How do Cryptocurrency Exchanges Work?

When looking to exchange and trade crypto assets, you will come across the options of centralized or decentralized exchanges.

Centralized Exchanges (CEX)

Centralized cryptocurrency exchanges otherwise known as CEX are intermediaries between a buyer and a seller of crypto assets. These CEXes commonly make money through commissions and transaction fees. Think of a CEX similar to a stock exchange, but for digital assets.

CEXes operate using an orderbook system, meaning that buy and sell orders are listed and sorted by the intended buy or sell price. The internal matching engine of the exchange will then match buyers and sellers based on the best executable price given the desired lot size. Naturally, the price of a digital asset such as Bitcoin will depend on the supply and demand for it in a free market, whether that be against a fiat currency such as the Malaysian Ringgit (BTC/MYR) or another crypto asset (BTC/ETH).

Advantages of CEX

• User-friendly

CEXes offer newcomers a familiar and friendly way of trading and investing in crypto assets. This is in contrast to peer-to-peer decentralized crypto trading which requires an added level of knowledge for execution. CEXes are also an all-in-one platform where you can view balances, trading history, performance, and so on at once. This differs in a decentralized environment where multiple applications are commonly required for operation.

• Reliable

CEXes offer an extra layer of security and reliability when it comes to investing and trading. By executing trades through a centralized platform, any error in process could be subject to review by the according support personnel.

Disadvantages of CEX

• Transaction fees

Unlike DEXs and peer-to-peer platforms, CEXes often charge higher transaction fees for their services. This becomes a significant factor when trading high volumes.

• Custody of Assets

When trading on CEXes, the exchange will hold your digital assets as a custodian in their internal digital wallets. You lose custody to your assets and put trust in the exchange to ensure fair and secure management. Though enabling convenience, you expose yourself to risks, namely an occurrence of a fraudulent and illicit exchange.

Decentralized Exchange (DEX)

A decentralized exchange (DEX) is another type of exchange that enables peer-to-peer (P2P) transactions directly from your sovereign crypto wallet. This eliminates the need for an intermediary. DEXs operate with the help of smart contracts, self-executing code on the blockchain. These smart contracts allow for added privacy and typically lower transaction costs.

In other words, DEXs are by design, governed by code and the blockchain. The elimination of an intermediary also means you as a user are left on your own. DEXs have a much steeper learning curve and are suited for sophisticated investors as damages are likely irreversible.

Advantages of DEX

• Custody

Users of decentralized exchanges do not need to transfer their assets to a third party. Therefore, there is no risk of a company or organization being hacked, and users are assured of greater safety from hacking, failure, fraud, or theft.

• Less Censorship

Decentralized exchanges do not require customers to fill out know-your-customer (KYC) forms, offering privacy and anonymity to users. Since DEXs don’t exercise censorship, more cryptocurrencies and digital assets are available than through a CEX. As a matter of fact, many Altcoins are only available on DEXs.

Disadvantages of DEX

• Complexity

Users of decentralized exchanges must remember the keys and passwords to their crypto wallets, or their assets are lost forever and cannot be recovered. They require the user to learn and get familiar with the platform and the process, unlike centralized exchanges, which offer a more convenient and user-friendly process.

• Liquidity

The large majority of crypto transactions are facilitated by CEXes, which suggests that they are accountable for the majority of the trading volume. Due to the lack of volume, DEXes often lack liquidity, and it can be difficult to find buyers and sellers when trading volumes are low leading to unfilled orders, larger slippage, and more.