After the recent controversy surrounding the popular centralized exchange FTX, the contagion has spread to other centralized exchanges (CEXs). With unprecedented scrutiny towards centralized exchanges and fear and uncertainty draining confidence from CEXs, there has been a mass exodus of users to decentralized crypto exchanges.
DEXs are seen as more transparent, secure, and trustworthy than centralized exchanges since they are self-custodial, allowing users to have sole custody of their cryptographic keys and funds. But is this love for DEXs only temporary or are they ready to go mainstream?
CEX vs DEX, what’s the difference?
Centralized exchange (CEX): A centralized exchange is a marketplace that uses a third party to facilitate transactions between crypto buyers and sellers. CEXs are similar to using a trading platform for stocks like TD Ameritrade. CEXs often go against the spirit of web3 technology, but there are many advantages to using a centralized exchange, which is why they are so popular.
There are two types of centralized exchanges: custodial and non-custodial: Custodial exchanges have a copy of the user’s private keys which allows them access to user wallets. The only advantage is in case the user misplaces their private key, they can easily recover access to their wallets. Non-custodial exchanges through their peer-to-peer network, serve to match buyers and sellers and do not have any access to users’ keys.
Decentralized exchange (DEX): A DEX is a type of cryptocurrency crypto exchange that connects users with each other in a decentralized manner. And do not hold the user’s private keys. As the name implies, this type of exchange doesn’t have a central server that users can connect to. Instead, users communicate directly with each other through a peer-to-peer network and transact without leveraging any middlemen. They are not subject to the same level of regulation as CEXs, and there is less chance of customer funds being accessed, misused, or stolen.
CEX or DEX: what’s better?
Let’s look at the advantages and challenges facing both decentralized and centralized exchanges and see whether DEXs are a viable option for the average crypto trader.
While CEXs offer user-friendly interfaces, similar to traditional trading platforms, making it easier and more convenient for investors for users to buy and sell Bitcoin and other digital assets within seconds, most decentralized exchanges are still in their infancy and lack the same level of user-friendliness and support. This can be a significant barrier to entry for mainstream users who are not familiar with cryptocurrency trading.
CEXs accept fiat currencies and offer high-frequency and volume trading, making them better suited for crypto trading. A few of the most popular centralized exchanges also offer futures markets and options, enabling traders to take short-term or long-term positions in certain assets, and traders are assured that the contract will automatically be settled.
DEXs are based on their respective blockchains, so traders must have crypto in a compatible wallet to interact with a DEX. Although DEXs complete transactions more quickly and cheaply than their centralized exchanges, they are very fragmented and have issues with speed and interoperability. Some more advanced DEXs do offer flexibility by allowing users to create their own markets and trade the assets they define.
Liquidity is how quickly crypto can be converted and exchanged for fiat and vice versa. A highly liquid market has a lot of active buyers and sellers. CEXs have been around for a longer time and have a more extensive user base and higher liquidity than DEXs. Due to their relatively small size, most DEXs need help attracting the same level of trading volume as their centralized counterparts. This lack of liquidity can make finding buyers or sellers for certain assets challenging, leading to wider spreads and higher transaction costs.
CEXs must comply with regulations in different geographic jurisdictions to offer legal trading services. They require user verification via KYC/AML and collect user data. But in the event of a security breach, CEX users are locked out of their accounts until the security breach is investigated.
Decentralized exchanges are open to users in all jurisdictions as they are not regulated. They provide complete anonymity for traders as in most cases, they do not require any KYC identity checks and AML compliance procedures. Since DEXs utilize decentralized servers hosted on different nodes, users do not experience service outages, as the failure of one node does not affect the entire network. But DEXs are a massive challenge for market regulators as their status is ambiguous due to their feature of anonymity, which contradicts the legal requirements of other financial exchanges, and most countries are yet to develop regulations for such platforms. The biggest challenge is that since DEXs are not operated or controlled by a legal entity or person, no one is directly responsible when violations occur.
