Centralized Exchanges vs Decentralized Exchanges: A Complete Guide

A centralized exchange is a custodial financial platform that offers cryptocurrency trading services. Centralized exchanges manage users’ funds. Users are required to transfer their assets to a crypto wallet owned by the exchange while the exchange provides an interface where these funds can be accessed and transacted.

Centralized exchanges are custodial trading platforms, where the central administrator controls most user activities including withdrawals, deposit crediting, and routine trading. Some popular centralized exchanges include Binance, Bybit, and Kucoin.

An Interface for Conducting Trading Activities

Centralized exchanges provide a digital platform where crypto investors can trade assets. They feature an interface that allows users to place and monitor trade requests, study market conditions, and manage their funds. 

Orderbook 

The orderbook is a record of users’ trade requests on a centralized exchange and it holds every uncompleted order. It presents the main details of an order such as the order value, the set price, and the completion status. Orders are removed from the book once completed.

User Asset Custody and Management System 

Centralized exchanges hold crypto assets on behalf of their users. They create a system that enables them to easily obtain, review, and execute users’ requests regarding their funds held on the exchange. This system handles deposits, withdrawals, internal fund transfers, and the movement of users’ funds for secondary operations like passive income programs and lending.

Customer Service Facility 

The customer service facility is a response system for users’ issues. Most centralized exchanges have a 24/7 customer support system that assists users.

Additional Financial Services and Fiat Operations 

Apart from spot and derivatives trading, centralized exchanges offer extra services like enterprise crypto financial solutions, passive income programs like crypto staking, IEOs (Initial Exchange Offerings) for new crypto projects, and crypto lending. Centralized exchanges also offer support for fiat currencies and fiat-pegged stablecoins. Using on-ramp trading exchanges, users can purchase crypto assets on centralized exchanges via their traditional financial service institutions.

Fee Structure

Centralized exchanges charge fees for services like routine trading and crypto withdrawals. Some exchanges also charge for deposits. Fees charged on centralized exchanges could be a percentage of the total amount transacted or a set amount.

Like a regular market Centralized Exchanges provide a platform for buyers and sellers to interact. The underlying technology manages the major aspects of user operations. Centralized exchanges hold users’ funds and are equipped with technologies that keep a record of user balances as they transact on the platform.

Users’ trade requests are handled by the order book. Orders are matched according to the presiding price of the asset traded. When the market conditions are right, an order is executed, otherwise, they are held in the order book.

Centralized exchanges hold administrative rights over funds held on their platform. Therefore, users are required to create a request to withdraw their funds or perform other activities, these activities are only completed if the exchange approves.

Decentralized exchanges are self-custody cryptocurrency financial service providers that allow users to maintain complete control over their assets while using the platform. They are deployed on blockchain networks and leverage blockchain primitives like smart contract technology to create a connection between user accounts and the blockchain.  

Decentralized exchanges are ‘decentralized’ in terms of their administration and the blockchain technology on which they rely. They are permissionless platforms and hence require no prior registration from users. Investors can connect to the platform using their cryptocurrency wallets and start trading available crypto assets. Popular decentralized exchanges include Uniswap, Pancakeswap, and CowSwap.

An Interface for Conducting Trading Activities 

Decentralized exchanges feature an interface through which users can perform operations like running asset swaps, adding assets to the liquidity pool, and other available activities. 

AMM Technology and Liquidity Pools

Automated Market Maker (AMM) is a self-operating protocol that handles traders’ operations on decentralized exchanges. It serves trade requests and updates the prices of assets in a pair according to their demand and availability on the liquidity pool. The liquidity pool is a collection of paired assets. Users can commit their assets to the pool and earn through trading fees.

Self-Custody and Smart Contract Technologies 

Smart contracts are pieces of code that trigger blockchain operations. Decentralized exchanges are applications on the blockchain. They use smart contracts to develop a communication path between users, their wallets, and the blockchain. DEXs use smart contracts to handle asset management and other core operations on the platform.

Fee Structure 

Decentralized exchanges also charge a fee. Fees charged on DEXs are major trading fees. Most DEXs do not charge for deposits and withdrawals since users maintain custody of their assets for the most part.

Passive Income Strategies 

Decentralized exchanges also offer passive income opportunities like liquidity farming, yield farming, and on-chain staking. Liquidity Farming programs reward users for committing their assets to the liquidity pool while staking is usually a tokenomics strategy.

How Decentralized Exchanges Work

The primary role players in a decentralized exchange are the AMM protocol, liquidity pools, smart contracts, and an Oracle data system. The AMM protocol handles the execution of trades by serving requested assets according to the presiding value and updating the prices after each trade.

For an asset to be tradable on a decentralized exchange, a liquidity pool is created (anyone can create a liquidity pool on a DEX). Holders of the assets in the pool lock equivalent values of both assets in the pool. The AMM serves requested assets through this pool.

Control and Ownership of Assets 

Centralized exchanges are permissioned, self-custody exchange platforms. A central administration presides over user activities and the exchange keeps custody of users’ assets. This is done differently on decentralized exchanges. Decentralized exchanges allow users to stay in control of their assets as they transact on the platform. They are open to general use. Anyone can enable trading for assets by creating a liquidity pool, conversely, assets go through examinations before they are listed on centralized exchanges.

