Centralized exchanges vs decentralized exchanges: Can the DEX win out?

Entry barriers keep DEX uptake low among casual users, but security fears could harm CEXs

Stacks of blue PancakeSwap tokens against black background – Photo: Shutterstock                                 
Trading pairs on PancakeSwap are multiplying like rabbits, but quality is a concern – Photo: Shutterstock

Although attempts have been made as far back as 2014, it was not until the launch of Uniswap’s V2 protocol in early 2020 that the decentralized exchange (DEX) began to make waves in the crypto sector. Non-custodial by nature, with lower trading fees and no pesky brokers in the way, to many the DEX represents the true face of cryptocurrency’s trustless philosophy.

While DEX offerings have continued to grow and multiply, their combined trading volume remains only a fraction of the total market share, which is dominated by big-hitting centralized exchange (CEX) platforms such as Biance, FTX, Coinbase and of course, Currency.com.

But is centralized supremacy here to stay, or could DEXs wedge themselves further into the mainstream? And if so, how?

With assistance from Brandon Rochon, data scientist at the blockchain data provider Covalent, Currency.com got the lowdown on the centralized versus decentralized exchange argument and what the future could hold for both.


Centralized exchange vs decentralized exchange: What’s the difference?

In broad terms, what is the difference between decentralized and centralized exchanges? It is mainly a question of trust. CEXs are trusted platforms, meaning traders must put their trust in a central body overseeing the platform’s operations. CEXs handle the majority of crypto trading activity by a considerable margin, some of the largest being Coinbase, Binance, Crypto.com, Kraken, FTX, KuCoin and Currency.com. There are hundreds more.

DEXs are trustless. This is not actually a bad thing. Rather than a singular entity at the centre of operations, DEXs function via user-generated liquidity pools; hence why they are called decentralized exchanges. Users are incentivised to contribute to these liquidity pools via staking rewards.

Screenshot of PancakeSwap interface – Source: pancakeswap.finance
A typical DEX user interface – Source: pancakeswap.finance

Historically, exchanges have acted as the market makers, holding vast reserves of tokens to facilitate swaps. But Uniswap’s game-changing automated market maker (AMM) protocol showed that decentralized liquidity was possible. Other major DEXs include PancakeSwap on BNB Chain, the stablecoin-focused Curve Finance platform and SushiSwap on Ethereum.

Centralized exchanges are considerably more user friendly, a fact which, according to Rochon, is a major roadblock hindering the growth of DEX market share. “Centralized exchanges have a very low barrier to entry. You can just come in and buy crypto with your credit card and you get to participate in the upside of crypto without having to actually learn about how to use blockchain, how to protect yourself in blockchain, all of the different elements of how to set up a hardware wallet or anything like that.”

Screenshot of CEX user interface – Source: currency.com
A typical CEX interface – Source: currency.com

Centralized exchanges tend to facilitate larger trades. “If you look at the user base of these centralized exchanges, the more prominent ones anyway, these are trades with larger sizes that require more security,” said Rochon.

Options for investors

Even though CEX “on-ramping” is easier, they usually offer more sophisticated trading options. At the interface level, CEXs emulate traditional stock exchanges, offering candlestick charts and technical indicators. Stop losses and limit orders are commonplace, as are leverage options.

On the other hand, DEXs offer ways of earning money that CEXs do not and cannot. You can provide DEXs with the liquidity they need to operate, earning passive income as a reward (usually sourced from transaction fees). Staking rewards vary from token to token. Be careful: cited annual percentage yields (APYs) do not take inflation into account. Realistically, you should expect lower returns than what is stated.

Screenshot of various staking pools and rewards on PancakeSwap – Source: pancakeswap.finance
APY rewards vary between staking pools, and are subject to inflationary pressure – Source: pancakeswap.finance

Earnings potential does not end there. DEXs also provide yield farming options for greater potential rewards. Yield farming lets you open a staking position while simultaneously entering collateralised lending and borrowing positions. this requires enhanced DeFi knowledge and comes with the risks of impermanent loss, market volatility and having your position liquidated.

CEXs provide the tools for investors looking to open larger, long-term positions against fiat as well as cryptocurrencies, while DEXs provide greater passive income options for people with an enhanced knowledge of the DeFi space.

Regulatory matters: challenges for both camps

Regulation has emerged as one of – if not the – most critical debates likely to affect the future of digital assets. The collapse of Terra Labs will only magnify the issues. While regulation affects the DEX and CEX markets alike, the specific issues are quite different.

Rochon sees regulation as the main obstacle to growth of the CEX market. As previously covered in Currency.com, the European Union has gone to great lengths in bringing centralized exchanges in line with know-your-customer (KYC) and anti-money laundering (AML) legislation. Sanctions against Russia and Belarus have been formally extended to CEXs, while the Money in Crypto-Assets (MiCA) proposals could bring in even greater oversight of how these exchanges operate.

Stablecoin regulation may be the main point of concern in the United States, but the coming US Infrastructure Investment and Jobs Act will tighten the leash on CEXs, requiring more robust KYC, AML and tax-reporting standards.

DEXs have an ambivalent approach to regulation. By design, they do not conduct know-your-customer and anti-money laundering procedures, and there is no quality control over trading pairs, leaving them more prone to shitcoin listings and scams. This could prove a double-edged sword for DEXs. Lax regulatory standards could drive some people to the market while deterring those with an appetite for regulatory oversight. However, “the data doesn't point to that being a big issue” for the DEX market, according to Rochon.

