Centralized vs. Decentralized Crypto Exchanges
A crypto exchange is a trading hub where users can purchase, sell, or exchange cryptocurrencies. There are two main types: Centralized Exchanges (or CEX) and Decentralized Exchanges (or DEX).
Each type offers a platform to help you acquire crypto, but they operate on distinctly different principles.
Let me say upfront that Centralized Exchanges are the only exchanges new crypto investors should consider, mainly because of their ease of use. But for the sake of completeness, I will go over both types of exchanges.
The video below gives a good summary of centralized vs. decentralized exchanges. The rest of the text is a simplified version of some of the subject covered in the video above for your reference.
Overview of Centralized Exchanges (CEXs)
The most prominent cryptocurrency exchanges you might be familiar with, such as Coinbase, Kraken, and Gemini, are centralized. These platforms often become the first choice for many new crypto investors for several reasons.
Centralized Trading Mechanism
Centralization means that all trading is conducted through a centralized intermediary that uses an order book to record and validate orders. All transactions are processed and stored within the exchange's database, and user information is securely held on the platform's servers. This is much like how traditional online stock brokers operate.
Privacy and Compliance
One of the limitations of centralized exchanges is the lack of anonymity. These platforms require users to provide personal information as part of their Know Your Client (or KYC) and Anti-Money-Laundering (or AML) requirements, similar to the information required by banks and online brokers when you open a stock trading account. This protocol helps prevent fraud and the use of cryptocurrencies for illegal activities.
Ease of Use for Beginners
Centralized exchanges are particularly popular among newcomers to the cryptocurrency world because they offer a straightforward trading process. Users simply select the cryptocurrency they wish to purchase, complete the transaction, and the digital assets are transferred to their accounts. However, it's important to note that these exchanges are "custodial," meaning they hold your funds and information on their server. In other words, they are the keeper of all your cryptocurrency investments.
So if hackers are successful in attacking the exchange, all your investments could vanish unless the exchange has strong security measures to prevent such invaders. The good news is that there are measures investors can take to offload their crypto investments from the exchange platforms to prevent such events.
Regulation and Security
One of the best things about centralized exchanges is that they are regulated and obtain operating licenses in multiple jurisdictions, making them adhere to a country's rules and regulations. This regulatory framework is why users must provide identification documents before trading on a centralized exchange.
Overall Benefit of Centralized Exchanges.
For those seeking an easy-to-use system without the need to manage their crypto wallet directly, a centralized exchange is an excellent option. It provides a user-friendly platform that is especially advantageous for beginners looking to invest in cryptocurrencies. In addition, centralized exchanges are more discriminating about the digital assets they allow on their platforms than decentralized exchanges which can sometimes feel like a jungle full of fraudsters.
We strongly recommend that new crypto investors begin their crypto journey with a centralized exchange – especially one that is in a country with strong regulations.
Overview of Decentralized Exchanges (DEXs)
Decentralized exchanges share several similarities with centralized exchanges but also differ in fundamental ways which we explore further in this section. Two of the top decentralized exchanges are Uniswap and Pancake Swap. These have gained popularity due to their user-friendly interfaces and robust ecosystems.
Decentralized Exchange Operations
Decentralized exchanges facilitate transactions directly on the blockchain through what's referred to as smart contracts, with orders executed on-chain. These contracts are computer programs that make it possible for sellers and buyers of crypto to exchange value. This decentralized structure means that the exchange does not have control over your crypto assets, which may reduce the risk of certain hacking incidents that can affect centralized exchanges.
Privacy and Anonymity
In terms of privacy, decentralized exchanges do not handle regular currencies like the US dollar, and do not require users to submit personal details, identification, or bank information for Know-Your-Client or Anti-Money-Laundering compliance. To be more specific, you can’t buy crypto on a decentralized exchange by whipping-out your credit card or connecting your bank account to it.
The purchases must be made with other digital assets. This makes decentralized exchanges particularly appealing for those seeking greater anonymity in their transactions which is something many cryptocurrency enthusiasts crave.
Considerations for New Users
While decentralized exchanges provide benefits like complete control over assets, lower transaction fees, and access to a wider variety of cryptocurrencies than centralized exchanges, their complexity might not be suitable for beginners. In addition, decentralized exchanges can be like the wild, wild, west. Compared to centralized exchanges, decentralized exchanges house many more questionable crypto offerings. To put it bluntly, you are more likely to be scammed by cryptos on decentralized exchanges than those in centralized exchanges which are more discriminating in terms of what digital assets they allow on their platforms.