DEX vs CEX: Competition or Allies?by@octaloophq
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DEX vs CEX: Competition or Allies?

by OctaloopMay 21st, 2021
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Centralized exchanges have been the dominant form of trading platform in the cryptocurrency space for the last decade. Decentralized exchanges offer more privacy than centralized exchanges. Automated Market Makers (AMMs) could pose a threat to even the most popular centralized exchanges, says Andrew Keen. Keen: Decentrals exchanges have come a long way from their early days, and will they ever go out of fashion? Keen: There are different types of exchanges that cater to all kinds of investors.
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Bitcoin isn't the most accessible asset in the world, but it was even harder to obtain until just a few years ago. Despite the first Bitcoin transaction taking place in January 2009, between Satoshi Nakamoto and Hal Finney, the first sale of Bitcoin for fiat currency wouldn't occur until October. It wouldn't be long before things picked up -- the infamous Bitcoin Pizza Day took place in May 2010, and less than a year later, the Silk Road was born.

Most Bitcoin trades that took place before cryptocurrency exchanges became mainstream were conducted on forums, discussion boards, and chat rooms. But if Bitcoin was to replace traditional money, there needed to be a more convenient way to distribute it.

An exchange acts as a supply, enabling millions of people to buy, sell, and hold their investments. Today, anyone can sign up for a cryptocurrency exchange account and access thousands of digital assets. Of course, nothing is perfect, and this applies to exchanges too.

Centralized exchanges have been the dominant form of trading platform in the cryptocurrency space for the last decade. Traders use these platforms to place bids and asks, while a central server collects these requests and arranges them so everyone gets what they want. This is an incredibly efficient process and can scale to billions of dollars of transactions in a day.

The problem with this form of exchange is that it has a central point of failure. With every trade and transfer being run through a single entity, it creates a rather obvious attack surface for people with malicious intent. Because of this, centralized exchanges are forced to have some of the most secure networks in the financial services industry, and their reputation depends severely on this image of security.

However, until recently, decentralized exchanges (DEXs) were not yet functional enough to cater to a more mainstream audience. By trying to imitate the functions of a centralized exchange using decentralized infrastructure, these platforms became slow and unreliable. Further, because most DEXs were running on un-audited code, they became instant targets for traders looking for loopholes.

Decentralized exchanges have come a long way from their early days, and with the advent of Automated Market Makers (AMMs), they could pose a threat to even the most popular centralized alternatives. Not only do they offer more privacy, but they also enable traders to access less popular assets that may not be available on centralized exchanges.

So why haven't we seen a mass shift from CEXs to DEXs? Will decentralized exchanges ever dominate over the space? And will centralized exchanges ever go out of fashion? The answer is complicated. Different people have different priorities for what they want out of an exchange, and while this creates two distinct (perhaps slightly overlapping) groups of traders in the market, consumers can't complain about choice.

Similar Roles, Different Goals

Today, there are exchanges that cater to all kinds of investors, from retail traders with little disposable income to hedge fund managers trading million-dollar derivatives contracts. The recent boom in DeFi has also opened up the industry to various services and enabled countless people to access financial services with just a smartphone and an internet connection.

Exchanges are pillars of the blockchain ecosystem and are part of the industry's essential infrastructure to maintain markets. Centralized exchanges don't just launch IEOs and handle transactions – they are also responsible for providing accurate market data for APIs running into other dependent applications, and protecting the assets stored on the exchange. 

Cryptocurrency markets don't close, meaning these exchanges have near-zero downtime. Most popular centralized exchanges handle billions of dollars worth of transactions every day, forcing them to employ the highest security measures available.

However, trading fees are higher on centralized exchanges, and while they can seem harsh, it pays to understand what those fees cover. Decentralized exchanges have recently become more efficient with the introduction of Automated Market Makers, but while they may be cheaper and offer a wider variety of cryptocurrencies to invest in, there are certain conveniences they don't provide.

Bringing CEXy Back

The most significant difference between orderbook-based CEXs and AMM-based DEXs is that centralized exchanges have you trade with other people, while decentralized exchanges have you deal with a smart contract – a program on the blockchain designed to perform a few pre-determined functions. DEXs also allow users to trade anonymously, but this can be a double-edged sword.

Since there is no central database to verify KYC data, it's much harder for DEXs to comply with regulations, and this also forces users to use third-party off-ramp services to cash out their tokens. DEXs also ask users to take custody of their assets, which might seem like a good thing, but while funds stored on exchanges are at risk of attack from hackers, most CEXs’ insurance coverage ensures users don't lose any assets.

At the time of writing, the largest centralized cryptocurrency exchange, Binance, is processing over $32 billion every day. Between early 2020 and Q1 this year, the number of active users on Coinbase has nearly doubled to 60 million, with a 13x increase in the total assets on the platform, while daily volumes on Binance have increased sixfold since the start of the year.

Relatively new derivatives exchanges like FTX and Phemex have also seen astronomical growth numbers in 2020-21. FTX last month handled enough volume to make it one of the largest exchanges. It now processes $14 billion per day which marks a 25-fold increase from April 2020.

Just comparing Q1 of this year to last, Phemex saw over 450.2% growth in trade volume, and a 150.9% increase since 2020 taking the number of active traders to over 1 million on the platform. Seeing education as a bottleneck for adoption, the exchange has also produced detailed user-guides for its features, along with highly informative articles on cryptocurrencies and blockchain technology through its comprehensive Academy section.

However, centralized exchanges do present an easy target for governments to censor cryptocurrencies if they determine their use opposes their financial laws. This also affords regulators unadulterated oversight into the data collected by the exchange to ensure compliance with their policies.

DEXs are crucial to the growth of the blockchain industry and represent the new wave of innovation and development coming to the space. However, genuinely decentralized exchange offerings are still very much in their infancy, with low trading volumes, and this lack of liquidity makes using them even more inconvenient.

Still, they do give newer projects a way to list their token without going through the stringent, and often restrictive listing processes on centralized exchanges. This also gives centralized exchanges a chance to see how a project performs and ensure its validity before offering it to more mainstream users.

They represent how far the technology has come and are a signal of the innovative applications that the future of decentralized networks holds. With more platforms arising every day, providing everyone from individuals to institutional investors access to digital assets, the industry is going through a fundamental shift.

As the industry evolves, so too will its underlying infrastructure. Modern exchanges are only in the first stage of a long evolutionary path to the perfect financial architecture, but with the constant innovation seen in this space, we might be there faster than expected.