LeoGlossary: Centralized Exchange (CEX)
A centralized exchange (CEX) is an exchange that allows for the trading (or swapping) of assets yet is not decentralized. Most exchanges fit this criteria including those that handle stocks, commodities, or bonds. These, however, are rarely terms as CEX.
When something is called a centralized exchange it usually refers to one that involved cryptocurrency. The reason is because decentralized exchanges (DEX) is almost a completely crypto phenomenon.
An exchange is essentially a marketplace where buyer and sellers come together to trade. Each shows up with their own interests, some to sell their wares while others are looking to purchase. Of course, these exchanges are digital marketplaces swapping financial products.
Cryptocurrency carries the ideal of decentralization. Much of the first decade of the industry was serviced by centralized exchanges. Binance, FTX, and Coinbase are some examples of CEX that cater(ed) primarily to cryptocurrency.
One of the reasons for the popularity is the ease of use along with security. DEX, especially early on, tend to be rather technical. They also can face severe liquidity issues. CEX solved this problem by having front ends that were modeled after other exchanges. At the same time, the exchange acted as a market maker. It kept an order books, the same as the larger equity and commodity exchanges.
Another area that CEX excels is concerning keys. Many newer people were overwhelmed with the idea of private keys and having to manage them. From this mindset, CEX was able to offer a service that removed this from the equation.
This did, however, go counter to a long-standing cryptocurrency premise, not your keys, not your crypto. It was a lesson that was reaffirmed throughout 2022 as the likes of Celsius and FTX ended up going under. When putting coins or tokens on a CEX, they are instantly becoming a custodian. This introduces counterparty risk.
Security tends to be higher on a CEX. Most of these companies handle large sums of money, hence are incentivized to protect customer assets. They are constantly upgrading their security as attempted hacks are on-going.
In return for security and ease of use, the transaction fees on CEX tend to be higher than on DEX. Customers are obviously willing to accept this as an overwhelming majority of cryptocurrency trades (estimates are 95%) are on CEX.
Decentralized Exchanges (DEX)
Decentralized exchanges (DEX) are a new player in the game. These tend to be very small at the moment yet they are gaining momentum.
There are a number of different ways these can be configured. Some, such as the Internal Exchange on Hive, keep an order book similar to a CEX. The difference is the exchange is coded into the blockchain, hence no counterparty. This means the book is simply buy and sell orders from individuals, maintaining the peer-to-peer transactions.
When there is no order book, DEX often are tied to liquidity pools. They will access a swap (or series of swaps) based upon where the different coins or tokens are located. For something like Bitcoin, this is rather straightforward. It can get a bit expensive if dealing with an obscure coin.
DEX can offer market making services through the use of software. This is robotic trading through an algorithm. It is known as automated market maker.
There is great debate about what the future holds. As CEX such as FTX went under, the fallout was great. Billions of dollars was lost as people were exposed. This is ramping up calls for regulation.
Many long time cryptocurrency advocates question the need for CEX. One of the key services they provide is on and off ramps to fiat currency. This is a vulnerability the industry still has.
As efforts to step up regulation take place, it is likely Wall Street firm step in. Here is where the proponents of cryptocurrency and blockchain have a problem. They believe it is setting up the system where the financial intermediaries are in control.
The net result, under that system, is expenses go up and it becomes exclusionary. Governments prefer it since they can enforce KYC laws.
During 2022, the question of dealing with centralized entities was driven home. Many are now claiming the future is with DEX, at least for crypto-to-crypto transactions. To achieve this, the applications are going to have to be truly decentralized. Much of the industry was promoted as such yet, in the end, were run by centralized institutions.
Another factor is that open source software will be vital. If DEX are attacked, the ability to spin up new ones is vital.
Essentially, we are dealing with a game of cat-and-mouse in this debate. The determining factor will likely be how much people adopt DEX or if they still gravitate towards CEX.
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