DEX Series #4 - Centralized vs. Decentralized Exchange

DEX Series #4 - Centralized vs. Decentralized Exchange

In the past three episodes of the DEX Series, we have explored the determiners of assets, trading and exchange, and the issue of governance.

This article brings you a perspective on the benefits of decentralized exchanges compared to centralized ones.

Crypto asset markets and exchange platforms started out and nourished on the same trading principles as we have known since traditional marketplaces and stock exchanges like the New York Stock Exchange (NYSE).

As blockchain tech brought about the disruptive concept of individual autonomy, decentralization, and elimination of the middle person, it was only appropriate to rethink the traditional ways of doing trading with crypto assets, as well. Here is how decentralized exchanges can improve the trading experience for users, compared to centralized platforms.

Decentralized exchanges as an answer

Regardless of the coin or token of choice, most of them are traded on the growing pool of exchanges which remain centralized such as Binance. The core idea of blockchain as a distributed ledger is therefore not fully applied. More importantly, centralized exchanges function as any other traditional institutions - the benefits of the community don’t come before profit. Not to mention the numerous pragmatic risks at hand (abuses, maintenance, lack of access, dependency, etc.), further eroding the community advantages and trust. As an answer to the challenges above, decentralized exchanges (like Waves Dex) are slowly but convincingly entering the mainstream, bringing about numerous advantages.

Centralized exchange - Classic hierarchy of a traditional marketplace

Running in a centralized way, it does not differ much from classical marketplaces, where a company or another business structure exercise power over users, traded assets and data. In return, they provide them with a platform of a broad network, high liquidity, and a variety of tradable assets.

The operations, relations, and business model are all based on a set of rules, terms, and conditions, that act as a legal base in case of disputes, usually written in a way to protect the financial interests of the central business entity over the users’. Once the users agree with stipulated terms of involvement, there is not much maneuvering space for their alteration or ambiguous interpretation if a user feels misled or deceived.

Centralized types of ownership, operations, and transactions bring about the following issues:

1. Proneness to security issues: Since they are running on a central or a single server and having a single point of entry (centralized asset account), they are also more vulnerable to targeted attacks. Several centralized exchanges like Zaif, Binance, and CoinCheck have suffered hacks recently (either attacking their APIs, hot wallets, etc.) and ended up losing hundreds of millions USD.

2. Assets held by the platform: Dependency on the platform reduces the autonomy of asset management for users. Once they deposit funds or execute orders, the funds are in the hands of the platform until withdrawal.

3. Large expenditure: Apart from server fees (raising with the traffic), and much like a traditional business, centralized exchanges face high overhead costs to cover their employees, security requirements, maintenance, and taxes. These expenditures are usually covered by user fees incurred during trading.

4. Traffic scaling and frontrunning: central server provides a determined computing power which could result in delays or even temporary closing of the platform due to clogging. Also, centralized platforms can read the orders, and even use them to their benefit to conduct trading based on insider information.

Once we apply a decentralized approach to these processes, users can leverage many benefits for them and their assets.

Decentralized exchange - From anonymity to reliability (and everything in between)

When applied principles of the blockchain, the pyramid hierarchy of centralized exchanges dissolves into a scattered pattern of same-level, distributed operational and authentication processes in blockchain-run DEXes.

Terms and Conditions imposed by CEXes as a trust mechanism are replaced by automatization of smart contracts, reliability, and impermeability of the blockchain infrastructure in DEXes. Instead of business goals and platform operators, the power and potential of trading assets depend on users owning them.

1. Attack-proof: No central point means increased reliability by default (higher uptime due to distributed nature), but also significantly higher security, as it is nearly impossible to issue an attack on the distributed network of private servers. This precludes individuals, organizations or even governments to intervene, ensuring a more democratic use of technology for the benefit of all. With the absence of a central authority, which gives users permission to exercise transactions, a decentralized exchange facilitates a permissionless ecosystem, increasing users’ autonomy. Given the increasingly stronger regulatory pressure from governments, the direct nature of trading relationships on decentralized exchanges is becoming increasingly important also as a deterrent against censorship.

2. Assets and data in the hands of users: In a decentralized exchange, the proverbial middle-man is no longer an indispensable part of the process. As no central authority holds control of the traded assets, the trading entities (buyers and sellers) directly facilitate one-to-one deals. The trading entities actually own the traded assets by keeping them in their wallets, which is especially important, as users do not have to relinquish the control over their assets to anybody and these cannot be arbitrarily withdrawn. This tighter user-centered control lives up to the “not your keys, not your coins” principle, which basically means that any assets stored off the actual exchange mean less risk. They also ensure anonymity as the personal information of the trading counterparties remains protected within their respective wallets.

3. Cheaper trading: Since the transaction fees usually imposed by a central authority are not always incurred in the decentralized exchanges, the latter can also be cheaper. DEXes can still charge fees to cover gas, but they are usually lower compared to centralized that need to cover operational overhead expenditures.

4. Faster traffic: By abolishing a third party intervention, transactions between trading parties are done instantly, provided all the parameters work and the transaction is authorized. Instead of having to rely on centralized software or a middleman confirming a transaction, such operations are done automatically through the code of a decentralized transaction.

CEX vs. DEX face to face

Centralized exchange (CEX) Decentralized exchange (DEX)
Authority/governance: centralized, accumulated, singular, autocratic Authority/governance: decentralized, distributed, plural, democratic
Control of assets and personal data: central, on the platform Control of assets and transactional data: private, in the user’s wallet
Cost of use: usually higher, covering authority’s expenditures Cost of use: usually lower, covering mostly computational effort (gas)
Route of information: APIs, software, interface, non-independent central server, run by a central authority Route of information: blockchain, distributed peer-to-peer protocol, interconnected independent nodes
Exposure to security risks: high, a central point of attack (server), assets stored on a platform Exposure to security risks: low, distributed network of servers, immutable and sealed transactions, assets stored in private wallets

Future - decentralized?

Decentralized exchanges aim to create a future-proof environment, where digital assets are managed in a manner that it delivers on the promise of diminished abuse and reduced risk and unhindered trust - a kind of trust, crucial for communities to develop and flourish.

That said, decentralized exchanges also have some downsides compared to centralized, for example, atomic swaps are (mostly) not possible cross-chain yet. Also, the user experience is often less pleasant and slower on DEXes, since order matching has to be ensured first which could take a bit longer than merely updating some figures on a centralized exchange database. These traits are the price a user pays for leveraging increased security when using a decentralized exchange.

Decentralized exchanges will furthermore be facing several challenges as the ecosystem evolves. Regulations, liquidity, exchange rates, KYC/AML, etc. will be parameters determining the functionalities and adoption of DEXes.

But so far, much progress in bringing the trading of crypto closer to the user has been achieved and has already set the ground for what is to be the future of trading.

*Decentralized exchanges are paving the path towards a broader inclusion and trading customization. One of such platforms is also our decentralized SwapMarket, coming soon to all NFT traders.

For more on the topic of a decentralized way of trading assets, please check our other episodes of the DEX Series:

DEX Series #1: Tags and IDs
DEX Series #2: Trading and exchange
DEX Series #3: Governance and control distribution of exchanges
DEX Series #5: Academia
DEX Series #6: Crypto-collectibles