Centralized Exchanges (CEXS) and centralized digital asset trading vs Decentralized Exchanges (DEXs) and decentralized digital asset trading. The question that many are asking is: which model is the winner?
Whilst CEXs have paved the way for initial crypto adoption and trading, the use of DEXs, which are natively based on a blockchain and enable peer-to-peer crypto exchange, is increasing. Both CEXs and DEXs have their own pros and cons, the question is- what do we need in a rapidly developing Web3 economy? What model can serve the purpose best the needs of the digital World?
The Key Differences between CEXs and DEXs
Centralized exchanges are for-profit centralized organizations that run on their own servers and have orderbooks to facilitate the trading of digital assets. They provide user-friendly interfaces, fast trading experience, comprehensive functionalities such as limit order and leverage trading, and sometimes they are a gateway from fiat currencies to the crypto World. Centralized Exchanges are usually regulated- a user has to pass the KYC/AML procedures to be able to onboard. When conducting transactions on a CEX, a user is in its hands as the exchange controls the private keys of the cryptos and the ability to trade, deposit, and withdraw the assets.
Decentralized Exchanges are built on a blockchain and enable the permissionless, peer-to-peer exchange of crypto assets. The use of DEXs began not such a long time ago and has increased with the explosion of the Decentralized Finance- DeFi. In contrast to CEXs, when using a DEX a user is always in control of his funds as he simply interacts with it using a Web3 wallet such as Metamask. However, DEXs might not appear to have such a user-friendly interface and can be challenging to understand for an average user- DEXs are commonly used for experienced DeFi crypto users.
In addition, the current versions of DEXs lack comprehensive trading features such as limit order and leverage trading, which restricts the options to the users. Furthermore, the DEXs of today are based on Automated Market Makers (AMMs), meaning that the buy and sell orders are matched by smart contracts, which sometimes results in a so-called slippage.
Diving into the Digital Financial Economy
Both CEXs and DEXs cater to the needs of the market in their own ways; the question is- what model opens up more opportunities in the future Web3- powered digital financial and economic World?
Having financial freedom, financial inclusion, and the digital economy in mind, we have to consider what is important to achieve these goals. With this vision, we need to think about what systems and protocols we need to interact smoothly with the elements of the digital financial economy.
When we talk about digital assets today, we refer to the ecosystem of cryptocurrencies, Ethereum based tokens, and stablecoins such as USDC. However, looking into the future, we face digital money that comprises government-backed digital currencies: digital Yuan, digital Dollar, Euro, and others. It remains to be seen what role the current cryptocurrencies and stablecoins will play in this World and how these means of exchanging value will interact with each other.
Digital Gold vs the Tools for Daily Transactions
If we look from a broader perspective and the current global monetary policy, the current issuance of the fiat currency-US Dollars, Euros- is highly inflationary. Never in history, there was so much new money that has been issued to the market. Whilst this has been necessary for stimulating the global economy, let’s remember the basic economic concept- what increases in supply, usually reduces in value. This is why gold has been traditionally so valuable- it is scarce and people have used it as a store of value and to protect their purchasing power.
In the digital world with digital transactions, we need a ‘digital gold’, or several digital golds. In other words, we need an asset-protectionary store of value in a digital form. Many call Bitcoin the ‘digital gold’- as it has a limited supply with only 21 million Bitcoins ever be issued, making it so-called ‘sound money’. Whilst Bitcoin has traditionally been the king of cryptos, Ethereum is shifting its monetary policy and as of July 2021, and there will be an ever-decreasing supply of ETH, making it ‘ultrasound money’.
Today, observing what there is in the market, we can speculate that Bitcoin and Ethereum have the potential to be the equivalents of digital gold. In addition, Ethereum has proven that it can operate as an economic bandwidth, supporting the transactions of the digital economy.
When digital government-backed money experiences mainstream adoption, let’s hypothesize what interaction it might have with the digital gold- BTC, ETH, and the crypto stablecoins like USDC.
Could USDC become a means of payment in daily transactions and also serve as a getaway for government-backed digital currencies? In the meantime, people hoard BTC and ETH for the store of value.
Recently, VISA has announced that it will become the first major payments network to use a stablecoin-USDC- to settle transactions. VISA has said that it will ‘help evaluate fundamentally new business models without the need for traditional fiat in their treasury and settlement workflows’. It has also stated that it will be able to ‘directly support the new central bank digital currencies (CBDCs) as they emerge in the future’.
Transacting between Ultrasound Money and Fiat Equivalents
To continue the hypothesis that store of value is held in BTC and ETH whilst daily transactions are settled in fiat equivalents such as stablecoins and CBDCs- how do we enable a smooth interaction between these assets? What we need is a quick exchange of assets in a seamless and frictionless manner, whilst enabling maximum security and control of the funds by the user.
The vision- a user makes the asset exchange transactions while holding digital funds without the need to transfer them to a centralized company/ financial institution. The user simply receives the needed assets in his/her digital wallet. Such service is available for everyone and no one can interfere with the transaction.
This is in line with the previously stated goals of financial inclusion and financial freedom, and this is precisely what decentralized exchange trading should be able to provide. For a well-functioning digital financial economy, we need a smooth, permissionless system that enables digital transactions.
Some sort of centralization is likely to be implemented to interact with the decentralized systems, to ensure a smooth, efficient, and cost-optimal model for the users.
The crypto ecosystem, centralized, and the first version of decentralized exchanges set a great start to the adoption of crypto and digital currencies. We have observed outstanding developments and innovations which are set to transform our economic and financial World.
Today, we have efficiently running centralized exchanges that have enabled the initial onboarding of customers from fiat to the crypto World. The decentralized exchanges and decentralized trading have taken the concept of the permissionless economy to its true core and started enabling the exchange of financial assets peer-to-peer.
Right now, the explosion of Decentralized Finance and decentralized applications have shown that the rapid development of this ecosystem requires an upgrade to enable a smooth interaction between the digital financial assets. While CEXs have paved the way with their efficient centralized model, the current version of DEXs is only the tip of the iceberg of what decentralized trading can achieve.
It will be beneficial for the market when we have DEXs that are as fast as the CEXs. Furthermore, the future DEXs need to be experienced in scalability, have efficient transaction processing speed, and comprehensive trading functionalities such as limit order trading. The zk proof technology, which is a cryptographic way to ensure transaction validation, is paving the way for great innovations within the DEX area and teams are working on producing models that can be used for the efficient scalability of transactions.
All of those who are part of the crypto ecosystem today as a user or as a builder are experiencing great times of innovation. The explosion of decentralized finance and developments in the crypto market show that the time is ripe for change and the adoption of new, more sophisticated, and efficient models, that will enable us to transact smoothly.
About the Author
Agne K is part of the team that is building DeGate– an Ethereum Layer- 2 Decentralized Exchange. DeGate L2 DEX will implement scalability using optimistic and zk rollups and operate an efficient L1–L2 Asset Bridge. The DEX will offer comprehensive features such as limit order trading, and fiat on/ off ramps. DeGate seeks to be a comprehensive DEX and liquidity pool on Ethereum Layer 2, offering a user-friendly experience and aiming to bring decentralized trading mainstream. More about DeGate