CEX - Centralized Exchange
A CEX is a centralised exchange run by a 3rd party organisation that facilitates the buying, holding, exchanging, and trading of crypto. A CEX is designed to be simple to use and in most cases makes the exchange to and from fiat currencies pretty easy and straightforward.
Okay, so you're thinking of getting into crypto, where do you begin? The easiest and most convenient, especially for a crypto newbie would be via a centralised exchange also known as a CEX. Here you can buy your choice of crypto using a regular fiat currency like the EURO or US dollars. Just like with a bank or a brokerage house, you have an account and in this account sits your crypto. You can then trade that crypto with other crypto and whenever you like exchange that crypto back into a regular fiat currency.
The origins of the centralised exchange - CEX
If you think the current world of crypto is the wild west, think again! In relative terms, we are nowhere near the kind of wild west scenario that was around in the very early days of Bitcoin. In order to understand the centralised exchange, we need to first go back to the genesis of crypto, Bitcoin.
When Bitcoin was virtually worthless and could be mined on a personal computer the only ways of getting it would be either via mining or by buying it from other Bitcoin holders. This initial buying and selling was somewhat risky and far from straightforward. It would usually require communicating via a forum like Bitcointalk that was set up by Satoshi Nakamoto, the mysterious inventor of Bitcoin. On that forum, early bitcoin enthusiasts could discuss, buy and sell bitcoin but there was no proper exchange in place. Of course, in those early days the stakes were low as bitcoin was virtually worthless, for example in 2010, Bitcoin peaked at $0.39, I'll let that number sink in for a moment!
As bitcoin grew in popularity the need for some kind of centralised exchange was recognised and the seed for the first exchange was planted paving the way for the centralised exchanges and the crypto world that we know today. Interest in Bitcoin continued to grow and new ways of getting it started to appear. A core bitcoin developer, Gavin Andreson created a Bitcoin "faucet". It was a website that would give anyone with a Bitcoin address five bitcoins for free. It was around this time that the first bitcoin exchanges emerged. Bitcointalk launched Bitcoin Market in 2010, it offered a floating exchange rate for bitcoin and buyers could purchase bitcoin by sending another user US Dollars via Paypal during which time Bitcoin Market would hold the sellers' Bitcoin in Escrow until the seller received their money. This got the ball rolling.
Things began to heat up and before long crypto highway robbers made their first appearance!
As crypto increased rapidly in value, the criminal elements began to take an interest, after all this was indeed a wild west environment with no regulation, no armed security guards or secure infrastructure in place, easy pickings!
A notable example of one of the first major crypto heists was Mt.Gox, an early centralised exchange created by Jed McCaleb in 2010 who would later go on to co-found both Ripple and Stellar. McCaleb sold Mt.Gox in 2011 and in that same year one of the first major crypto heists occurred on Mt.Gox where an account with a significant holding was compromised, allowing the hacker to sell the crypto causing the price of bitcoin to fall from $17 to $0 within a few minutes. The hacker also stole personal information forcing the exchange to temporarily go offline. However, by 2013, Mt.Gox was in full force handling 70% of all global bitcoin transactions.
Mt.Gox was the first of many crypto hacking victims, other major centralised exchanges to be hacked included Binance, Bithumb, Bitfinex, Poloniex and ShapeShift. The vulnerabilities of centralised exchanges to hacking attacks gave rise to the well known and used mantra "not your keys, not your crypto". What does that mean you ask? Well, very simply, unless you hold and secure your private keys yourself, your cryptocurrency is potentially vulnerable to criminal hacks.
Let's look at the centralised exchanges of today
Some of the most popular centralised exchanges of today include Coinbase, Binance, Kraken, CEX.IO, Gemini and Bittrex. Compared to the early days of bitcoin where the trading volume was pretty tiny, these days we are talking massive numbers, in 2021, centralised exchanges recorded in excess of 2 trillion US Dollars trading volume. That's pretty amazing when we think that bitcoin and crypto only appeared on the scene in 2009!
Imagine the centralised exchange as a physical marketplace
To look at the centralised exchange in a non-technical way we could imagine it like a physical marketplace owned and operated by a central 3rd party. People would store their goods in a large warehouse and the marketplace owners would facilitate trades between the owners of the goods in exchange for a fee. Pretty straightforward. If the warehouse was broken into by thieves they could make off with all the goods leaving the owners of the stock quite vulnerable. For small traders, perhaps it wouldn't be too risky, but with large traders with a lot of stock it could be a bit too risky. To reduce this risk these big traders could keep the majority of their stock in their own private warehouse and just add more stock to the central marketplace as and when needed. This would be a lot safer as not all their stock is at risk, however, the downside would be that they would not be able to immediately trade the goods that are sitting in their private warehouse. Well in crypto centralised exchanges, something similar exists in the form of hot and cold wallets.
Custodial hot and cold wallets
With a centralised exchange, the crypto is held in what are known as custodial wallets, in simple terms this means that the centralised exchange is responsible for your wallets and the crypto you hold. You as a customer do not hold a private key and therefore have no direct control over your crypto and its security. Think back to the "not your keys, not your crypto" scenario. Security of your assets is of course a major consideration and to make things a little less risky many centralised exchanges offer what are known as hot and cold wallets.
