21 Nov 2022
Note: As a data-driven firm, we make every attempt to engage with readers through meaningful impacts valued by our elaborate research and concise delivery, both of which you can easily find in this article:
1. The following write-up will provide an in-depth explanation of CEX and DEX
2. A few TLDR infographics along this article serve as visual guides in case you need help structuring what you have read or wish to contemplate more on the subject post-reading.
Enjoy your read!
Though more than 10 years has passed since the birth of Bitcoin, the crypto market is still admittedly young, especially when compared to the historically deep-rooted banking system. However, as of date, there are nearly 22,000 cryptocurrencies in existence while statistics last December released by Crypto.com shows that nearly 300 million users worldwide were acquired into the cryptosphere at an increasing HoH adoption growth rate of 13% over the latter half of 2021. All these data points must have left you wondering: Should I be a part of this, too? And if your answer has not yet arrived, rest assured that M3TA will show you the way in our series of M3TA 101.
If you have read our AMMs episode, there is a high chance you came across the term “Decentralized Exchange”. Today, we will expand the scope of that concept, together with its counterpart - “Centralized Exchange”.
As for a hardcore crypto trader, there seems to be nothing more important than privacy and security. However, throughout this article, you may find some other factors and elements equally need to be considered before your venture into the trading scene begins. With that said, why don’t we start from the basic, at the place where trades take place - cryptocurrency (crypto) exchanges?
A cryptocurrency exchange, or digital currency exchange, is a virtual platform that provides infrastructure for digital financial services related to decentralized digital assets, such as coins (tokens) and NFTs, to operate.
Just as if you grow corn and want to exchange an amount of harvested corn for an equal weight of fabric, you go to the farmers' market and conduct an exchange with one of the fabric sellers there that matches your trading expectation of price and goods. The farmers' market in this situation is comparable to a crypto exchange, to some extent. However, in all seriousness, that is exactly what was happening when the modern monetary system was not ready yet.
In addition, for this infrastructure to be sustained throughout time, some certain components are of the essence:
Trading Mechanism: Do I have to stand up and name my corn price in front of 100 people or is there a different way for me to do it with less fuss, less time, yet still allowing me to engage with the most desired buyer? The same question still applies in the event that I am a buyer.
Trading Pair: Corn/Fabric, Corn/Tea or Corn/Chicken
Market Maker: I cannot carry around the corn I have harvested and the fabric I have purchased all day long, let alone a month or a year. I need a place to consign my trading assets when I am at the market, and from the exact storage, I can take them home whenever I want.
Product Offering: If I didn't bring enough corn to the market today, yet I still wish to buy some more goods and collateralize what I have left here. Is it still possible for me to trade?
Security Standard: Who takes on the responsibility of writing down each transaction I made in case I need to retrieve it later on? Where is it stored? Is that place big enough to store all transactions performed in the next 20 years and safe enough so that no one can defraud me by altering the information or falsely disclosing it to someone else?
Regulatory Framework & Censorship: In case of dispute, which law should I abide by? Who would have authority over me?
Having established some essential aspects that every crypto exchange will bear relation to in terms of structure, we go on with our analysis concerning the two most prevalent types of crypto exchange on the market thus far: Centralized and Decentralized.
As the name suggests, a Centralized Exchange, or CEX, is not self-operated, but run by a third party - which effectively owns the crypto exchange centrally. This means that the third-party company has all the rights, and duty, to (1) facilitate transactions among trades, (2) monitor activities within the platform, flag suspicious conduct, aptly act on it, (3) store and protect the assets being traded on their marketplace.
Figure 1. CEX Trading Process
From the order book, traders will find listed details of:
- buy order placements: all the bids from highest to lowest, the amount and the price
- sell order placements: all the asks from highest to lowest, the amount and the price
- past trade log: all successfully executed transactions
Recently, exchanges have supplemented the hard-to-read order book with a more user-friendly version called a market depth chart, which displays the total number of buy-sell orders available for one trading pair in a real-time line chart. This practical function should help inform traders of conscious investment decisions.
Figure 2. A sample market depth chart.
Source: River Finance
For instance, if observed from the chart that there has been a significantly higher tally of buy placements than sell ones, the price's direction will likely move higher owing to the buying pressure across the market and vice versa. This order-book data and other data relevant to several transactions that they process daily as a central entity cash in a small profit to these exchanges when they decide to supply those for investors and other private parties for analytical purposes, besides other services.
After being matched, these orders undergo a round of settlement. Differing from those on a DEX, transactions on a CEX are settled off-chain, meaning they take place on a centralized server of the exchange where “transaction signing” is applied to verify the transactions. All of the signed transactions on one of these CEXs are completed electronically, though not automatically as what DEXs can do, and encrypted in the single blockchain that enables the creation, storage, transfer and transaction of the particular crypto assets being traded. In other words, CEXs are not the agency for storing transaction “blocks”; they are merely the go-to shops for trading orders to be done.
Deploying blockchain technology is indeed the necessary giant leap that separates a CEX from a traditional stock exchange. Since the sole existing purpose of blockchain is to maintain a decentralized and immutable succession of transactions, which are arranged within the exchange and on the exchange's interface, it inherently eliminates the role of intermediary brokers from sight.
In case you would like to withdraw or liquidate your funds from a certain CEX, it is out of this CEX’s pocket that your funds are extracted and converted into the currency you prefer. Technically speaking, whenever such liquidity takes place, CEXs simultaneously take on the role of a liquidity provider. This is one of the most important factors to consider before a trader decides to join any CEX since the lack of liquidity capability could escalate to a drastic catastrophe as in what has just happened with FTX - a top 3 trading platform in terms of total trading volume.
