A cryptocurrency is a digital currency that is protected by cryptography. Blockchain specifically addresses the structure of data and allows for decentralized digital ledgers where wrongdoing cannot affect transactions. Cryptocurrency exchanges are places where anyone can buy or sell cryptocurrency. Each cryptocurrency exchange has its own set of terms and conditions, and they all offer users access to the most popular cryptocurrencies.
In recent years, digital asset trading has grown significantly. Centralized and decentralized exchanges are the two different types of platforms where cryptocurrencies are traded. Centralized exchanges are where the majority of cryptocurrency trading takes place in terms of trading volume. Centralized exchanges (CEXs) act as the primary venue for exchanging tokens and money. The infrastructure that CEXs maintain in cryptocurrency markets is comparable to that seen in traditional equity markets, with similar protocols and equivalent trade execution rules that encourage liquidity provision and the price discovery process.
Various types of assets are traded on centralized exchanges in contemporary financial markets. An electronic limit order book (LOB) is often used in this dominant market structure, which matches end-user orders in a fairly transparent, efficient and centralized manner. For off-chain cryptocurrency trading on centralized exchanges, LOB markets have also been widely adopted.
Decentralized platforms are the only places where newly launched tokens can often be traded alongside popular cryptocurrencies. These decentralized exchanges have seen an exponential increase in volume of late, including automated market makers. Decentralized exchanges are growing in importance for buying and trading a significant portion of cryptocurrencies. The phrase “decentralized exchange” generally refers to distributed ledger protocols and applications that allow users to trade cryptocurrencies without having to rely on a centralized body to act as an intermediary or custodian for their holdings.
However, decentralized exchanges have come to the fore as a different market structure for digital assets, fueled by the increase in innovation brought about by the introduction of blockchain technology. These markets are based on automated market maker (AMM) smart contract systems that enable on-chain trading.
Decentralized exchanges offer several significant advantages, such as lower counterparty risk, the possibility of lower transaction fees, and a more diverse selection of trading pairs that can open up access to riskier or less liquid cryptocurrencies. In the coming years, decentralized exchange technology may experience rapid growth in utilization, development, and adoption as demand for these features increases.
Key Differences Between CEX and DEX
The benefit of LOB-based CEXs is their ability to offer a reasonably competitive and efficient price discovery process and liquidity pooling even in extreme circumstances.
No third party is needed for the trade to be executed on a DEX, full custody of the assets remains with the user. This advantage brought about by the decentralized trust offered by blockchain technology has several important consequences. The trustless and censorship-resistant nature of user crypto assets is the first benefit that users can take full advantage of. Second, it gives users access to various protocols on which they can use their crypto assets and benefit from their services. Third, it eliminates the possibility of hackers attacking the market and stealing assets. Fourth, it allows users to avoid paying the costs often associated with moving money in and out of CEXs. Finally, and most importantly, trading and settlement on DEXs happen simultaneously.
The market can integrate and change rapidly to meet the demands of its DEX participants. Users can, for example, list instantly and without any selection procedure any pair of ERC20 tokens at any time. Therefore, it is likely that new tokens can be traded on DEX sooner, while CEX approval processes may take a long period.
Also, DEX could allow trading with tokens that are not offered on CEX. On the one hand, this creates a benefit by expanding the range of investment possibilities, improving diversification, and speeding up the market completion process. But this has the disadvantage of exposing people to resources that may be malicious.
It is essential to note that the execution and settlement of DEX trades coincide. Therefore, trading on CEX involves even higher fees, longer delays, and risks when settlement issues are factored in.
Furthermore, companies that run centralized exchanges are responsible for their clients’ holdings. Large exchanges typically store billions of dollars worth of bitcoins, making them an attractive target for hackers and theft. Mt.Gox, once the world’s largest cryptocurrency exchange before reporting the theft of 850,000 bitcoins, is an example of such an incident.
And centralized exchanges allow 99% of crypto transactions, which implies that they are responsible for most of the trading volume. Decentralized exchanges are often illiquid due to a lack of volume, and it can be difficult to identify buyers and sellers when trading volumes are low.
Decentralized exchanges are still in their early stages of expansion, with higher trading latency, lower liquidity, and less intuitive user interfaces making them less attractive to mainstream retail users. However, as centralized exchanges continue to suffer from security breaches and postpone the listing of new coins, more users will choose to use decentralized exchanges, despite their high friction.
The development and expansion of the decentralized exchange ecosystem is worth investing in to foster liquidity in an increasingly diverse token ecosystem, greater user control over cryptocurrencies, more privacy features, and reduced censorship risk.
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