Funds are #Safu?

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16 Apr 2022

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Within the crypto space there are two primary types of facilitators for investors to trade, buy or sell cryptocurrencies; Centralised Exchanges (CEX) and Decentralised Exchanges (DEX).

Centralised Exchanges (CEXes)

Centralised exchanges (CEXes) in the crypto space follow a classical exchange structure akin to stock and commodities exchanges. The design of the exchange is based on an order book that is continually updated with a list of all the open offers from buyers and sellers interacting with the exchange. Prospective buyers will place limit buy orders specifying a maximum price at which they are willing to buy an asset (the bid price) and sellers correspondingly place limit sell orders for the minimum price they are selling at (ask). In crypto the asset pairs traded would usually be an amount of one token for another for example ETH/USDC or BTC/BNB.

The exchange operator, which is the centralised party, has access to the orderbook and matches buyers and sellers, executing orders when a bid price is higher than the highest asking price. This matching process happens continuously as orders are continuously updated. Usually the exchange receives a commission on every executed order and thus it is in the best interests of the operator to process orders as quickly as possible. The exchange also has access to the customers’ funds (which are automatically updated after trades), market positions and personal information (by legislation).

Examples of Centralised Exchanges include Binance and Coinbase.

Decentralised Exchanges (DEXes)

Decentralised exchanges (DEXes) function differently to centralised exchanges, utilising blockchain technology to manage buyer and seller interaction. Many DEX designs exist, with the most popular design being the automated market maker (AMM) which circumvents the use of order books. The AMM does not hold customers’ funds, positions, or information, and only serves as a matching and routing layer for trade orders. Users of the AMM exchange hold their assets on the chain in their wallets and interact with the exchange operator via transactions with the exchange’s smart contract that holds a reserve of the tokens.

Like an order book exchange, trading pairs (ETH/USDC and BTC/BNB for example) still exist. However a counterparty (i.e a seller matching to a buyer) is not required to execute the trade. The market is made by the exchange’s smart contract through interactions with a liquidity pool hosted by the exchange which is a pool of tokens consisting of pairs (ETH/USDC for example).

This is best illustrated by an example, consider a prospective buyer wants to purchase asset ETH with asset USDC. The buyer is quoted on a rate for the amount of ETH received for USDC based on the liquidity pool (ETH/USDC) which is the price of ETH in terms of USDC (This isn’t 100 percent accurate, the mathematics is explained in a future article). When the buyer executes the trade, the exchanges smart contract interacts with their wallet sending them the ETH at the above rate and taking the USDC. Thus the liquidity pool for the exchange now has less ETH and more USDC adjusting the price again.

If a user buys B using A, the price of A denominated in B offered by the smart contract for the next trade is increased.
If a user instead sells A for B, the price decreases.

Exampes of Decentralised Exchanges include Uniswap and Sushiswap.
Decentralised exchanges deserve an article themselves, and a future article will cover in more detail in how they work and the mathematics behind liquidity pools and token pricing.

Exchange Comparison

The following is a comparison between DEXes and CEXes.

Trade Volume

CEXes

Higher trade volume as it is easier to access.
Majority of crypto trade volume still occurs on CEXes.

DEXes

Lower trade volume due to requirement for software wallet.
Trades execute slower than CEXes due to smart contract execution time.

Liquidity

CEXes

Overall higher liquidity due to more trading volume.
Less suitable for less liquid tokens because order cannot be executed until counter party exists.

DEXes

Overall lower liquidity due to lower trading volume.
More suitable for less liquid tokens because order can be executed as long as liquidity pool exists.

Fiat Compatiblity

CEXes

Allows bank transfers, debit/credit card transfers.

DEXes

Only allows cryptocurrency transfers.

Protection from Downtime or Hacks

CEXes

Many centralised exchanges have been hacked in the past and users have lost their money.
Infrastructure is centralised and operators will be more centralised.

DEXes

Only interaction with user wallet is during trade hence your money is safe unless an attack occurs during a smart contract interaction.
Infrastructure is distributed via nodes thus less change of downtime.

Transparency and Privacy

CEXes

Exchanges usually have to be licensed or registered with a country and usually publish location information.
User privacy is limited since there is requirement by legislation for users to submit personal data to the exchange.

DEXes