Security & transparency
This year, a large number of investors had their funds wiped out when multiple centralized crypto companies such as FTX, Celsius, Voyager, and BlockFi all declared bankruptcy. Investors learned a costly lesson: centralized crypto exchanges do not operate with the same level of transparency as decentralized crypto exchanges.
Most centralized exchanges are notorious for being hacked. With the significant holdings of funds, these exchanges become a honeypot for hackers, and how well they secure the user’s private keys determines if the exchange servers can be breached. Registering for an account on a centralized exchange requires providing personal data and complying with the government’s KYC and AML regulations. This means that the exchanges have to manage the user’s cryptographic keys, which give them access to user data and their assets. According to Chainalysis, $3 Billion in digital assets have already been stolen this year. This includes 2 Million BNB, worth $586 million, stolen from the Binance Smart Chain, from Binance, the biggest CEX in the world. Still, few centralized exchanges like Binance and Coinbase insure users’ funds (SAFU or Secure Asset Fund for Users) to compensate them in case of a breach. But unfortunately, the majority of CEXs remain uninsured.
Another downside to centralized exchanges is that users do not have full control of their funds. Like in the case of FTXs, the terms of service stated that users alone have access to the fund, yet that was not the case.
According to their TOS, section 8.2 states,
“You control the Digital Assets held in your Account,”
“Title to your Digital Assets shall at all times remain with you and shall not transfer to FTX Trading.”
“None of the Digital Assets in your Account are the property of, or shall or may be loaned to, FTX Trading; FTX Trading does not represent or treat Digital Assets in User’s Accounts as belonging to FTX Trading.”
For that reason alone, using a DEX or self-custodial solution wallet to trade crypto is better. Decentralized crypto exchanges are non-custodial, users have full control of their wallet’s private keys and their funds. Transactions on a DEX occur directly between two parties, meaning there is no middleman between the user and a trading partner. This can mean lower fees for customers and more efficient transactions for traders. In addition, since there’s no single point of failure, a glitch on the part of the exchange would not lead to funds being compromised. Since a DEX doesn’t have a central server, all transactions take place in the open and can be viewed by anyone with access to the network. Even if the server is hacked, it will not lead to the loss of customer data since all the information is stored locally on the customer’s device.
Although users are entirely in control of their private keys and their funds, DEXs are not shielded from security risks, and unlike CEXs, there is no insurance for recovery if funds are stolen. Over the past few years, the worrying spate of high-profile hacks has posed a significant threat to the Defi platform’s emergence as a viable alternative to traditional financial institutions. The latest Chainalysis 2022 Crime Report indicate that hackers are increasingly targeting DeFi-related protocols.
Millions of crypto funds have been siphoned off due to exploitable bugs in publicly available smart contract codes exploited by hackers.
One of the biggest smart contract hacks this year was Ronin, a cross-chain bridge used by the popular NFT game Axie Infinity, where the attackers found a critical vulnerability in Ronin’s smart contract code, compromised the private keys used to validate transactions on the network, and allowed fake withdrawals of over $600 Million in crypto.
A month earlier, hackers exploited the smart contract in Wormhole bridge, facilitating the interoperability between the Ethereum and Solana blockchains, and diverted $320 million worth of ETH to their crypto wallets.
Flash loan attack, another exploit mechanism on Dexs, is when attackers borrow a lot of crypto funds that don’t require collateral and then manipulate the price of that crypto asset on one exchange and quickly resell it on another. The process is quick, and the attacker can profit significantly by repeating the process multiple times and leaving without a trace. Recently, Polygon’s Quickswap was a victim of this type of attack.
Another problem is that in DEX, the mining pool or miners can obtain previews of transactions when confirming and validating them on decentralized exchanges. These previews can result in miners manipulating the market for their gains.
The Future is DEX
In conclusion, despite the numerous challenges, decentralized crypto exchanges have potential, and in time, wil eventually go mainstream. With the continued development of new technologies, it is likely that DEXs will become more user-friendly and liquid, helping to make them a more viable option for mainstream users.