ETH-DAI pool, and the price of ETH rises during that time. Since the ratio of the two assets always has to remain the same, traders will be allowed to buy ETH at a discounted price to bring the pool to an equilibrium. This means that there’ll be less ETH in the pool. Depending on the ratio the user contributed, they’ll end up with more of the tokens that lost value, in this case, DAI, compared to the one that gained value.
While users of centralized exchanges don’t have to worry about impermanent loss, it’s still a big problem for decentralized exchanges.
Security and Privacy
Due to the amount of assets held, centralized exchanges are often in hackers’ crosshairs. While some CEXs have been hacked in the past and billions lost in the process, most exchanges have learned and effectively placed measures.
DEX users have full control of their assets, but holding your assets in a wallet does not guarantee 100% safety. Your private keys could be lost, rendering your assets irretrievable. A CEX, on the other hand, will give you a chance to reset your password to regain access to your assets.
Another common problem associated with DEXs is the risk of losing money through scam coins. Since anybody can list a token on the exchange, rug pulls are not uncommon. In contrast, CEXs will only list reputable tokens, giving users better protection from scams.
However, in terms of privacy, DEXs offer complete anonymity to their users since they don’t require them to fill out their personal information.
Bottom Line
While DEXs may come with their unique benefits, like saving users from the hassle of KYC verification or giving them more control over their assets, they still have a lot of rough edges and have a long way to go.
Centralized exchanges are currently the best first entry point for anyone trying to enter the crypto space. Finding an easy-to-use central exchange that you can trust with a wide range of functionalities like SMART VALOR can be essential in contributing to your success in the crypto space.
Get started with a trusted and secure exchange today! Sign up today to SMART VALOR – your trusted gateway to blockchain tech.