Digital asset exchange platforms are for buying or selling digital assets; some even offer wallet and custodian services. This guide goes in-depth on how these exchanges work and how to choose the best option to suit your needs.
Understanding the Basics
From the user’s point of view, exchanges let you buy or trade one coin for another, for example, exchanging BTC for ETH. But under the hood, something very different is happening. After all, BTC and ETH don’t physically exist: they are coded on a specific blockchain, and in this case, it’s not the same blockchain. This presents an interoperability problem; think of it as trying to run a .exe file on a Mac or a .dmg file to work on Windows.
Exchanges use a range of tactics to achieve interoperability for the user. We’ll cover these different approaches to creating interoperability which leads to developing different types of exchanges.
The Different Types of Exchanges
There are several ways to solve the problem of exchanging two assets without existing outside their respective blockchains. We’ll get into the details further down this post, but the first thing to understand is that exchanges can be grouped into two types: centralized and decentralized.
Centralized Exchanges (CEX)
Most commonly, your first port of call to trading cryptocurrency is a centralized exchange (CEX), a marketplace where users can safely trade digital assets. CEXs are user-friendly and offer more liquidity by taking the role of market makers and provide regulatory oversight, which is important for those new to trading. It also means the company running the exchange has a lot of responsibility for the financial stability and health of the exchange.
Here is how a centralized exchange works:
1. To become a user, it is important to undergo KYC (know your customer) verification, validating a person’s ID, name, and other personal information. Once validation is complete, the user can use their login information to get full authoritative access to their account, go through any rules or regulations and, most importantly, begin trading.
2. Many central authority exchanges will assume custody of assets deposited by the user, which limits user activity. Often a CEX will use order book technology to keep track of pending transactions to help traders buy and sell accordingly, plus it allows them to manage data from the orders placed. Typically these exchanges will keep track of data and offer access to it for an additional fee.
3. Assets are held in a wallet and can be moved freely to the exchange at any point when a user wants to trade them. As many CEXs are private entities, more fees are involved since transactions are stored on a traditional server versus a blockchain.
While this option has been a top option for many traders, it also presents several disadvantages. A central authority mediates the actual exchange, which means that everyone is served from reserves held on various blockchains by one central website. In addition, the website does not have a decentralized governance structure making it more vulnerable to thefts and mismanagement by the owners or operators. Unprotected by encryption and consensus, they are vulnerable to hacking; this is not a theoretical concern.
However, these exchanges are easy to use and present a Web2-style user experience that we are all, by now, relatively familiar with.
An additional advantage of a CEX is that accounts have ordinary passwords and other login details; when these are lost, it’s possible to recover them. This isn’t true of blockchain wallets.
Decentralized Exchanges (DEX)
Decentralized exchanges (DEX) operate entirely on the blockchain and allow anyone to transfer digital assets on an open market with no middlemen. Similarly to a centralized exchange, the capabilities of a DEX are much the same. Still, they make it easier to exchange currencies that are accessible online without worrying about limiting coin listings.
One major difference is that DEXs require minimal customer information, making them feel more anonymous. Decentralized platforms remove the intermediary entities that take a cut of transaction fees to complete transactions faster and cheaper than their centralized counterparts. Unlike traditional exchanges, DEXs use automated market maker (AMM) protocols to determine the prices of assets without a centralized entity conducting trades.
So the real debate comes down to which one?
DEXs are much more complicated than CEXs because they have to solve the interoperability problem on their own terms. We’ll briefly go into several widely-used solutions to this, but here are some pros and cons.
CEX vs. DEX: Pros and Cons
If you’re wondering which option is better, it is important to remember that both have advantages and disadvantages. It really comes down to what you need as an investor.
Firstly, CEXs are way more regulated with high safety and transparency, as they operate within strict rules that protect investors and all involved. As well, execution speeds are faster, and there is higher liquidity due to the market makers who ensure that assets can be easily exchanged.
