Exchange is the first place you should look to purchase or sell cryptocurrency. A centralized business (CEX) is the typical starting point for anyone interested in trading cryptocurrencies. Some of the most well-known ones are Binance, Kraken, Coinbase, and so on. The collapse and insolvency of the once-prominent cryptocurrency exchange FTX in November 2022 were precipitated by a CoinDesk scoop.
Since this is the case, many crypto traders have been looking for decentralized exchanges. Decentralized currency exchanges like Uniswap and Pancakeswap are an apparent option. These distributed marketplaces reimagine the nature of trade in fundamental ways.
Is Now the Right Time to Move?
Over the past five years, decentralized exchanges (DEXs) have emerged to compete with traditional centralized exchanges (CEXs). In a nutshell, decentralized exchanges (DEXs) attempt to provide cheaper transaction fees, allow users to directly keep their assets, and circumvent some regulatory hurdles. However, companies must pay their liquidity providers for a unique risk known as “permanent loss,” which can be costly.
The benefits of CEXs are not to be overlooked. The economic models of most centralized exchanges are based on those of more established institutions like the New York Stock Exchange, which is familiar to and possibly more appealing to more conservative investors. They provide greater liquidity and stronger regulatory certainties, which can be especially significant for institutional clients, and their interfaces and apps tend to be more beginner- and user-friendly. However, this also places substantial authority and accountability on the exchange’s central management firm to ensure the exchange’s continued financial viability and soundness.
How Does DEX Function?
DEXs are designed to be faster and less expensive than their centralized competitors when it comes to completing transactions. They achieve this by avoiding the need for the intermediaries that CEXs typically employ to collect their transaction fees. When it comes to fees, Uniswap, the largest DEX in the world, promises “zero rent extraction” in its 2018 whitepaper. Its purpose is to shield customers from the higher prices brought on by the need for CEX intermediaries to turn a profit. Launched in 2017, Bancor calls itself the world’s first decentralized exchange (DEX) and argues for decentralization in the following way:
“Historically, only a small group of professional trading firms with authorized access and specialized equipment have provided liquidity on traditional asset exchanges. To put it another way, “this causes liquidity to be concentrated in the hands of a few players who can pull their assets out during times of volatility and limit trading of an asset when users need it the most.”
Late in 2021, the top DEX, Uniswap, had a transaction cost of 0.05% on a $100,000 deal that was sampled by the international accounting firm KPMG. Coin exchange fees ranged from 0.1% to 0.2% at Binance, Coinbase, and Kraken.
Without a central authority to regulate trading, DEXs set asset prices through “automatic market maker” processes. The “constant product” mechanism is widely used; it uses the ratio of the DEX’s total reserves of each asset to establish the offered prices. This helps maintain a healthy balance in the bank accounts: If a resource were to suddenly become scarce, the price would skyrocket.
Let’s Define Impermanent Loss
This technique is quite ingenious, but it does pose a threat to the liquidity providers who back the pool. Temporary loss is the potential outcome. It is not the number of tokens that a liquidity provider provided that matters, but rather the value of the pool that they are entitled to withdraw. Since the proportion of each token type held in the pool fluctuates as trades are made, it was impossible to guarantee that each supplier would receive exactly the number of tokens they had requested. There will initially be a smaller proportion of the token that is decreasing in value in the pool, and the inverse will be true as the ratio adjusts to match the current wider market pricing.
As a result, a liquidity provider will often withdraw more of the token that declined in value and less of the token that rose in value, relative to their initial holdings. As a result, they will be worse off than if they had kept their money and property to themselves. Liquidity providers are often paid by DEXs through transaction fees. However, this will need to charge more money than they would otherwise.
Dealing with institutional investors could be more challenging for DEXs than for CEXs. They lack the scale to provide as much liquidity as the biggest CEXs do at the moment. When large orders encounter limited liquidity, they may incur “slippage,” or unanticipated expenditures. It might be difficult for institutional investors to work with exchanges that do not adhere to the same anti-money laundering (AML) and other regulatory standards as they do.
Banks and hedge funds have been sluggish to engage in decentralized finance (DeFi) due to their own regulatory difficulties, according to Sergej Kunz, co-founder of liquidity aggregation DEX 1inch Network. Even though 1inch Pro is a DEX, his company wants to release it in order to satisfy the needs of these customers. New aggregator protocols, such as 1inch, have evolved with the express purpose of assisting institutional investors in avoiding liquidity issues when trading on DEXs. In 2020, 1inch successfully completed a $12 million fundraising round headed by Pantera Capital.
With the proliferation of aggregators, consumers no longer have to choose between DEXs and CEXs for trading liquidity. DiversiFi is both a protocol and a DEX, and it aggregates liquidity from both types of exchanges to facilitate larger trades for its users. For investors, this means less risk of having their order rejected because an exchange doesn’t have enough liquidity.
It all comes down to two factors when deciding on an exchange method: A CEX is a way to go if convenience is your top priority and you don’t feel confident managing your own funds. A decentralized exchange (DEX) is the way to go if you care most about saving money and keeping more of your own money. No of your strategy, you must know how to move your cryptocurrency from exchange to cold storage to ensure its long-term safety.
DEXs may have been able to avoid some regulatory barriers in part because of their rising popularity. The company that creates a DEX doesn’t have to comply with KYC and AML regulations because it doesn’t act as a financial intermediary or a counterparty to any transactions. According to ShapeShift’s CEO, the company lost 95% of its users in 2018 after being compelled to apply KYC requirements. To avoid this issue, Shapeshift made the conscious decision to transform into a DEX in 2021.
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