But there remains a substantial regulatory blindspot for the centralized exchanges too. As of today, customers’ assets held in CEX custody accounts are not privy to consumer protections in any major jurisdiction- not the Federal Deposit Insurance Corporation (FDIC) in the US, the Financial Consumer Agency of Canada (FCAC) in Canada, the Financial Services Compensation Scheme (FSCS) in the UK, or the various analogues across Europe.

This could prove a problem down the line. Rochon foresees a situation in which an insolvent CEX could instigate a bank run as investors withdraw their funds on a mass scale. Such an event could greatly destabilise the entire crypto market; the recent bank run on TerraUSD alone caused enormous turmoil.

“But the centralized exchanges have the ability to stop that thing, which kind of puts them between a rock and a hard place,” Rochon said. “If they want to survive, they have to stop the bank run right? But if they stop the bank run, it jeopardises the trust of the users.” During the GameStop fiasco of 2021, Robinhood did just that. The trading platform’s halting of GameStop trades sparked outrage among retail investors and the public, leading to a congressional hearing amid accusations of unfair practices.

No crypto exchange would want to suffer the reputational hit felt by Robinhood, yet Rochon believes that such a bankruptcy scenario is “inevitable”. Furthermore, the recent revelation that $256bn in user funds could be at risk if Coinbase goes under has raised questions over the security of centralized exchanges. It is a situation DEXs will never need to face; they simply do not behave in a way that makes unfair trading bans possible.

Market share: which side is winning?

Does Rochon see DEX market share outpacing centralized competition? “I would say presently, no. The majority of DEX trading is high-frequency trading, a lot of bots… If you're talking about actual people, interacting with crypto assets, you're looking at a lot more activity on the centralized exchange front.”

The buzz surrounding DeFi does not seem to be translating into greater DEX market share. “I don't think decentralized exchanges are really taking over as fast as Binance and Coinbase are growing,” Rochon said. “Centralized exchange growth is probably outpacing decentralized exchange growth, especially with Coinbase going public and Binance being regulated in a lot of different places.”

Graph of trading activity on Binance, Coinbase and Uniswap – Source: theblockcrypto.com via CoinGecko
Binance regularly handles $17bn in trades daily, far more than its competitors – Source: theblockcrypto.com via CoinGecko

The above graph supplied by The Block shows that Uniswap, by far the largest DEX, with more than 53% of market share, enjoys slightly fewer trading volumes than Coinbase, the NASDAQ-listed exchange which recently saw a decline in market share from 11.5% to 11.2%, according to its latest quarterly report. Binance dwarfs both by a significant margin.

Because of their lower standards of entry, the decentralized exchanges host a far larger number of trading pairs compared to centralized exchanges. According to Rochon, Covalent’s data shows: “PancakeSwap has almost a million different trading pairs, almost 938,000 trading pairs, whereas on Uniswap, there's about 73,000 pairs. And if you go down the line and look at Trader Joe on Avalanche, there’s only about 16,000 pairs. On Fantom there's about 21,000 pairs and on Polygon, there's about 34,000 pairs. PancakeSwap on Binance has basically 10 times the number of trading pairs than everybody else."

However, this could be a “quantity over quality” situation. Rochon sees a large amount of wash trades on PancakeSwap, facilitated by Binance’s lower gas fees. The Ethereum-based Uniswap has an observably more sophisticated user base, judging by its average trade value of $15,000.

Graph of total DEX market share against CEX market share – Source: theblockcrypto.com via CoinGecko
DEX market share kicked off in 2020 following Uniswap V2, going up and down since– Source: theblockcrypto.com via CoinGecko

Put together, data from The Block does indicate a recent increase in DEX spot trade market share in the past two quarters, though whether this short-term gain can be sustained in the long run is yet to be seen. Uniswap’s V2 launch in March 2020 did instigate a brief run on DEX market share to nearly 20%, though in general has remained below the 10% mark.

Could DEXs overtake CEXs?

The difference between centralized and decentralized exchanges is fairly clear but there are challenges facing both sides of the coin. While enterprises like the Ramp Network seek to engineer lower barriers to entry, DEXs still remain out of reach for the casual user. On the flipside, security and reputational risks remain a bugbear for the centralized exchanges.

Regulation will play a major part in the battle for market dominance going forward, depending on the path taken by the regulatory powers. Enterprise-friendly legislation could further institutionalise centralized exchanges, but overbearing regulation and even outright bans on certain digital assets could drive users further towards decentralized exchanges.

Whether DEXs can solve their prohibitive on-ramping procedures remains to be seen, but for now, it seems likely that they will remain a relatively minor part of the cryptocurrency ecosystem. 


Are centralized or decentralized exchanges better?

Each has their pros and cons. centralized exchanges prioritise larger trades, are easier to access, have more sophisticated investment options and more robust user interfaces. Decentralized exchanges have fewer regulatory barriers, provide options for passive income, and do not rely on a centralized market maker. Many investors use both. Make sure to figure out what you want in a crypto exchange before committing to one.

Are decentralized exchanges safe?

There are risks involved with using decentralized exchanges. Since anyone can list a trading pair, scams are common. You also risk liquidation and impermanent loss when staking and yield farming. If something goes wrong, DEXs have no centralized body to help you recover lost tokens.

Are centralized exchanges safe?

Using centralized exchanges comes with risks. Your funds may be lost in the event of insolvency or bankruptcy, since investor protection laws do not apply. Being centralized, your account is exposed to malicious activity in the event of a hack. 

Further reading

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