When you want to buy or sell cryptocurrency, your first destination is a cryptocurrency exchange. They can be centralized and decentralized exchanges. There are many crypto exchanges like Binance, Kraken, Coinbase, Gemini, Uniswap etc. Most of these crypto exchanges are centralized exchanges (CEX), like Coinbase or Binance, using a similar business model to traditional asset exchanges like stock exchanges. At present, decentralized exchanges (DEX) are becoming popular as an alternative to centralized exchanges — with monthly data showing nearly $70B in volume. Among these two options, which one is better?
Well, this is a tricky question and you may not like our answer.
It depends on what your crypto intentions are. If you’re a crypto maximalist, you might be a strong supporter of “decentralization” and, therefore, decentralized exchanges (DEX). If you’re a casual crypto user, then you might be skeptical about the pros and cons of using a DEX. Then, you’re at the right place. Let’s find out how to select a suitable crypto exchange!
Centralized vs. Decentralized Exchanges? How Do They Work?
Centralized exchanges (CEX) operate like an authority that matches buyers with sellers. These platforms usually hold users’ funds in custodial wallets – crypto wallets where a third party stores private keys. CEXs use the traditional mechanism of “Order Book,” like in a stock market, to facilitate trades. All users of a CEX can see all the buy and sell orders that take place in the market, making CEXs highly liquid and more popular. These CEXs charge a small fee for each trade to facilitate it.
On the other hand, Decentralized exchanges, or DEX, are also peer-to-peer (P2P) marketplaces where users can directly trade cryptocurrency without an intermediary. DEXs are powered by smart contracts (i.e., self-executing pieces of code based on a set of agreed-upon terms) that run on a blockchain — eliminating the need for a third-party middleman. These exchanges are often more private, less user-friendly, and have lower liquidity. This is because of the lack of a central authority to match buyers and sellers.
For example: when users want to buy or sell coins or tokens, they can do it directly on the DEX. This allows a more direct trade and helps keep fees low, as there is no need for a third party to take a cut of the transaction.
Among choices, there are three main types of DEXs. They are,
- Automated Market Makers (AMMs) are decentralized exchanges that use smart contracts to pool liquidity. AMMs connect buyers and sellers without the need for an order book, and they trade against the liquidity locked in smart contracts. They use mathematical formulas to calculate the prices of assets. Many crypto traders usually consider AMMs as promoting autonomy and as highly incentivized. Uniswap and Balancer are two popular AMMs.
- Order book DEXs use an order book concept, and it can exist on- or off-chain. Order book DEXs offer leveraged trading options to crypto users. This means that these exchanges let users lend their funds to other traders. These loaned funds earn interest over time and get secured by the exchange’s liquidation mechanism. However, order book DEXs are high in risks related to smart contracts and often face liquidity challenges.
- DEX aggregators allow users to trade on multiple DEXs simultaneously. DEX aggregators provide a single platform that connects to numerous DEXs, enabling users to compare prices and find the best deals when trading. 1inch is a currently popular DEX aggregator.
How to Use Decentralized Exchanges
Once you select which type of DEX is best for you, your next step is to understand how to use them. Decentralized exchanges are still in their early stages, with many only supporting basic trading functionality. As they mature, we can expect to see more features and improvements. Nevertheless, there are a few key things to know about using DEXs.
You will need to have a wallet compatible with your platform. Not all wallets are created equal, and not all platforms support all wallets. Exchanges that only support specific wallets can be considered centralized, while those that accept any wallet can be decentralized.
The most popular cryptocurrency wallets are desktop, mobile, web, and hardware. Centralized exchanges typically only support one or two of these wallet types, while decentralized exchanges typically support all four.
It’s important to remember that decentralized exchanges are still a relatively new technology. As a result, they may not be as user-friendly or have the same level of customer support as their centralized counterparts.
Here’s a quick guide on how to use decentralized exchanges:
Step One: Choose your decentralized exchange. Some popular options include Uniswap, Curve, PancakeSwap, and Binance DEX.
Step Two: Connect your wallet. You’ll need to connect a cryptocurrency wallet to trade on a decentralized exchange. Some popular wallets include MetaMask, Trust Wallet, and Coinbase Wallet.
Step Three: You can then add the native token compatible with the DEX, like BEP-20 for Binance DEX, and select different options from trading or yield farming.
DEX: Pros & Cons
Unlike centralized exchanges, which require users to submit Know-Your-Customer (KYC) information, decentralized exchanges allow entirely anonymous trading. The KYC process is meant to prevent money laundering and other illicit activity on these platforms. DEXs are still considerably more private than their centralized counterparts since you don’t need to hand over sensitive personal information.
DEXs are often less user-friendly than centralized exchanges, leading to a steep learning curve for anyone unfamiliar with the space. Poor customer service has also plagued DEXs. Any DEX is only as good as its community support.
Since these platforms are not subject to geographical restrictions, any ERC-20 token is tradeable on DEXs. This gives users a much more comprehensive range of assets to trade compared to traditional exchanges.
|Transaction Fees dependent on the chain|
The transaction fees of DEXs depend on the chain it exists on and the ecosystem of this chain. For example, Uniswap has high fees because it operates on Ethereum. But DEXs do not have trading fees like in CEXs.
The decentralized nature of these exchanges also makes these exchanges more censorship-resistant than their centralized counterparts. Because no central entity can be shut down or censored, DEXs can often operate more freely in jurisdictions where crypto activity is heavily restricted. On the other hand, this decentralization may also make it more difficult for governments to regulate a DEX. This means users are responsible for their own actions without a regulatory safety net.
Because DEXs are still in their early stages of development, the number of DeFi coins and tokens listed on them is often quite limited compared to centralized exchanges. This can make it challenging to find the right trading pair in a liquidity pool, and you may have to use a DEX aggregator to find what you are looking for.
As you can see, in CEXs, you need to trust the third party to secure your assets, and centralization makes you prone to hacks. But DEXs help us to reduce this vulnerability risk. You do not have to complete KYC information or hold your Identity details for verification. You can connect your wallet and start trading! However, a DEX is not entirely risk-free. It has its own risks related to security.
For instance, the smart contracts used to operate DEXs can have bugs. Especially complex DEXs are hard to audit, and some unknown bugs may exist in the code. It’s also possible to create smart contracts, which can be modified by master keys. These upgradable smart contracts can be misused to change parameters. The hackers can also use token mechanics of oracles to do arbitrage transactions in their favor.
As both CEXs and DEXs have their benefits and drawbacks, the choice of a crypto exchange is truly individual. Here are some points you can consider before you make that choice:
- Willingness to share KYC information
- Token availability
- Level of comfort in sharing access to your digital assets
Future of Decentralized Exchanges
Decentralized exchanges have been attributed to a few key advantages over traditional, centralized exchanges. These include increased transparency and independence from a single entity. It’ll be difficult for DEXs to enforce KYC verification as they contribute to creating a self-regulated peer-to-peer crypto community. Their popularity is more attributable to building a financial system where everyone can participate without limitations. However, as the space continues to evolve, we can expect to see more innovation and adoption of DEXs in the months and years to come with the hope of creating a more diverse and balanced society.
Finally, you cannot avoid paying taxes whether you choose to use a DEX or CEX for crypto trading. Register here with the Blockpit app to easily track your portfolio and calculate your taxes!