After the fall of centralized exchange FTX in November 2022, the trading volume on decentralized exchanges (dexes) surged. Let’s talk about the similarities and differences and compare the benefits and drawdowns of centralized and decentralized exchanges. What should you consider when deciding which type of exchange(s) to use?
The TL;DR
The difference between centralized and decentralized exchanges in a nutshell? Unlike a centralized exchange, on a decentralized exchange, you don’t need to make an account. Also, you don’t have to send any funds to it to start trading. You just connect your crypto wallet and start swapping coins.
What is The Best Starting Point to Buy Crypto?
Let’s start from the point of being a nocoiner: someone who doesn’t own any crypto. In that case, will you go for centralized and decentralized exchanges? Unless you’re a miner or if someone pays you in crypto, you will need to go to a centralized exchange (cex). A dex doesn’t accept dollars.
There is no lack of exchanges to choose from! And this centralized bottleneck into the ‘real’ crypto is probably for the better, as the user experience is comparable to traditional banking and many other types of accounts:
How do you Start Trading on a Cex?
- You sign up and provide personal details like a copy of a passport
- You deposit dollars or other fiat currency
- You can buy crypto and start trading crypto
- Like a company, the cex sends you e-mails and you can correspond with a Helpdesk
The Most Important Centralized Exchanges
In terms of trading volumes, these are the biggest centralized exchanges:
- Binance
- Coinbase
- Kraken
Decentralized Exchanges: A Separate Universe of Crypto Trading
Why can’t you buy crypto at a decentralized exchange? Because there is no way to deposit dollars or euros or any other fiat currency in a decentralized exchange. It’s a contained universe. In that sense, you can compare a dex to an arcade or casino (lol). To play there, you first need to exchange your ‘real’ money for the coins that are the currency in that local domain. The difference between an arcade and a dex is that dexes accept not just one coin but hundreds of cryptocurrencies.
How can a dex work without a centralized custodian and referee? Well, a dex doesn’t have an order book like a cex. Instead, it pools the capital of users who choose to do so in liquidity pools of dozens of different token pairs. For example, a liquidity pool of ETH/USDC provides the liquidity needed for users to swap these specific coins.
The Most Important Decentralized Exchanges
- Uniswap
- dYdX
- Kine protocol
How to Start Trading on a Dex
- You set up a software or hardware wallet
- You connect your wallet to the decentralized exchange
- You can start swapping tokens
The Differences: Cex vs Dex
| Cex | Dex | |
| Custody | Cex is custodian | Self-custody |
| Account/KYC/Helpdesk | Yes | No: peer-to-peer |
| Accepts fiat | Yes | No |
| Barrier to entry | High (KYC) | Low (no registration required) |
| Ease of use | High | Low |
| Transaction fees | Depends | Depends |
| Risk | Bankruptcy | Hack, regulation |
User Experience of Centralized or Decentralized Exchanges
The user experience of a centralized exchange is a bit like a traditional financial service. A decentralized exchange is different in the sense that it is basically another example of software disrupting an industry that used to rely on a middleman. In order to use a dex, you don’t need to knock on the door and present yourself to this middleman. You just connect your wallet and start trading with other users.
There are differences in user experience. A dex will confront a novice with some novel terms and more question marks. Why do I have to choose a network? Which one do I choose? What to think of these ‘gas fees’?
Still, a centralized exchange can in its own way be hard to use. Often, the amount of options are overwhelming to a beginner. ‘What is spot, what is margin, what is earn?’
For transactions on a cex:
- You log into your account
- If you buy crypto with fiat, you choose a payment method, for example credit card
- You chose the type of crypto you want to buy and confirm
- In case of a conversion, you choose the pair of crypto coins you want to swap and confirm
For transactions on a dex:
- You connect your crypto wallet: this can be a hardware wallet or a software wallet (app or browser extension like MetaMask)
- You choose the chain you want to transact on, for example, Ethereum or Polygon
- You choose a trading pair, e.g. ETH/DAI
- You check the order data, for example, the slippage and gas fees, and confirm
Transactions Fees: Comparing Cex vs Dex
What about fees for centralized or decentralized exchanges? Dexes aim to be cheaper than their centralized counterparts. They don’t have to pay rent for office space, customer service staff, etcetera. This explains why they can be cheaper than a centralized exchange: they leave out the intermediaries that take a cut. It doesn’t have a central authority managing orders.
Uniswap pays its liquidity providers (LP) a 0.3% fee. That is the flat fee that you pay the LP as a trader swapping coins. Apart from this flat fee, you will have to pay for using the blockchain of your choice. Those are the gas fees, which on Ethereum can spike depending on how busy the network is. Even in quiet market conditions, you will probably pay a few bucks. Whereas, for example on Polygon, it is only cents.
Let’s look at the centralized exchange Coinbase for comparison. It charges US users 1.49% for buying crypto and 1% for converting (swapping) crypto. Binance, on the other hand, doesn’t charge fees for conversion with its Convert option. For normal spot trading, it’s 0.1%.
So if you want to swap to coins like MATIC and USDC, it will probably be cheaper on dex Uniswap than on cex Coinbase – provided, in case of low amounts, that on Uniswap you use the Polygon chain and not Ethereum. But for Binance it might be a different story.
