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The evolution of exchanges: from traditional to CEX and DEX

The evolution of exchanges: from traditional to CEX and DEX

Explainers DeFi

29 Jun 2021

In the modern trading environment, we can make a distinction between centralized and decentralized exchanges. The differentiation between the two types of exchanges is a totally new concept, pioneered by cryptocurrency trading.

But before we dig in to the difference between the two types of crypto exchanges, let’s take a quick tour around a traditional exchange so that we can truly appreciate the evolution of the way we trade assets.

How traditional exchanges work

In the traditional world of trading, think forex and stock markets, we are almost always talking about a centralised exchange: one company that has both buyers and sellers on board. For example, the New York Stock Exchange is a centralised exchange - it is a company that runs a marketplace enabling people to exchange one asset for another.

When two people want to trade US dollars for Apple shares for example, they need a place to meet in order to exchange those two assets. The best way for them to meet is via an exchange, which keeps all the different prices transparent so that everyone can see what the going rate is for exchanging USD for Apple shares. That is essentially the role of all traditional centralised exchanges like NYSE, NASDAQ, DOW JONES, and HKEX.

While the common belief is that traditional exchanges like the NASDAQ run a smooth operation, the reality of the layered inefficiencies that happen beneath the surface actually paint a different picture.

When two people trade on one of these exchanges, they are not actually trading directly with each other. Instead, it’s the centralised exchange that is the counterparty. For example, it is the NYSE that has the US dollars and Apple shares in custody. The centralised exchange acts as the middleman that matches the requests between buyers and sellers of US dollars and Apple shares. That concept is referred to as order matching.

But that doesn’t mean anyone can go to the NASDAQ website and sign up for trading. There is also no NASDAQ bank account to send money to. What happens instead, is that individual traders need to go through brokers (say, a trading app like eToro) that are connected directly to the exchange. That’s at both ends of the trade which means we’re talking about several layers of intermediaries just for one simple trade.

But there’s more.

Brokerages settle between each other and the centralised exchange using different accounts with different banks. As another intermediary layer, banks act as a multiplier of inefficiency. They are not incentivised to make transactions quicker because holding on to money longer can be lucrative for the banks themselves.

In fact, most traditional exchanges around the world work with a T+2 model, which means it actually takes two days for settlement to occur. Even if your trading app says “order filled”, the reality behind the scenes is that the trade will only be settled after 2 days. Taking the size of the industry in consideration, this means billions of dollars are held in the bank’s custody every single day waiting to be settled.

Altogether, the whole process seems out of touch with how things work today where everyone is used to downloading a mobile app and start using a service immediately. Traditional exchanges aren’t even open 24/7 which means that if something big happens over the weekend, markets can’t react until Monday morning.

Having to deal with several middlemen is becoming less accepted, and while the traditional world seems committed to that model, crypto exchanges have made dramatic improvements to the way we trade assets.

How a centralized crypto exchange works

There are hundreds of crypto exchanges around the world including AAX, Binance, Coinbase, Kraken, FTX, BitMEX and many more. Unlike traditional centralised exchanges, you can go straight to the website of any of these crypto exchanges, sign up and start trading. Trades are done by connecting directly to the exchange, meaning there are no more brokers or other middlemen involved other than the exchange itself as the counterparty that acts as the order matcher.

Another big difference compared to the traditional model, is that a centralised crypto exchange actually controls the order book and your funds. The centralised exchange is in charge of keeping your funds secure and protect it from hacks, which makes trusting the exchange to act as a good custodian a very important factor.

Crypto centralised exchanges are fast, but not as fast as traditional exchanges. That has everything to do with the total number of customers they serve and the location they are in. A traditional exchange really only serves a limited number of customers - the few brokers who have access - with servers installed right next to the exchange. In contrast, a crypto exchange needs to serve anyone with a computer anywhere in the world.

Most liquidity in the crypto market is on centralised crypto exchanges because they are generally easy to use. You don’t need to manage your keys, don’t need to learn or understand complicated wallets. All you need is an email and a password to start trading. The downside of that is that all the funds are held in a centralised place, making it a target for exchange hacks – and there have been quite a few in the past.

Decentralized exchanges (DEXs) are the next stage in the evolution of trading, aiming to provide a more secure trading environment among many other benefits.

How decentralized exchanges work

DEXs are practically the opposite of what we’ve described under centralised exchanges. A DEX offers a trading ecosystem that closely reflects the core values of the crypto community around individual empowerment, disintermediation and financial sovereignty.

In general terms, crypto exchanges have three essential functions: fund management, order books, crypto transactions. For an exchange to be truly decentralised, each of these functions must operate in a decentralised manner:

  • Users’ funds are not entrusted to a third party. Users are their funds’ custodians and therefore keep their assets in their own hot and cold wallets.
  • Orders must be broadcasted directly from one trader to another, with their apps compiling an order book, without any dependence on some kind of central order book service.
  • With users’ apps communicating to set up the trading process, orders are matched directly between traders which are then broadcasted over the inter-chain network and settled directly, peer-to-peer.

The DEX works in a distributed way where crypto trades occur directly between transacting parties on a peer-to-peer basis, settled on the blockchain. This means that instead of a single centralised authority, users are relying on multiple independent nodes connected to the exchange to facilitate trades.

Because trades on the DEX are direct transactions between counterparties, the DEX does not hold each of the investors funds in exchange-owned wallets. Individuals on the DEX have custody over their own funds, wallets and keys. There is no centralised authority that can stop you from trading or freeze your accounts. But if you lose access to your account or lose your keys, there is also no centralised party that can restore access. Much like in the real world, if you leave your wallet on a park bench and walk away, you’ve simply lost your wallet.

In the early days, trading on a DEX came with some serious downsides: slow transactions, low liquidity and broadly speaking a pretty awful UX. Decentralized exchanges were mostly used by crypto veterans, unfazed by the DIY nature of trading on niche platforms. But that has since changed. A lot.

Trading on a DEX today can be just as easy as trading on a centralized exchange. A lot more work has been done on the user interfaces, making it more intuitive for crypto traders at difference experience levels. With the rise of DeFi, liquidity on top DEXs like Uniswap, MDEX, PancakeSwap, SushiSwap and 1inch Exchange has improved vastly. And with superior next-gen blockchains like Solana offering more powerful capabilities for the many projects based on their blockchain, trading assets on-chain no longer comes at the cost of lower speeds.

It does still require that individual traders take the responsibility to manage their own keys and wallets. On a DEX, you are on your own.

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