One of the main defining features of centralized exchanges (CEXs) is that they are supervised. Therefore, when you want to trade on a CEX, you will hold your funds in a wallet associated with the exchange itself, rather than in your own wallet. Not managing your private keys greatly reduces the risk of attacks and provides superior security. However, while securely managing your private keys is one of the biggest concerns for cryptocurrency holders, trusting the exchange becomes imperative. In this report, we take an in-depth look at the main features, pros and cons of centralized exchanges.
Although decentralized exchanges have been around since 2012, using hashed time-locked contracts (“HTLCs”), they did not shut down until the launch and development of Ethereum. To better understand decentralized exchanges, we will look at order book DEXs and automated market makers and cover their pros and cons.
To help raise awareness, we compared centralized and decentralized exchanges. The most important thing to remember is to “do your own research” whether choosing a centralized or decentralized exchange.
introduce
Cryptocurrencies are constantly evolving and adapting to technological and exogenous changes. Although cryptocurrency exchanges have been around for a long time, they have come a long way since the first iterations. Know Your Customer (“KYC”), increased compliance, improved enforcement, and establishing stronger risk management are the latest trends in terms of exchange centralization. However, following the 2017 bull run, we have also seen innovation in the space that led to the development of so-called decentralized exchanges.
Currently, we can distinguish between these two types of exchanges (centralized and decentralized), although there are some hybrid options.
Just as traditional stock exchanges allow retail and institutional investors to buy, sell, and hold stocks, crypto exchanges allow you to buy, sell, and hold cryptocurrencies. Exactly how your trades work — and what possibilities you have on each platform — depends on the type of exchange you use.
To better understand the space, let’s look at centralized and decentralized exchanges in more detail and learn about their strengths, weaknesses, and key features.
Centralized Exchanges
Centralized exchanges (sometimes referred to as CEXs) are well-known entry points into the crypto ecosystem. Binance, Coinbase, and Kraken are just a few examples of centralized exchanges. Centralized exchanges typically have their own order books that record and verify all cryptocurrency-related transactions.
Before we dive into the details of centralized exchanges, let’s first define what centralized exchanges are:
A centralized exchange is a platform that enables traders to buy, sell, and exchange cryptocurrencies for fiat currencies or other cryptocurrencies.
They are token marketplaces that are critical to the ecosystem as many of them support payments using fiat currencies (non-cryptocurrency holders are able to purchase cryptocurrencies using USD, EUR, and other currencies). This often provides an easy entry point into the crypto ecosystem, and the recent trend towards strong KYC requirements allows minimizing the number of bad actors.
Centralized exchanges are often trusted intermediaries as they monitor and facilitate crypto transactions. A trusted cryptocurrency exchange should also allow you to safely store tokens and fiat currencies, thus acting as a custodian.
Looking at the order book of a centralized exchange, information is passed internally through an efficient network and protected by comprehensive security mechanisms. Currently, leading centralized exchanges have an [extensive built-in] know-your-customer policy. In addition, to avoid financial fraud, some centralized exchanges have built strong compliance and investigation teams over the years and work closely with global regulators to prevent crime. This is a clear advantage over decentralized exchanges.
There are some key challenges with centralized exchanges, and large exchanges are the most effective way to address these challenges. This includes not only the lack of resources for smaller exchanges to address security and crime prevention issues, but also the overall characteristics of cryptocurrency behavior. Money often moves quickly, involves multiple participants, and knows no borders. Bad actors may be located in different countries than their victims, some of which are in jurisdictions that are out of reach of most law enforcement. Having a centralized exchange that operates in most countries and has a strong crime prevention team is essential to creating a safe environment where crime can be effectively prevented.
Similar to stock exchanges and commercial banks, centralized exchanges are exchanges where transactions are conducted through a centralized entity. A decentralized exchange, on the other hand, is a peer-to-peer marketplace that allows traders to trade directly with each other. Centralized exchanges are usually managed and owned by a single institution, which traders must trust. Therefore, centralized exchanges function very similarly to stock exchanges, except that they allow the purchase, sale, and exchange of cryptocurrencies in addition to stocks.
To become a user of a centralized exchange, you must undergo KYC verification, provide proof of identity, and (in some cases) biometric verification to become a registered user. While almost all regulators require KYC verification, implementation of these requirements remains inconsistent (Figure 1). Most jurisdictions have not yet fully implemented the requirements of the Financial Action Task Force1 (“FATF”), which sets global AML/CFT standards for VAs and VASPs.