In conclusion, the question if transactions are cheaper on cex or dex has no straightforward answer.
It depends on:
- If you swap crypto tokens or buy crypto with dollars/euros on a cex
- In the latter case, the payment method you use with the cex (bank transfer, credit card, etc)
- If you hold the native token of the cex and get trading discounts as Binance does.
- For dexes, it depends on which dex you use and which chain you use.
- For dexes, the timing of the trade (busy time or not)
- For dexes, it depends on the fee that your crypto wallet charges
- The slightly different exchange rates that cex and dex quote
It is probably best to compare for yourself. Open Uniswap on one screen and Binance on another and prepare some swaps.
In the below image, you can see that swapping MATIC to USDC is less costly on Uniswap than on Coinbase, mainly because of the different exchange rates they quote.
Custody on Cex vs Dex: Benefits and Risks
What about custody issues for centralized and decentralized exchanges? In the table above, it’s no coincidence that we listed type of custody in the top row. On centralized exchanges, you hand over custody to the company behind the exchange. You wire them crypto or fiat and have to trust that they handle your funds prudently.
The FTX catastrophe proved that cexes can’t always be trusted. Until a solid standard of proof-of-reserves is widely in use, there is no guarantee that you will be able to withdraw your funds from a centralized exchange. Some exchanges, such as Coinbase and Kraken, are in higher regard than others. But the bottom line is that the government doesn’t insure your money on crypto exchanges like they do on banks.
On a dex, you are the owner of your coins
Swapping coins on a dex is different, as it doesn’t involve custody from the dex. You swap your coins from and to your own wallet, which is connected to the dex. But the coins don’t ‘sit’ in the dex. On dexes, you keep custody of your coins. This is huge. No one can freeze your account, or seize your funds, since on a dex you don’t have an account! You can access a dex from your hardware wallet, for example.
That changes if you chose to become a liquidity provider, in which case you deposit your coins in a smart contract called a liquidity pool. This pool makes trading possible. As compensation for the opportunity cost and smart contract risk of handing over your coins to software (see below), you get rewarded transaction fees.
Most of the DeFi hacks of the past few years have happened on bridges between blockchains. Still, hacks of dexes have happened. Some notable ones were hacks of Thorchain (runs on Cosmos) Bancor (runs on Ethereum), Uranium Finance (on Binance Smart Chain) and Maiar (an Elrond dex). However, the fact that a dex experiences a hack doesn’t mean that all its users lose their funds. In the case of the Maiar hack, for example, the price of the stolen EGLD tanked after the hackers dumped their stolen EGLD.
Afterthought: How Decentralized is a Dex Really?
In a discussion about centralized and decentralized exchanges, it’s good to end on a note of caution regarding the decentralized nature of dexes. How decentralized are they really? These points don’t disqualify everything above in this article but they nuance it a bit.
In a lengthy and insightful piece about DeFi, Lyn Alden sums up why decentralized finance isn’t as decentralized as we would like. DeFi has ‘so many centralized attack surfaces, it’s not that hard for regulators to clamp down on them, reduce their usability, and increase their trackability.’
The Chains Are Not Fully Decentralized
Most trading volume runs on dexes built on Ethereum (Uniswap, most notably). Ethereum by nature isn’t as decentralized as Bitcoin. Node operators are less plenty and consequently less powerful, and miners no longer have power. And chains like Binance Smart Chain (BSC) are basically run by the company Binance, which can pause BSC whenever it wants. So is it fundamentally different trading on BSC’s dex Pancakeswap versus just trading on Binance?
Centralized Governance by Dexes
Then there’s the governance of the dexes. Is code really law? Not really, when push comes to shove. Take the example of Solend, a lending app on Solana (one of Ethereum’s biggest competitors) with in June 2022 over 1 billion in deposits. A ‘whale’ had borrowed $100 million of stablecoins there with a large amount of SOL as collateral. Because the price of SOL was falling, there was a risk that the collateral of this whale would be liquidated. This would mean that the price of SOL would crash even harder.
To prevent this on-chain liquidation, Solend hastily set up a DAO (Centralized Autonomous Organization). This is a way for community members to vote on a proposal. In this case, the proposal ‘grant emergency power to Solend Labs to temporarily take over the whale’s account so the liquida tion can be executed OTC.’
Censorship by Dexes
Decentralized exchange Uniswap has appeared to block 253 wallet addresses linked to illicit financial activities on its front end after the U.S. government imposed sanctions on Tornado Cash earlier this month. In the summer of 2021, Uniswap delisted tokens with pressure from the regulators as a likely cause.
Centralized Stablecoins
DeFi protocols in practice rely heavily on centralized stablecoins. issued by companies, which are susceptible to the whims of governments. And custodians/issuers of wrapped tokens like WBTC are corporations. For instance, FTX apparently took custody (!) of WBTC’s Bitcoin on Solana. Its price crashed.
Erik started as a freelance writer around the time Satoshi was brewing on the whitepaper.
As a crypto investor, he is class of 2020. More of a holder than a trader, but never shy to experiment with new protocols.
