Centralized vs Decentralized Exchanges

— explained by the CUTcoin team
One of the most attractive features of cryptocurrencies is their decentralization — the distribution of decision-making powers among network participants without a single central authority, which is why real cryptocurrencies are not centrally controlled.

However, the principles of decentralization embodied in cryptocurrencies themselves are not yet fully integrated into cryptocurrency exchanges. Most cryptocurrency trading so far takes place on centralized exchanges, not decentralized ones.
Centralized exchanges
Centralized exchanges are company-operated platforms that mediate the trading process. In exchange for providing such a service, they charge trading fees. Centralized exchanges are a gateway for newbies who want to enter the world of cryptocurrencies and who need an interface that connects them to both cryptocurrency and the traditional economy.
Since their inception, centralized exchanges have given wide audiences access to bitcoin, ether, and other cryptocurrencies, giving them a liquidity boost - so that they get noticed by the masses.
However, at the same time, there are a number of shortcomings behind centralized exchanges, due to which they have faced a lot of criticism from the crypto community:

Hackers' Attacks and Theft of Funds
Over the past 10 years, there have been more than 30 hacks of cryptocurrency exchanges, among which the most notable are Mt.Gox, BitGrail, Coincheck, etc. Attempts to steal occur every day, as hackers are still looking for ways to exploit vulnerabilities in centralized systems

Private Key Management
By purchasing cryptocurrencies from centralized exchanges, you don't actually own your digital assets, as exchanges don't give you private keys to your wallets. Your orders are simply assigned an identification number, and you do not work directly with private keys.
In addition, there is the problem of compliance with KYC requirements, which imply the submission of documents proving the identity of users. Here another risk arises - leakage of personal identification information through centralized exchanges.

Government Bans

Not all governments welcome cryptocurrencies, and some adhere to tight regulation of trading, mining, and other cryptocurrency transactions. The loudest bans and repression took place in China.

Decentralized Exchanges
There are two types of DEX. The first of which is the order book P2P exchanges, and it uses a bidding model to fulfil the trades. The second DEX type is an exchange that is based on liquidity pools. It means that they leverage automated market makers to fulfil the trades.

Order Book Decentralized Exchanges
In an order book DEX, the buying order from a trader is matched with the selling order of another trader to complete a trade. The core concept of the order book exchanges is far more suitable for centralized exchanges. A high trading volume and the centralized structure of exchanges indicate that there is high liquidity on the platform. It ensures that there is a tight spread. Hence, the crypto traders face minimal slippage while placing large orders.
An order book DEX allows a trader to submit two types of orders on its platform. These are a limit order and a market order. A user can buy a crypto token at the best available price by submitting a market order. The trade is completed on order book DEX by pairing the open orders of both the buyers and sellers. On the other hand, the open order DEX sets a specified price for a trader to purchase a set number of tokens. The most popular open book DEXs include EthFinex, IDEX, and EtherDelta.

Liquidity Pool-Based Decentralized Exchanges
The algorithm behind the liquidity-pool-based DEX is known as automated market makers. It's not a new concept as automated market makers have been known among the mechanism design and academic game theory circles. They have known about it for more than a decade. Yet, it became popular in the crypto world pretty recently.

The automated market maker DEX is different from the open book decentralized exchanges. It does not specify the prices at which the seller wants to sell a digital asset. Neither does it specify the amount at which the buyer wants to buy a digital asset. Instead, the automated market maker exchange pools crypto assets in a liquidity pool. Then, it leverages deterministic algorithms to make markets. The algorithm uses some predefined criteria to quote prices to the buyers. But each automated market maker exchange has its own algorithm. To dive deep on liquidity exchanges, let's discuss how people benefit from it. All pool-owners enter with equal shares of both currencies, like if ETH costs 1000 USDT, you can put, for example, 5000 USDT and 5 ETH in the pool. The pool always ensures that the total number of ETH is equal to the total amount of its USDT (in terms of price in USD). So when someone hits the pool with one ETH, the pool gets a little less ETH and a little more USDT. And the pool increases the price of ETH by a pretty penny. If the price goes too far from the rest of the exchanges, the arbitrageurs come and level it. If you enter the pool as a liquidity provider and right after an hour the price doubles or increases, then you lose money. This is called impermanent loss.

Currently, Uniswap is the market leader in the DEX segment. Uniswap uses the automated market maker model in its operations. It allows everyone to earn fees from the Uniswap by providing liquidity to the exchange. The fees that a user earns by providing liquidity on Uniswap is their share of earning from the trading activities on Uniswap.

Advantages and Disadvantages of Decentralized Exchanges

Most of the strengths of decentralized exchanges stem from their distributed architecture and lack of a unified control center. Here are a few key benefits:
  • a decentralized exchange does not store users' assets, therefore neither hacker attacks nor a complete collapse of the exchange itself threaten to lose funds, which radically distinguishes them from centralized exchanges that are hacked quite regularly, including such large exchanges;
  • a decentralized exchange does not have a single entry point through which all assets and data can be accessed, which complicates the work of hackers and makes the attack itself pointless;
  • there are no personal accounts on the decentralized exchange, no verification is required and no email is even required, so no one can use or steal personal data of users.

At the same time, the same architecture of decentralized exchanges and complete control of users over their own funds entails a number of difficulties:

  • many options for traders, such as stop loss (stop loss), margin trading or lending, are not available to users of most decentralized exchanges;
  • decentralized exchanges usually have a smaller pool of liquidity in comparison with centralized platforms;
  • a decentralized exchange, by definition, cannot have a support service capable of affecting transactions or user accounts;
  • since many decentralized exchanges are governed by smart contracts, cryptocurrencies that do not interact with smart contracts cannot trade on them.

The compatibility between the decentralized exchanges and the DeFi space has set DEXs at a path of hyper-growth. At the time of writing, total value locked on decentralized exchanges is more than $8B (according to DeFi Pulse, actual for Jan 22nd, 21). Various players are beginning to develop decentralized exchanges, among them — Ethereum rival Polkadot announced the launch of a new DEX last month. Also, privacy-oriented crypto projects are also interested in launching their decentralized exchanges - among examples, we can say about AtomicDEX from Komodo.

The CUTcoin team carefully monitors the state of the market and is working on various options for the DEX, the development of which we announced in our last whitepaper.