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January 11, 2023

Centralized Exchanges vs Decentralized Exchanges

Centralized Exchanges vs Decentralized Exchanges

Abstract / Summary

Markets have existed in centralized form even before classical economic theory published a word about them. Beyond the reasons why, there’s a simplicity to their logic that has stood the test of time. However, the ongoing evolution of economic models and marketplaces has resulted in the appearance of alternatives to centralized exchange systems, namely decentralized exchanges. One of their advantages include allocating risk more efficiently among traders with various appetites for it, attitudes which have been partly fostered by cryptocurrencies themselves and how they work.

This article explores the evolution of decentralized exchanges in relation to centralized models during the last two decades, a time that has seen the emergence of marketplaces with different types of market clearing, including directly matching with an intermediary, trading in a dealer network and the use of centralized electronic exchanges by institutional or retail investors.  

CEX vs DEX

CEX vs DEX: What are the main differences? 

Even though they follow certain classical economic principles, cryptocurrencies gave birth to their own types of exchanges, producing centralized or decentralized models. Both dedicated and casual investors are drawn to this budding domain with its fluctuating financial dynamics.

A crypto exchange is a platform that allows the buying and selling of cryptocurrencies in the form of digital assets. Centralized exchange (CEX) platforms rely on third-party or intermediary accounts to monitor and confirm the safety of the transactions – traders deposit the funds into a middleman account for a certain period of time until the transaction is approved. Thus, CEXs require users to submit personal information for verification, causing privacy issues against principles that are fundamental to the blockchain ethos. However, the system also requires the same of organizations or companies.

What’s more, verified traders on centralized exchanges have higher withdrawal quotas, as well as better customer and tech support. These models are the most common – companies like Binance, CEX.io, Kraken, Coinbase Exchange, OKEx or NDAX.io, all CEXs, use the order book method to regulate asset prices and authenticate all cryptocurrency-related operations. Some of the benefits of these centralized crypto exchanges usually include easy-to-use interfaces, compliance with governmental regulations, support restoring lost data like login information and insurance models to protect investments from hackers. 

On the other hand, decentralized exchanges (DEX) allow the transferring of various digital assets on a safe and open market without mediators, meaning traders don’t have to send their funds to a third-party account when transacting. With DEXs, traders rely on smart contracts and self-custody wallets. These models adopt all the boundaries of CEXs but stand out for making it easier for users to exchange all the currencies available online. DEXs are usually built on the Ethereum network, which is by far the most implemented in the crypto financial market.

Unlike CEXs, decentralized exchanges are not centered on the transfer price and customers employ various platforms when they need to, like Uniswap, Bisq, GDEX or Pancakeswap. The rationale for trusting DEXs is the availability of features with strong reliability, but the fundamental advantage of DEXs over CEXs is the anonymity they provide since they require very little information from the customer. Lacking an integrated system-owned digital wallet, DEXs allow users to retain control of their data, which CEX clients cannot do.

Several versions of DEXs have been released over time since cryptocurrencies were introduced, particularly in the last five years. The main concept behind decentralized exchanges is that they eliminate the middleman, which always takes a portion of transaction costs. DEXs use automated market protocols to determine asset prices without a centralized body orchestrating or governing trades – the most common approach is the "constant product" mechanism, which determines prices offered as a function of the DEX's total reserves of each of the assets involved. This strategy assists the system in maintaining relative reserve balance. Even so, if any asset became rare, it would turn prohibitively expensive.

Regardless of the previous consideration, assets both in DEXs and CEXs are offered at the same prices. This prevents traders or bots from quickly profiting from discrepancies through arbitrage. In CEXs, for example, if a certain pool contains very little ETH, it would let traders sell it at a higher price than the wider market indicated, opening the opportunity for easy profit. On the other hand, DEXs use the order book system, just as CEXs but in conjunction with smart contracts, to coordinate asset purchases and sales in a more egalitarian, realistic way.

Discussion

The cryptocurrency exchange market is still accelerating and growing, evolving the actual economic model that governs them down to its most basic blockchain components. Just 14 years ago, Bitcoin changed the rules with a model that led the market. Nowadays, the differences between centralized and decentralized crypto exchanges still don’t favor one over the other. Decentralized models, for instance, protect privacy but are also an open door for irregular anonymous activities or money laundries – centralized models require much more information from users so it becomes harder to violate fair market principles. However, aspects like safety, prevalence, control or costs are shifting the spotlight to DEXs platforms, given the model's boundaries. Since they eliminate the need for intermediary accounts, decentralized exchanges are less prone to cyberattacks and cheaper to make transactions in.

DEXs are also affected by unstable liquidity in cryptomarkets and slower transaction speeds since validation requires each user to go through the order book method. Nonetheless, it is expected that DEX systems will grow in the coming years, finding solutions for the disadvantages that limit their performance at this time. 

References:

[1] Council, B. (2022, September 8). Centralized exchange (CEX) vs. Decentralized Exchange (DEX). Web3 & Blockchain Certifications. Retrieved January 4, 2023, from https://www.blockchain-council.org/cryptocurrency/centralized-exchange-vs-decentralized-exchange/ 

[2] Malamud, S., & Rostek, M. (2017). Decentralized exchange. American Economic Review, 107(11), 3320-62.

[3] Schär, F. (2021). Decentralized finance: On blockchain-and smart contract-based financial markets. FRB of St. Louis Review.

[4] Lehar, A., & Parlour, C. A. (2021). Decentralized exchanges. Working paper.

[5] Ranaldo, A., & Barbon, A. (2022). On The Quality Of Cryptocurrency Markets: Centralized Versus Decentralized Exchanges.

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