Security and Risk Factors

Decentralized exchanges claim to inherit blockchain-level security since they run their operations directly on the blockchain. However, they are vulnerable to external security risks like loopholes in the smart contracts. DEXs’ user-privacy systems also adds to the security. Comparatively, centralized exchanges’ asset and use profile management systems expose them to more risks. Breaches may lead to loss of users’ assets and private information.

Liquidity and Trading Volume

Liquidity on centralized exchanges is the sum of every trade request held in the order book at any point in time. On decentralized exchanges, liquidity is the sum of assets held in the liquidity pool. The liquidity structure of centralized exchanges and the user count allow for higher liquidity and trading volume, compared to decentralized exchanges.

User Experience 

Centralized exchanges are designed like regular digital asset trading platforms. Traders who are conversant with other investment sectors can easily adjust to using a CEX. Decentralized exchanges are a younger concept, and their basis of operation could be harder to understand. However, both platforms offer a satisfactory user experience.  

Centralized exchanges are the earliest and most popular types of cryptocurrency exchanges, they offer several benefits to users, albeit with a few disadvantages, especially when compared with decentralized exchanges.

High Liquidity 

Thanks to a large user base and the free flow of trading users, centralized exchanges have relatively high liquidity. With sufficient liquidity, users can conduct their trades without running into significant slippage. Centralized exchanges handle thousands of orders through the order book.

User-friendly Interface 

Centralized exchanges feature intuitive interfaces that enable users to run their operations with ease. Each section on the platform is focused on the primary operation. Most reputable centralized exchanges apply recommended principles in their designs.

Faster Transactions 

Centralized exchanges handle thousands of transactions per second. Depending on the popularity of the exchange, thousands of users can run concurrent trading requests at the same time across different pairs.

Efficient Connection with TradFi 

Centralized exchanges present a gateway to traditional finance for cryptocurrency investors. On-ramp crypto trading services enable users to purchase crypto assets using their fiat currencies and via mainstream finance institutions. Several exchanges also offer P2P fiat-to-crypto trading services.

Risk of Hacking 

Centralized exchanges suffer hacks regularly. Between 2022 and 2023, over $5 billion was lost to hacks on centralized exchanges. Due to the practice of holding users’ assets on a single wallet, centralized exchanges easily run into grave losses when hacked. Users run a risk of losing the whole or a part of their funds held on the platform.

Custody of Assets 

Centralized exchanges hold the user’s assets on the platform. Users only trade with a representation of their balances. Exchanges have been implicated in the mismanagement of users’ funds in several cases. Users will require the exchange’s approval to move their funds from the platform. Technically, users on centralized exchanges do not own their assets on the platform.

Regulatory Oversight 

Centralized exchanges are easy targets of regulatory crackdowns. Centralized government affects regulatory provisions on centralized exchanges. In case of a default, they are subjected to penalties which might have negative effects on their users.

Users Retain Asset Control 

When using a decentralized exchange, users’ funds are held in their wallets and only transacted upon their approval. The transaction is handled by decentralized protocols, so no central administrator has access to users’ assets. Users are in true custody of their assets on decentralized exchanges.

Greater Privacy 

Decentralized exchanges do not require the rigorous registration process seen on centralized exchanges. Users only need to connect their wallets to the platform. Decentralized exchanges do not store users’ information. User privacy is therefore maintained while they use the platform.

Reduced Risk of Hacking 

Decentralized exchanges are deployed on the blockchain and use decentralized protocols. The exchange does not hold users’ funds. Assets in the liquidity pool are held on smart contracts. While decentralized exchanges are not immune to technical exploitations, they have a reduced risk of hacking and fewer losses.

Lower Liquidity 

Decentralized exchanges have low liquidity as users’ trade requests are served from assets held in the pool. The pool structure is markedly different from order books where requests are arranged according to parameters like set prices. Low liquidity on decentralized exchanges leads to significant slippage for traders.

Slower Transactions 

Trades on decentralized exchange go through the blockchain directly. Traders are also required to approve the asset for use on the exchange and confirm each transaction. These transactions go through blockchain verification. As a result, regular transactions on decentralized exchanges take time. Depending on the blockchain’s throughput, DEX transactions can be very slow and costly.

Complex User Experience 

Using a DEX could be overwhelming for traders, this is because of the overall structure of decentralized exchanges. The heavy use of advanced blockchain primitives reduces the ease of use. Users who are not conversant with blockchain-level operations might struggle while using DEXs.

Centralized exchanges work better for investors who wish to freely trade assets from several blockchains at the same time. Centralized exchanges also save on-chain fees for traders. Where the focus is not on security and asset custody, centralized exchanges are more efficient for routine traders who seek an efficient platform to trade cryptocurrencies. However, if security and privacy are paramount, decentralized exchanges are the best trading platforms to use.

Our CoinHint analysts project that while centralized and decentralized exchanges currently dominate, hybrid exchanges will grow in relevance in the future. Decentralized exchanges are also exploring improvement in UX through technologies like blockchain abstraction. Meanwhile, exchanges will also strive to scale to the growing demand and user base.

Cryptocurrency exchanges open the crypto space to investors all over the world. They are a macro design for P2P crypto trading and are evolving into giant finance platforms. In this article, we discussed the two major types of cryptocurrency exchanges. Note the strengths and weaknesses of both types of exchanges and how they apply to your trading activities. As always, consider the security of your assets while choosing an exchange.