On the other hand, DEXs offer cheaper trading fees, anonymity for users, and direct access to transaction data via the blockchain without paying extra. There are many DEXs because setting one up is often easy and cheap. Therefore, users can find themselves “shopping around” at multiple locations, and all might have bare shelves.
However, the main advantage of a DEX is the excellent security of the blockchain. With trades taking place on-chain, users are protected by consensus and cryptography. Since the cryptography used is unbreakable and the consensus algorithms of the larger blockchains are secure, trades are vulnerable only to a small number of attack vectors. Typically these consist of attacks on the website’s code or “social engineering” attacks that exploit user carelessness.
DEX Interoperability Tools
To understand interoperability, let’s define it first. This concept refers to the ability different blockchain networks have to exchange and leverage data between one another. In the case of exchanges, it helps move various digital assets between the networks’ respective blockchains.
The various forms of blockchain interoperability either rely on a single overarching blockchain structure or use multiple forms of inter-chain representation, which include:
The BitAsset system
The BitShares blockchain represents coins from other chains directly on the chain, pegging the value of a BitAsset token to the value of an underlying asset. Take BitUSD, for example. The first crypto-backed stablecoin issued on the BitShares blockchain pegged to the US dollar.
The mechanism works by pegging the token’s value to the underlying asset but backing it with BTS at 200% or more. The backing of BTS ensures it can always be exchanged for other BitAssets, and the pegging to another asset, including digital assets, ensures price stability.
Because of its relatively straightforward interoperability, BitShares is a common basis for DEX; however, it’s not used often for large transactions, making liquidity an issue.
Wrapping is very similar and is commonly used to import tokens into the Ethereum blockchain; since many tokens are already native to Ethereum via the ERC-20 token protocol, this makes a lot of sense for exchanges and investors.
The process works by creating an ERC-20 token backed 1:1 by the underlying coin. So a wrapped BTC (WBTC) is an ERC-20 token running on Ethereum while allowing its holders to interact with other coins and tokens freely. Additionally, Ethereum can even be used to trade pairs of tokens, neither of which is Ethereum-native.
The Blockchain of Blockchains
The final method of getting different tokens to interact with each other without leaving the blockchain is to create a blockchain ecosystem that makes that possible.
Ethereum and Bitcoin were created when that interoperability wasn’t an issue, and later, players entered the space like BitShares, who never gained the traction required. But a new generation of blockchains is being built from the ground up for interoperability.
Typically, this means creating an overarching environment in which custom blockchains can operate or where a communication system between blockchains exists. The Polkadot blockchain uses a system of heterogeneous sharding, while Solana uses a system of interchain transaction verifications. In addition, most new blockchains are ‘chains-of-chains’ ecosystems and interoperable with Ethereum on-chain.
What are On-Ramps and Off-Ramps?
Regarding exchanges, two major services exist, known as onramps and offramps, which grant access to the digital assets ecosystem from the outside. An on-ramp refers to when a user can offer fiat money in return for cryptocurrency. Off-ramping is the opposite, where a user can convert cryptocurrency into fiat or possibly products and services.
Depending on the type of exchange, it is possible to buy digital assets for fiat on the exchange itself. In general, centralized exchanges offer an easy onramp because there’s a centralized entity behind them, and this entity can meet current regulations.
Laws in most countries don’t cover the concept of a decentralized entity without legal personhood, so DEXs are unregulated and decentralized; this often means payment processors such as Mastercard are reluctant to touch them. Most CEX will simply take a card payment or bank transfer. Therefore, using a CEX as an onramp is not unusual and then performing trades on DEXs.
Alternatives include edge cases like Bisq. However, there is also a growing number of DEX-oriented on-ramps. CoinSwap allows purchases to any non-custodial wallet via the Ramp network. Custodians typically handle on-ramping where clients request it, as do financial advisors using specific tools.
If you’d like to know more about how to get access to the digital assets market, get in touch!