There are two types of crypto exchanges – centralized and decentralized. Centralized exchanges are the ones you’re familiar with such as Binance, while decentralized exchanges only came into existence recently.
You don’t know the difference? No problem. This guide explains the two types of exchanges, how they work, and the key differences between the two.
If you’re keen on investing in the crypto space, it is important that you learn this differences because they have serious implications.
The type of exchange you use can impact the security and other outcomes of your investment. Without any further waste of time, let’s get into it.
What is a Centralized Exchange?
A centralized exchange is an online platform that allows users to buy and sell cryptocurrencies securely.
They are the most common type of crypto exchanges, and are the most commonly used platforms for trading cryptocurrencies.
They are preferred to as centralized exchanges because they have a middleman that facilitates transactions.
Just like in a bank, users trust the middleman to coordinate the affairs of the exchange. The exchange connects sellers with buyers in a complex manner and ensures that there is no cheating.
Centralized exchanges don’t only facilitate trades, but they also keep your digital assets safe using an exchange wallet.
They use order books, which are the list of buy and sell orders and the prices at which they are executed at any given time.
What is a Decentralized Exchange?
Decentralized exchanges are the opposite of centralized exchanges. They do not have a middleman to coordinate trading activities. Instead, everyone can just pick a trading pair and trade independently.
Unlike a centralized exchange, a DEX allows pair-to-pair (P2P) trading of assets directly between users from their wallets rather than using custodial wallets.
The transactions are controlled by a smart contract which sets the conditions that must be met for a transaction to be completed.
The user of a decentralized exchange is fully responsible for the security of their wallet and are responsible if anything goes wrong such as when they send funds to the wrong wallet address or they lose their private keys.
Any decentralized exchange is either an Automated market maker, Order book DEX or a DEX aggregator.
Automated market makers (AMM) use information from different platforms to determine the best price for an asset.
This kind of exchanges use liquidity pools that reward liquidity providers and let traders execute trades in a permissionless way.
Order book DEXs operate in a manner similar to centralized exchanges. They compile all open orders to buy and sell assets for specific asset pairs.
They’re further categorized as on-chain order book and off-chain order book DEXs.
The first hold order book information on-chain while the second hold order book information off-chain. In both cases, funds are in the user’s personal wallet.
DEX aggregators aggregate liquidity from several decentralized exchange platforms.
They are good for avoiding slippage on large orders, optimizing swap fees and letting traders buy or sell assets at the best possible price.
Some DEX aggregators even use liquidity information from centralized exchanges to further improve their user experience.
Which is Better?
There is no better or worse option between centralized and decentralized exchanges.
Which one you use depends on the asset you wish to trade and which one you’re more comfortable with.
If you wish to trade a DeFi cryptocurrency that is only available on DEXs, you must use a DEX. There are also assets that are only available on centralized exchanges.
There are DeFi tokens that also trade on centralized exchanges though, in which case you’ll need to decide which type of exchange to use.
Generally, DEXs are more messy to deal with – the connecting of wallets to the platform, the search for pairs and authorizing payments, it can all get very confusing.
Ultimately though, it is up to you and you can choose whichever works best for you.