The 5th EU Directive significantly strengthened existing AML/CFT regulations. The 6th AML Directive aims to provide financial institutions and authorities with additional tools to combat money laundering and the financing of terrorism by expanding the scope of existing legislation, clarifying certain regulatory details and strengthening criminal sanctions across the EU.
KYC is an effective tool to help protect users from hackers, market manipulators, and money launderers. As a crypto user, you should be wary of platforms with poor KYC measures. If you do not complete the KYC verification process, you may not be able to access all features of the cryptocurrency exchange.
Know Your Customer (KYC) regulations are mandatory for major cryptocurrency exchanges as it ensures that they comply with regulatory rules and laws, such as FATF’s AMLD5 and AMLD6, as mentioned above.
As mentioned above, the goal of KYC is to curb illegal activities and highlight suspicious behavior as early as possible. Without KYC verification, cryptocurrency exchanges may be held liable when users get away with crimes due to their failure to perform due diligence. Henceforth, major exchanges prefer to maintain Anti-Money Laundering (AML) compliance.
Requiring identity verification is the first checkpoint in the fight against money launderers, who often try to obscure the origin of their funds by spreading small amounts across different accounts.
Another important aspect we should consider when talking about centralized exchanges is custody. Similar to stock exchanges, centralized exchanges do not directly custody but rather custody the assets deposited by users.
Best practices for protecting custodial assets include platform and user-level security. Currently, Binance follows the "NIST Cybersecurity Framework" and has obtained ISO, PCI, and SOC security certifications.
Unlike traditional crypto wallets, multi-signature (multisig) wallets require multiple private keys to authorize transactions.
However, compared to multi-signature, the distributed nature of multi-party computation (MPC) is more flexible. MPC eliminates the concept of using a single private key, which means that the keys are never collected on a single device at any time. Even if a portion of the key is available, you can still unlock the vault. To eliminate the risk of centralization, one solution is multi-layer technology and MPC cryptography to manage users' funds in a more secure way.
Key Features and Functionality
Looking at the other main functions of an exchange, providing liquidity in a safe and organized trading environment and acting as an intermediary for traders to easily buy and sell assets while not being vulnerable to financial risks. Providing deep liquidity is very important to foster a safe execution environment. A large liquidity pool is one of the best consumer protection mechanisms. It prevents market manipulation, volatility and reduces liquidations. Global liquidity means higher liquidity, and high liquidity means a vibrant and stable market where participants can trade quickly, easily and at fair prices.
We can summarize the main characteristics of centralized exchanges as follows:
Custody : One of the key defining features of centralized exchanges is that they are custodial. This means that when you want to trade on a CEX, you’ll be holding your funds in a wallet that’s tied to the exchange itself, rather than in your own wallet. What’s important is that the exchange holds the private keys to your wallet, not you — instead, you’re given the login details for the platform. This has some benefits, especially for new users who are just getting to grips with the intricacies of crypto: Securing your private keys is one of the biggest concerns for crypto holders. As such, holding your crypto on a centralized exchange is likely a good solution for most people, as leading exchanges follow best practices for protecting custodial assets, including security at both the platform and user level. However, you need to be able to trust the exchange you’re using
Liquidity: Centralized exchanges are designed to have liquidity due to their order book design. A key factor in ensuring this high liquidity is the global liquidity pool. Global liquidity means higher liquidity, and high liquidity means a vibrant and stable market where participants can trade quickly, easily, and at a fair price. The order book of a centralized exchange facilitates trading by matching users' "buy" and "sell" orders, also known as an "order book" system. This means that liquidity is a function of the number of buy and sell orders on the books, and since most people's first step into cryptocurrency is on a centralized exchange, their order volume is necessarily higher than decentralized exchanges.
Ease of use: Centralized exchanges are often associated with ease of use. They usually offer clear, user-friendly interfaces, with less complexity than decentralized exchanges.
KYC: Exchanges have made efforts to ensure that their platforms are not used by KYC users to facilitate financial crimes (such as AML/CTF). Therefore, before you start trading on a centralized exchange, you will need to produce documents to confirm your identity and sometimes your address to cooperate with these measures.
Advantages of centralized exchanges
The above mentioned sections have clearly illustrated some of the advantages. The user interface is easy to grasp and simple to use. Accessing various cryptocurrency trading platforms is simple and straightforward, with a high degree of overall functionality and a wide range of trading options. Apart from this, centralized exchanges are key to establishing strong AML and KYC in the crypto ecosystem.
