What is a centralized exchange (CEX)?
A centralized exchange is a platform (a website or an app), where people can buy, sell or trade cryptocurrencies and tokens available on that exchange. The platform is operated by a third party intermediary. Here people must sign up first and also provide banking and identifying details. If you want to buy a crypto asset, the exchange will establish the price, according to an “order book” of people buying and selling that asset. Another aspect is that if you buy specific assets, you won’t hold them, because the exchange acts as a custodian on your behalf. All wallets are controlled by the exchange, which also controlls the private keys.
What is a decentralized exchange (DEX)?
A DEX is a decentralized peer-to peer exchange, where people can securely trade cryptocurrency, without an intermediary, via smart contracts (automatically-executed protocols).
A DEX is a platform that emulates the roles of a centralized exchange, with the difference that it’s backend exists on a blockchain and no one takes custody of your funds. DEXs are places where people can purchase different cryptocurrencies and an extra feature is the fact that here stocks and other assets can be tokenized.
If traditional exchanges require signing up with an email, a strong password and verifying that account, DEXs don’t need this. Trades take place between two users’ wallets, with limited or no involvement of a third-party. The safety of assets is assured by a distributed ledger technology (DLT). The risk of theft is significantly reduced, because traders don’t need to transfer their assets to the exchange.
How does a decentralized exchange work?
Smart contracts function in three ways:
- On-chain order books means writing every transaction on a blockchain (e.g. a purchase, the request to sell, cancellation of an order). This method can make transactions slower and more expensive.
- Off-chain order books means that only the final transaction is written on the blockchain (e.g. orders are not stored on-chain). Transactions are cheaper and faster when using this method, but security issues may occur.
- Automated market makers (AMMs) are instruments which remove counter-parties in trading and use algorithms to set the price of different assets.
DEX advantages
- users don’t need to provide personal information
- DEXs don’t take control of assets, which provides increased security
- there is a low risk of hacking attaks
- there is a reduced risk of price manipulation or falsification of trading volumes
- independence from regulators
DEX disadvantages
- DEXs operate only with cryptocurrency assets and not fiat (e.g. USD/EUR)
- everyone is responsible for their own funds (self-service)
- liquidity pools raise the issues of price slippage and front running
- there is a lower transaction speed
- there is a limited set of operations that can be performed
- transactions are irreversible
