Crypto Exchanges Explained
A comparison between centralized and decentralized approaches
The Token economy and decentralized technologies are booming. Market capitalizations and trading volumes grow continuously. Increasing adoption by individuals, corporations and governments especially fuel the growth of exchanges.
Thanks to blockchain-based business models, we are moving towards a trustless economy with no need for third parties. Yet, exchanges for digital currencies are still dominated by centralized models. In a fundamental sense, centralized exchanges (CEX) are what decentralized models intended to abolish. Based on this thought, more and more decentralized exchanges (DEX) with novel approaches appear in the token economy. This article aims to explain the differences between CEXs and DEXs by comparing their concepts on the basis of the following aspects:
- Trust
- Anonymity
- Scalability
- Order Book
- Liquidity
- Fees
1. Trust
Trust refers to the level of autonomy traders have when issuing transactions. In Finance, you talk about Escrow Services as trusted third-party intermediaries to execute a trade. An Escrow Service is a legal concept where a financial instrument or an asset is held by a third party on behalf of two other parties that are in the process of completing a transaction. Trusted intermediaries are at the very core of the traditional financial service industry. Decentralization can be achieved by enabling direct trade between counterparties.
Centralized Exchanges (CEX): Based on Trust in an intermediary
The concept of a centralized exchange is equivalent to a traditional stock exchange. The architecture is based on the concept that one entity manages closed liquidity pools holding large amounts of tokens and fiat currency. Access to these pools requires an interface and a wallet provided by the exchange. Users of these platforms need to create an account, go through a KYC process and deposit some form of fiat currency they can then trade or withdraw. Assets are always held in the exchange, thus it requires trust by the user.
This trust can be asserted through aspects like the company’s location in a certain jurisdiction and its compliance with government regulations. Nevertheless, many CEXs have failed to adequately secure their customers’ funds. The use of cold wallets (a wallet which is not connected to the internet) became an alternative approach but not all exchanges employ it.
Decentralized Exchanges (DEX): Trustless
The non-custodial concept of a decentralized exchange is based on a trading interface and a smart contract to facilitate trading. Users directly trade from their personal wallet. As long as private keys are maintained, assets can always be obtained from the blockchain even if the platform stops running. Thus, users remain in control over their funds while trading on these platforms.
The concept of hybrid DEXs adds a centralized element to a decentralized exchange. Users still trade directly from their wallet but tokens are first deposited into a smart contract wallet before the transfer is made into the personal wallet. This results in the fact that the order book is controlled by an entity (a third party) thus making it not completely decentralized.
2. Anonymity
If an exchange holds a consumers’ FIAT, it is legally required to carry out KYC (Know Your Customer) and AML (Anti Money Laundering) processes. Depending on the amount of FIAT users want to trade, exchanges will request different degrees of authentications such as scanned passports or government-issued IDs. Regulators value this information as it gives them a tool to prevent tax evasion.
CEX: Authentication required
Many exchanges allow users to open an account without an identity check, but those accounts will have relatively small withdrawal/ deposit limits. For higher limits, users are required to go through a KYC process. The level of KYC depends on the amount of FIAT you want to trade on the exchange as well as the country of residence. Due to the large number of documents which have to be reviewed, verification sometimes takes days to weeks.
DEX: Choice between anonymous and authenticated
Decentralized exchanges usually do not require authentication. The only requisite to trading is owning a hardware wallet or a web wallet. In other words, anyone can trade without logging in or creating a profile. No profile means no social security number or government-issued ID photo that can be stolen. Some hybrid DEXs (e.g. Next.Exchange) offer an additional FIAT transaction option which requires a KYC process.
3. Scalability
Scalability relates to the ability of an exchange to handle new influx of traders on their platform. If systems cannot handle growth, this means possible system failures and the attention of hackers. Exchanges must grow as user bases expand, even if that growth rate is higher than expected.
CEX: Limited
Employing a central order book and local wallets come with limitations since exchanges can only handle as many actions as their system is built for. A clear demonstration of this point can be found in several cases of CEX interruptions. Just recently, Kraken gave a seven hour notice before upgrading their system. What should have taken 2 hours resulted in a 3-day period where the site was unavailable and people were losing money in a bear market.
DEX: In theory unlimited
A fully decentralized on-chain handling of exchange activity is limited in its scaling possibilities. As a result, several DEXs use an off-chain order book which introduces another form of centralization. With increasing scalability of blockchains, scalability of DEXs in theory are unlimited. However, currently there is a fundamental tension between scale and decentralization with no solution in prospect.
4. Order Book
An order book is the list of orders that an exchange uses to record the interest of buyers and sellers in a particular asset or utility token. Orders are executed when prices match and the market price is determined. There are different approaches to order books employed. Orders can be processed on-chain (on the blockchain), off-chain (off the Blockchain) or through an IOU (I Owe You) system. Transaction speed is directly connected to the type of order book an exchange uses. There is a significant speed difference between hosting interactions on the blockchain or off the blockchain.
CEX: Off-Chain through IOU
CEXs usually employ IOU systems. Here, users do not possess cryptocurrencies but promises to receive these currencies when withdrawing funds. Coins do not get sent to the customer. If the are purchased from a non-exchange seller, they are transferred into the exchange’s own wallet and are held there. A ledger entry is made, and the customer gets the IOU. If the seller is on the same exchange platform, no coins need to be shifted. The exchange simply notes the transfer of coins through swapping its native accounts. When trading different currencies on a CEX, you are actually only trading a representation of them. This system requires a high amount of trust to be put into third parties and is far from ideal. Just like any other financial IOU, it can be subject to default if the exchange crashes or is hacked.