Furthermore, centralized exchange structures supported by a centralized and independent infrastructure enable fast real-time trading. As such, they are algorithmically capable of processing multiple orders per second. As a result, market participants can make decisions quickly and react quickly to changing market conditions.
The largest traditional exchanges offer a wide range of virtual currencies and trading pairs. At the same time, they also provide fiat currency withdrawal and deposit options, making them a key component in furthering the adoption of cryptocurrencies. Since centralized exchanges are (in theory) owned and managed by centralized and regulated entities, users and regulators can contact and deal with it. Therefore, centralized exchanges offer key advantages to regulators.
Disadvantages of Centralized Exchanges
While bringing multiple advantages, centralized exchanges also bring some disadvantages. Because the exchange holds the private keys, there is a risk of loss if there is a breach in the exchange. While such situations are not common, they have happened before, again demonstrating the power and need for good cybersecurity practices.
Remember, to hold cryptocurrency securely yourself, you need to:
1. Prevent others from obtaining your private key; prevent hacker attacks and protect your computer from viruses, the Internet, etc.
2. Protect yourself from losing your private keys; have backups in case of loss or damage to your device, and protect those backups
3. Have a way to pass your private keys to your loved ones in the event of your death. This is not a pleasant scenario, but as responsible adults for our loved ones, we must manage this risk
To keep your funds safe, large exchanges invest heavily in security infrastructure. Security involves a lot of different areas, from equipment, networks, procedures, personnel, risk monitoring, big data, artificial intelligence, training, research, testing, third-party partnerships, and even global law enforcement relationships. It takes a lot of money, manpower, and effort to do security correctly. Smaller exchanges often don't have the scale or financial resources to do this. To learn more about security and how to keep your funds safe, you can read CZ's post on "How to Keep Your Funds SAFU"
While centralized exchanges typically offer fewer options and tokens, this generally creates a safer environment compared to DeFi. This is due to the extensive research that is done before listing a token, which helps reduce the likelihood of bad projects appearing on the platform.
Decentralized Exchanges
While decentralized exchanges have been around since 2012, utilizing hashed time-lock contracts (“HTLCs”), it wasn’t until the start and development of Ethereum that we saw them take off. The introduction of Ethereum smart contracts fueled the development of a new generation of exchanges and brought a number of improvements to HTLC-based exchanges. In 2016, Vitalik Buterin proposed what would become the key foundations of today’s decentralized exchanges (“DEXs”). Uniswap, started by Hayden Adams, was one of the first projects to implement Vitalik’s idea, which employed an on-chain automated market maker (“AMM”) with certain unique characteristics. Today, DEXs have become a key element in the cryptocurrency world and a key component of DeFi applications, enabling trading by significantly increasing crypto volume. While some DEXs have been up and running using classic order books, it was the introduction of automated market makers that have become popular in DEXs for their simplicity and increased liquidity.
Today’s decentralized exchanges allow you to transfer a wide range of digital assets on the open market without middlemen. As such, they have almost all the features of centralized exchanges, but stand out in making it easier to exchange all currencies accessible online. While Uniswap is a common DEX on Ethereum, PancakeSwap is the leading DEX on BNB Chain in terms of TVL.
To operate on a decentralized exchange, users generally only need a public address (which can be linked to a wallet such as TrustWallet or MetaMask). Additionally, running on smart contracts, there is no external third party overseeing or enforcing the rules of the exchange.
There are two main types of DEXs to be aware of: order book based and automated market makers
Order Book DEX
An order book is typically made up of buy and sell limit orders from market participants. The market price of an asset is the lowest ask (sell order) or highest bid (buy order). Placing a market order means that the trader will immediately buy or sell at the market price, taking liquidity away from the order book, so they often pay a taker fee as well. This order book matching mechanism essentially matches active buyers and sellers at a specified price, giving traders more control.
Some popular order book DEXs include LoopRing and Gnosis Protocol, both of which use algorithms to find trades between individual users, with smart contracts recording the transactions on the blockchain to reflect the coins and tokens moved between buyers and sellers. Another popular example is dYdX.
❖ On-chain and off-chain order books
Order books can be on-chain or off-chain. The order placement, matching, and settlement engines of on-chain order books are completed on-chain, and transactions are verified by validators. For on-chain order books, the index price is usually determined by validators who act as price oracles, submitting the last traded prices from various exchanges to the chain.
On the other hand, the off-chain order book uses off-chain logic 2 to handle transactions, trades, liquidations, index prices, etc.
Generally speaking, order books work best on exchanges with high liquidity. This is because they help keep slippage low regardless of trading volume. Conversely, in illiquid markets, traders must wait for long periods of time, which leads to greater exposure to market volatility and wider spreads.
