Exchanges where cryptocurrencies can be traded are roughly divided into: centralized (e.g. Binance, Bitstamp Kraken) and decentralized (e.g. Uniswap, CurveFinance, PanCake Swap).
Centralized exchanges (CEX for short) are controlled by a company that holds users’ assets. To start trading on a centralized exchange, users need to set up an account and verify their identity. Users place their trust in a middleman who, in theory, guarantees the security of transactions and funds deposited at the platform. The centralized exchange charges trading fees, part of which is allocated to platform maintenance and the rest represents the owner’s profit.
Moreover, exchanges usually set a minimum cryptocurrency buy or exchange limits as well as minimum cryptocurrency withdrawal limits. On the CEX, the price of each currency is based on an order book consisting of buy and sell orders. To buy a certain token, select it and confirm the transaction and the exchange will show the purchased tokens in the user’s account.
The main advantage of centralized exchanges is that you can transfer funds to and from your bank, so you can buy and sell cryptocurrencies for USD, EUR or GBP. Centralized exchanges offer beginners a relatively friendly way to trade and invest in cryptocurrencies.
The main disadvantage of centralized exchanges is their vulnerability to hackers. Large exchanges typically store crypto worth billions of dollars, making them a target for hackers and theft. An example of such an incident is Mt. Gox which was once the world’s largest cryptocurrency exchange before it reported the theft of 850,000 Bitcoin, leading to its collapse.
Moreover, centralized exchanges often charge high transaction fees for their services and convenience which can be particularly painful when traded volumes are high .
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Decentralized exchanges (DEX for short) are characterized by the fact that trading on them takes place directly between users under smart contract.
The benefits of decentralized exchanges include mainly higher security because the exchange does not hold its clients’ assets which are kept in private wallets. The tokens are safer in the wallet and third parties (e.g. the exchange owner) do not get access to the tokens, which protects the assets from abuse or hacking.
A second benefit of DEX is decentralization, i.e. no middlemen in transactions and no need for identity verification, which guarantees greater anonymity. Another advantage is that tokens that are not present on centralized exchanges can be traded, providing an opportunity for investment diversification. The fees charged by decentralized exchanges are often lower than on centralized exchanges.
The main disadvantage of decentralized exchanges is that they do not allow the conversion of cryptocurrencies into traditional money and their transfers to/from banks, making them less convenient for users who do not already own cryptocurrencies.
Moreover, users of decentralized exchanges must securely store the keys and passwords to their crypto wallets. Otherwise, their assets are lost forever and cannot be recovered. The vast majority of crypto transactions are handled by centralized exchanges, suggesting that they account for the majority of traded volume. Due to the lack of volume, decentralized exchanges often lack liquidity, and with low trading volumes it can be difficult to find buyers and sellers.
A BRIEF HISTORY OF DECENTRALIZED EXCHANGES
The birth of cryptocurrencies in 2009 created a new asset class in which millions of people started to invest. The emergence of centralized exchanges gave rise to new problems, such as hacking attacks, through which many people lost their funds or forced them to hand over control of their tokens to third parties. This contradicted the ideas of Satoshi Nakamoto, the founder of Bitcoin. These issues highlighted to the crypto community that decentralization must also extend to exchanges. This concept inspired many companies to start working on DEX. In 2014, NXT launched the first exchange for decentralized exchange called NXT Asset Exchange. In the following years, new exchanges were created, such as Komodo and Block DX.
The real revolution came with the launch of Uniswap at the end of 2018 which to this day is the largest decentralized exchange in terms of funds traded on it.
Uniswap is a fully decentralized software with high transaction liquidity for trading tokens on the Ethereum network. Uniswap has no order book and allows trading without intermediaries thanks to contracts built into the protocol.
Read more in my book ‘Second Crypto Revolution: Build Generational Wealth With Richard Heart’s Crypto Ecosystem“.