Another property natured to centralized platforms is their high compliance requirements with government regulations. Because they are considered legal financial entities, it means that they are mandated to collect, store and protect users’ personal information as well as making sure that trading activities occurring on their platform are subject to applicable regulations of various actors ranging from federal laws, state laws, to industrial laws, etc. Take the US - one of the most demanding markets in digital currency exchanges - as an example. The country has attempted to put into effect a series of currency legislations from the Bank Secrecy Act (BSA), the US Securities and Exchange Commission (SEC), the Commodities Futures Trading Commission (CFTC), and Financial Crimes Enforcement Network (FINCEN). The list extends far into the future, even catching the attention of President Biden.
One last feature of CEXs is that they act as custodial wallets - meaning they manage your private keys while storing and distributing your digital currencies across the platform. They offer a ready-to-go service that is of convenience to any sellers that wish to earn their passive income without too much effort. The sellers do not retain full control over their assets, but rather are subject to the securities and regulations of the exchanges. Therefore, it’s important to research the security history of an exchange before you entrust your funds to the platform.
On the other hand, Decentralized Exchanges (DEX) are not operated by a central entity but run on an innovative on-chain system of smart contracts. In other words, trades on DEXs are not human-driven as in the case of CEXs; they are automated. If CEXs wipe out the role of a broker, DEXs take a step further and manage to put the power back into the hands of traders and investors by cutting off the presence of third parties in the operating orbit. The exchange operator retains no custody of either the investors’ deposit or their identity, but simply provides the infrastructure for autonomous transactions to take place. Consequently, you do not need an account or go through KYC scanning to trade on a DEX.
The trading journey on a DEX is briefly described in the Figure 3 below.
Figure 3. DEX Trading Journey
According to IBM, smart contracts are blockchain-stored computer programs that get activated when predetermined conditions are met. Their optimal advantage lies in the fact that agreements are executed automatically with a certain outcome guaranteed without delay or intervention from an intermediary. With that being said, smart contracts prefer the application of automated market makers, rather than order books in the case of CEXs. In short, when a trade takes place, the pool maneuvers on the basis of balance, meaning its final goal is to bring the ratio of the two selected tokens back to 50/50. This mechanism provides the sound foundation for the calculation of selling/buying price at the time of trading.
DEXs base themselves on the backbone of smart contracts, which means they are subject to a set of rules stipulated by the single blockchain providing the smart contracts. These might include requiring users to use the blockchain’s native tokens to pay for a small fraction of transaction fees (mostly to reward liquidity providers) and gas fees. Take Ethereum and Uniswap as an example. Ethereum blockchain provides the standard technology which allows smart contract platforms to be built on top. Uniswap, one of the DEXs that take advantage of Ethereum’s smart contracts, only needs to create AMM liquidity pools so that ERC-20 tokens can be exchanged via their protocol. During the trading process, the DEX’s users must hold an amount of ETH to complete their transactions on the platform.
When you place a trade in a pool, the pool's algorithm is programmed to hand you a price calculated from how wide or how narrow the gap of this ratio is and proceed executing the trade on your behalf. When a seller is in play, the same approach is taken, meaning it will provide the seller a price point which can restore balance to the pool. The system uses liquidity pools to attract capital from users who wish to contribute to the pool and, in exchange, earn a portion of the fee overtime. The method can be considered a revolutionary way to facilitate trades with regards to decentralized on-chain settlement because instead of a central entity processing your withdrawal as in the SOP of CEXs, DEXs hand it over to intelligent automation and the community.
DEXs also resolve the issue that most crypto traders refer to on the street as “not your key, not your cheese". The phrase implies that if you are not in control of your private keys - which is the ultimate gate to your funds - you already lost your coins. This is unfortunately the case with CEXs - who take custody of your funds the moment you deposit on their exchange. However, DEXs have managed to circumvent this difficulty with the availability of immutable blockchain technology that they choose to operate on. The technology is permissionless; therefore, no other parties except for investors and traders that should be responsible for protecting their funds. Due to this fact, investors and traders are also highly advised against engaging with any malicious software that might threaten the security of their funds.
P2P lending, anonymity and variety has made DEXs grow in popularity in recent years with the absence of major regulation of financial legislation, although there have been some proposals brought forward by scholars and crypto experts for the decentralized model. Quarter market report conducted by CoinGecko for Q3 2022 revealed that decentralized protocols - which is the biggest player in the DeFi sector - witnessed an exponential QoQ 36.8% growth, equal to a whopping US$10.9B total market value. Another statistics released by Chainalysis last June indicates that since Sep 2020, the on-chain trading volume has shifted away from centralized to decentralized platforms. The trend culminated in Jun 2021 during which DEXs facilitated over 80% of on-chain transactions. The current ratio is at 55:45 in favor of DEXs by Q1 2022.
However, the main challenge when it comes to widespread adoption of decentralized infrastructure in the blockchain industry is that they suffer from poor liquidity and low trading volume, which have only been met with one exception so far - Uniswap. How will DEXs tackle these obstacles?
Follow us to Chapter 2 for a “wrestling match" of CEXs against DEXs where the featured side-by-side analogy is set to offer readers an objective outlook on which option is the most suitable for whom, in which context, with which priority in mind, what are the benefits and barriers of each kind, and what their future may look like.