DEX Automated Market Maker
Decentralized exchanges like Uniswap utilize what are known as “automated market makers.” The key reason for their existence is that order books perform poorly in illiquid markets.
The advantages of this model are simple. From an efficiency perspective, AMMs offer very low spreads, but at the same time, they only require blockchain transactions for actual trading, without the need to place or cancel orders. In addition, in terms of implementation, this is an overall simple design that can improve efficiency and transactions per second.
Automated market maker based DEXs replace order books with a pool of liquidity. This liquidity pool is essentially pre-funded by users known as liquidity providers (“LPs”). So instead of matching buyers and sellers, trades on AMM DEXs take place using a liquidity pool that is managed by smart contracts. Liquidity is “acquired” from users who essentially provide tokens (in trading pairs). Each AMM based DEX incentivizes LPs differently. That being said, in general, LPs effectively become market makers. Literally, any pair of tokens can form a liquidity pool, and the liquidity pool can support trading activity for tokens that are not yet listed on centralized exchanges. To better understand the AMM model, let’s look at Uniswap in more detail.
❖ Uniswap
Long before Uniswap, EtherDelta was probably the most used decentralized exchange. However, this changed in November 2018 when Uniswap v1 was launched on the Ethereum mainnet. In Uniswap v1, trades were made against liquidity pools, a mathematical formula determined the price of an asset, and liquidity providers added liquidity to the pool to help with market making. Uniswap v1 actually only supported swaps for ETH-ERC 20 pairs, making trading a little more complicated than it is now. Uniswap v1 also promoted the concept of LP tokens. The simple idea behind this is that LPs add liquidity to any pool, and they receive LP tokens that represent the added liquidity.
Uniswap v2 was launched in May 2020 and, you guessed it, got rid of the painful ETH bridge that made v1 less user-friendly. With v2, we finally have ERC20-ERC20 pools, which has greatly contributed to the growth of the DeFi space. Some other innovations that Uniswap v2 brought include the concept of flash swaps, which allows users to withdraw any amount of ERC20 tokens without paying upfront. Users can pay for the withdrawn tokens, pay a portion and return the rest or return all withdrawn tokens. Another notable innovation is the protocol fee. A protocol fee of 0.05% of the total 0.3% trading fee is now reserved for the development of the Uniswap platform
Uniswap v3 offers better capital efficiency and accuracy compared to v1 and v2. Instead of just picking two tokens of equal value, you can now choose your preferred fee tier in any liquidity pool. By default, Uniswap offers three fee tiers to choose from. Uniswap v3 also introduces liquidity concentration, which means you can set a price range in which liquidity is provided. This is a way to reduce impermanent loss. To better understand this, let's take a closer look at how Uniswap v2 works. In early versions of Uniswap, liquidity was evenly distributed along the x*y=k price curve, and assets were reserved for all prices between 0 and infinity. This meant that most of the liquidity was unused, instead of rewarding LPs for taking the risk of impermanent loss.
Uniswap v3 introduces the idea that a position only needs to maintain enough reserves to support transactions within its range, and can therefore have larger reserves (virtual reserves) within that range like a constant product pool. Liquidity providers can create as many positions as they see fit, each in their own price range. In this way, LPs can approximate any desired liquidity distribution in the price space. Furthermore, this is a mechanism for the market to decide where liquidity should be distributed. Rational LPs can reduce capital costs by concentrating liquidity in a narrow band around the current price and adding or removing tokens as prices move to keep liquidity active.
Liquidity Allocation Example
Since LPs can provide liquidity within a custom price range, their liquidity positions in Uniswap v3 are no longer fungible. Another key improvement that Uniswap introduced in v3 is related to oracles. Uniswap v3 makes significant improvements to the Time Weighted Average Price (“TWAP”) Oracle 3. It stores a set of cumulative sums instead of just one like Uniswap v2, so any recent TWAP over the past nine days can be calculated in a single on-chain call. This improvement makes it easier and cheaper to create more advanced oracles. Uniswap claims that this will reduce the gas cost of keeping oracles up to date by 50%
v3 brings many other benefits to Uniswap, but at this point, you’re better off heading straight to the Uniswap v3 whitepaper.
Advantages of DEX
❖ Storage
DEX does not exist as a central entity, there is no platform for funds to be invested. Therefore, unlike CEX, using DEX does not necessarily relieve the user of the burden of self-custody. Connecting a DEX to your existing wallet exposes you to smart contract risk, as decentralized exchanges that use smart contracts always have the risk of being hacked.