A hot wallet is directly connected to the internet, the "hot" and could potentially be vulnerable to outside attacks from hackers. Hot wallets however are fast as the crypto is immediately available for trading. On the flip side, a cold wallet is not directly connected to the internet, the "cold" and in the event of a hack, the attackers cannot get access to the cold wallets private keys which makes things a lot safer. There is a downside though, that is time and timing is pretty crucial in crypto trading due to the immense volatility. The crypto in a cold wallet is not immediately accessible for trades, the funds need to be first transferred to a hot wallet for trading. This could pose a disadvantage if the crypto is sitting in a cold wallet and you need to trade out really fast.
The centralised exchange has a permanent bullseye on its back
As we have seen above, centralised exchanges are big business, over $2 trillion to be precise, this is naturally going to draw the gaze of both criminal organisations and governments as they are in many ways a perfect target. Centralised exchanges are a very attractive target for criminals for both the theft of crypto but also the theft of user data. Governments on the other hand, scrambling to find ways to maintain control over the money system and trying to bring about regulation would naturally make centralised exchanges their first stop. This is naturally quite disconcerting for the users of these exchanges, especially if they are holding large amounts of crypto.
What about alternatives?
Well, an alternative exists in the form of DEX, a decentralised exchange. Firstly, crypto is itself decentralised, but the buying, selling and trading of crypto is centralised when you use a CEX. A DEX, however, is decentralised, there is no central entity to hack and no central entity to seize by governments. Well, that fact has not been lost on the crypto community and decentralised exchanges are flourishing and not only that, challenging the established centralised exchanges pretty heavily. In May 2021, the leading DEX, Uniswap processed over $76.9 billion in trading volume. Sushiswap did $23.4 billion and Ox Native did $12.8 billion. No small numbers. Overall centralised exchanges are still way ahead but the decentralised exchanges are growing fast. Aside from the vulnerability from criminals and governments, there is also the plain risk of the centralised exchange failing or the owners running off into the sunset with a huge chunk of your crypto. This centralised aspect and associated risk makes the decentralised exchange appealing, after all, one of the appeals of crypto itself is the fact it is decentralised, why then have a central figure in the middle? Decentralised exchanges also tend to have lower fees. The downsides of decentralised exchanges can be a poor user experience, also, ironically there is a lack of any legal oversight or protection as transactions take place using smart contracts which are bits of code and quite importantly, decentralised exchanges trade crypto to crypto, there is usually no fiat on-ramp to make it easy to convert your Euros or Dollars into crypto. Lastly, there is the issue of liquidity, centralised exchanges are generally way more liquid and allow quick and easy trading in and out of different crypto. Decentralised exchanges on the other hand do not tend to be as liquid and this can be a definite disadvantage. The primary takeaway when thinking about centralised exchanges vs decentralised exchanges is that centralised exchanges have total control over your assets when trading whilst with decentralised exchanges the user has control over their assets and centralised exchanges tend to have greater liquidity, fiat currency on-off ramps and a better user experience.
Centralized Exchange: Pros & Cons
Now that we know what centralised exchanges are, how they work and what the alternative is in the form of a decentralised exchange, below is a brief summary of the pros and cons of centralised exchanges
First the pros
- High Trading Volumes - This means liquidity in short. Centralised exchanges make it easy and possible to trade in and out of crypto assets fast which is a very good thing in the highly volatile world of crypto.
- Fiat/Crypto and Crypto/Fiat Currency Conversions - Centralised exchanges tend to support fiat to crypto on and off ramps which means that you are able to buy say bitcoin with euros or US dollars.
- Greater capabilities - Setting aside the huge array of crypto assets that CEXs support, they also offer features such as margin trading, crypto derivatives trading, exchange staking, margin lending and more.
- Ease of Use - This is one of the greatest benefits of CEXs, ease of use. Nowadays crypto traders are not all techies, they are non-technical people too wanting to get in on the crypto craze. They need an app-like experience, similar to that of their online banking or Uber to get things done. CEXs are designed with this universal ease of use in mind.
Now the cons
Whilst overall centralised exchanges offer many advantages and ease of use, especially for those looking to buy and trade crypto using fiat currencies there are some disadvantages too
- A requirement for Know Your Customer policies - for those that would like to trade anonymously a CEX is probably not the best choice as most if not all major centralised exchanges will require proof of iD before you are able to trade. For most people it doesn't pose a problem but for those wanting absolute privacy it's not the way to go.
- You are not in complete control of your crypto - centralised exchanges have custodial wallets, meaning that they hold control over your crypto, not you! If they disappear, your crypto disappears too.
- Greater risks of hacks - as mentioned above, centralised exchanges are a prime target for criminals. There are centralised exchanges that have managed to avoid being hacked however, the risk is ever present and will continue to be into the future.
The above hopefully helps to explain why centralised exchanges exist and continue to thrive despite the inherent risks. Decentralised exchanges are nipping at their heels though and it's not inconceivable to think that decentralised exchanges will soon catch up and eventually be able to offer the best of both worlds. For now, at least, centralised exchanges are big business and the easiest and most convenient way to get yourself onto the crypto superhighway!