DEX: On-Chain and Off-Chain
Decentralized exchanges are dependent on protocols in terms of speed, costs and the range of tokens they can offer. A protocol is a set of rules and guidelines for communicating data — in this case it is about communicating buying and selling intentions.
Since there is no central matchmaker in a DEX, transactions always depend on an underlying protocol. There are two main approaches: (1) The DEX maintains an on-chain order book where the trading of tokens is facilitated by smart contracts. In this case, transaction speed depends on a Blockchains’ network congestion which can be slow. (2) The DEX maintains an off-chainorder book and facilitates transactions through an on-chain trading protocol which is meant to be faster. The range of cryptocurrencies offered is defined by the underlying protocol.
DEX are employing peer-to-peer marketplaces to differing degrees. Following is a simplified summary of these differing degrees:
On-chain order book: Forkdelta, Idex
Forkdelta hosts its order book on-chain, resulting in significantly slower transaction settlement due to limited blockchain capacities. Hosting, modifying or cancelling an order on the Ethereum blockchain will cost gas. Some say on-chain exchanges are broken by default. Miners and pool operators are able to extract value from the exchanges’ ecosystem by manipulating the order and outcome of the underlying transaction.
On-chain peer-to-peer: Kyber Network
Kyber Network does not hold consumer funds in escrow nor does it keep a global order book. Its system fetches the best conversion offered amongst all of its externally-managed reserves and executes atomic transactions. These allow for different cryptocurrencies to be exchanged off the blockchain.
Off-chain order book: Radar Relay using the 0x protocol, Next.Exchange
Radar Relay facilitates instant off-chain order relays (a form of off-chain order book) and settles transactions on-chain. Relayers like Radar Relay merely facilitate signaling between market participants by hosting and propagating an order book that consists of generic messages. They recommend a best available price to takers who must then independently decide to sign and send the transaction to the blockchain. The reason for the dichotomy between order and settlements in the 0x protocol is due to the desire to cut down on ether gas fees and make decentralized exchange transactions more efficient. All non-settlement activities are essentially handled outside of the blockchain with the actual value exchange activity occurring on the blockchain.
Off-chain peer-to-peer: Airswap
AirSwap is attempting to streamline the process of finding a counterparty and negotiate a trade by offering the services of an indexer and a price oracle. An Indexer maintains a list of market participants that are interested in finding a counterparty and initiates a connection between two parties that are deemed to be a good match. Atomic swaps are the way to facilitate peer to peer trades in a completely trustless way. There’s no need for any kind of third-party, centralized infrastructure to make these swaps work.
5. Liquidity
Like in equity trading, liquidity is a distinguishing feature of crypto markets. It refers to the extent to which a market allows assets to be bought and sold at stable prices. Lower liquidity tends to result in a more volatile market (especially when large orders are placed). But generally speaking, assets with less liquidity (real estate, private equity, gold etc…) appreciate in value faster than more liquid assets (cash, stocks etc…) due to the imposed limits on interchangeability of the asset itself. Higher liquidity creates a less volatile market in the short term.
CEX: High liquidity
As the majority of crypto traders still use centralized exchanges, that is where the most liquidity lies. At the same time, CEXs like Kraken also make use of dark pools. These allow for liquidity to be hidden from sight. Hidden trades in large volumes on crypto assets in the market can have a significant impact on the price.
DEX: At the moment relatively low — could become high in the future
The main challenge for decentralized exchanges is to provide sufficient liquidity for a cryptocurrency to reduce volatility. In general, DEXs provide lower liquidity than centralized exchanges due to lower user adoption. Additionally, there are many providers fragmenting the market. However, several protocols are addressing this issue. With the 0x protocol for example, different DEXs share a liquidity pool. This so called networked liquidity allows for the same kind of aggregation of centralized exchanges, while remaining decentralized. Here you can track the network volume of the 0x network.
6. Fees
The last aspect when it comes to crypto exchanges is their fee structure and profit distribution. Fees can be split into listing and consumer fees. Listing fees refer to the amount of money a company needs to pay to get their token listed. Consumer fees refer to the price makers and takers have to pay for a transaction.
CEX: High fees
The market in the CEXs sphere recently overheated because of a high demand for token listings. Based on the in comparison small number of “trustworthy” exchanges, CEX are able to charge listing fees of up to 1 million USD. A listing in one of the major exchanges can certainly have a positive effect on daily trading volume. However, it is questionable for projects in the sphere of decentralization to pay excessive sums for listings with these major players.
On the consumer side, the major CEXs charge trading fees of up to 0.5% for makers and takers. On top, they sometimes require users to pay fees for deposits and withdrawals from their exchange accounts. The top 10 exchanges are making as much as 3 million USD in revenue a day in feesbased on calculations from publicly available data and trading fees.
DEX: Low fees, sometimes in tokens
Decentralized exchanges have different approaches to fees. Most DEXs charge no or relatively low listing fees. They decide which tokens will be integrated into their platform by means of qualitative examination. In theory, every token can be traded on DEXs since some exchanges like Forkdelta offer unofficial trading. However, in the long run DEXs with qualitative entry barriers will be the norm.
On the consumer side, users always need to pay gas fees on DEXs. Depending on the business model, some also charge a fee on top. Some require you to pay the fee in an exchange related token. However, a lot of DEXs currently have no or reduced fees for their market introduction.
The right approach?
In the end, there is no “right” approach when it comes to crypto exchanges. The choice for an exchange will always depend on balancing pros and contras. However, cryptocurrencies cannot achieve their ideological purpose of decentralization without decentralizing its infrastructure, too. The DEX approach is fundamentally embedded with what decentralized platforms like wysker want to achieve. To keep up with the intention of eliminating intermediaries, DEXs will have to establish as the norm.
Source: https://www.tokendesk.io/crypto-exchanges-explained/