❖ Diversity
Since the choice of coins and tokens on a DEX is unrestricted, users are more or less free to find projects they are interested in and start participating. However, this can expose you to risks and scams, as many CEXs have more defined criteria for the projects they bring onto their platforms to help mitigate these risks.
❖ Governance
Many AMM-based DEXs are offering governance tokens to their users to further democratize platform control and as a reward for providing liquidity. This allows users to participate in the decision-making process and future of the exchange. This is an increasingly important consideration as more DEXs choose to fully distribute their governance to users.
Key Differences Between AMMs and Order Books
Automated Market Maker (AMM)
1. Usually only market orders, but other order types are slowly becoming popular
2. If liquidity is low, there may be high slippage
3. More suitable for markets with poor liquidity, because liquidity exists at any price and transactions will always be filled
4. Risk of front-running via MEV or sandwich attacks
5. Liquidity providers face the risk of impermanent loss
6. No Oracle is needed to determine prices
On-chain order book
1. Multiple order types, such as limit, stop, trailing, buy stop, etc.
2. If liquidity is low, there can be high slippage, but the slippage risk can be reduced by setting limit orders.
3. More suitable for liquid markets rather than illiquid markets, as traders’ limit orders may not always be executed
4. If you take steps to reduce the risk of front-running
5. Off-chain liquidity providers do not take the risk of impermanent loss
6. Prices are usually determined by external market makers
Bad luck for DEXs
❖ Execution
Trading on a decentralized exchange is often much slower than trading on a controlled exchange. This is because miners must verify each transaction. As a result, decentralized exchanges are not suitable as trading venues when a quick response to changing market conditions is required. Centralized order books often provide a better execution environment for these use cases based on the underlying technology.
❖ Liquidity
A successful exchange requires high liquidity. Therefore, platforms with widespread trading are always the exchanges with the highest liquidity. Due to the novelty of the idea of decentralized exchanges, there are far fewer traders than on CEXs. As a result, liquidity is severely reduced.
❖ Complexity
DEXs are currently complex and lack a smooth user interface, which can be a barrier to entry for new users. Additionally, many traders cannot use limit orders, margin trading, or stop losses. Still, most decentralized exchanges are focused on implementing new features. Unlike centralized exchanges, decentralized exchanges do not accept fiat payments — in other words, they are unlikely to be anyone’s first step into the cryptocurrency space.
❖ Responsibility
Self-custody may well put you in the driver’s seat, but remember — it also makes you deal with the storage and security of your exchange assets. You can’t simply leave them on the exchange when you’re done, so making sure your crypto wallet is both compatible with the service and not at risk will be key to your experience.
❖ Blind Signature
DEXs use smart contracts. Their details are usually not revealed when you sign, exposing you to scams and smart contract risks. Therefore, we recommend: always do your own research. Although DEXs allow users to trade freely, the downside is that with so much freedom comes additional user responsibility. Since any token can be listed on a decentralized exchange, it is even more important to do your own research to ensure the authenticity of the project you are purchasing.
Comparing CEX and DEX
DEX is one of the key pillars of DeFi and cryptocurrency, as decentralized networks require decentralized exchanges to trade assets. To date, AMM DEX has been the most popular and widely used dApp, providing higher cumulative trading volume for spot trading than limit order DEX.
However, both centralized and decentralized exchanges have their own advantages and disadvantages. Centralized exchanges have high liquidity. They provide a helpful trading environment and an easy-to-use interface, and leaders in the field have strong KYC practices. With a centralized exchange, you can minimize a lot of the risks that come with the exchange’s custody of your assets.
In contrast, decentralized exchanges bring the freedom that many seek in the crypto community, and generally (albeit at the expense of liquidity and user-friendliness) give you access to more projects and the opportunity to provide liquidity directly to liquidity pools.
in conclusion
Centralized and decentralized exchanges each have their pros and cons. Ultimately, there is a need and use cases for both, and we welcome recent innovations in the space. Decentralized exchanges have become more efficient and user-friendly, while centralized exchanges have improved in terms of KYC and security.
Looking at centralized exchanges, it is important that the industry becomes more transparent, especially so that the market understands that the level of crypto held in custody is higher than what exchanges owe to customers. In addition, we should continue to support regulators around the world by engaging and sharing knowledge and expertise.
Going forward, we anticipate greater adoption of decentralized exchanges and hope to see further innovation in the space. That being said, centralized exchanges are an important part of the current crypto infrastructure and are likely here to stay.