Differences Between Centralized and Decentralized Exchanges

January 5, 2022

Buying crypto is tough. It forces us out of our comfort zone.

Many of us are comfortable logging on to TDAmeritrade or Fidelity to buy and sell stocks. It’s easy, it’s secure, and the institutions have been around long enough to have built up trust.

However, we can’t buy cryptocurrencies with these institutions (yet). So crypto investors are forced to look to new companies and exchanges to buy cryptos.

Once we start looking for crypto exchanges, fear starts to set in… We have hundreds of exchanges to choose from.  I’m not exaggerating. There are hundreds of exchanges to choose from.

But all exchanges can be divided into two different groups. These are centralized and decentralized exchanges. Today we’ll talk about the pros and cons of each.

What Is a Centralized Exchange?

Most people getting started in crypto now will begin with a centralized exchange.  

You can think of these as being like a stock brokerage.

Centralized exchanges (CEX for short) act as middlemen that conducts, verifies, and controls the assets.

We refer to these exchanges as user friendly. And they feel good to use as there is often a help number you can call to talk to someone if you need help.

For most people, to get fiat money (dollars) into a crypto account, they’ll need a CEX. These exchanges have the proper licenses and put the proper  identity verification services in place to comply with U.S. laws.

Centralized exchanges require users to fill out the same KYC (know-your-customer) documents that banks require… At least if they want to do business with American citizens.

That means banks and credit card companies can transact with these companies. Most banks and credit card issuers will block transactions with decentralized exchanges.

Centralized exchanges are easy to get money into and start trading.

One major benefit of using a reputable centralized exchange is they vet all coins before listing them on the exchange. That makes it much less likely you will come across a scam-coin on a CEX.

But there are downfalls to centralized exchanges…

One is trade fees. Most centralized exchanges charge a 1.5% transaction fee. This is steep, especially if you’re trading in high dollar amounts.

On top of that, centralized exchanges typically don’t give you the best order price on your transactions.

This is changing as competition increases. But as a general rule, we trade as little as possible on these exchanges.

The biggest downfall for CEX’s though is that these exchanges keep the private key to wallets holding the crypto. That means users of centralized exchanges don’t control their crypto.

This bothers a lot of purists in the cryptocurrency community. They have a saying, “not your keys, not your crypto.”

This is technically true… But if you trade with a reputable exchange, this isn’t a problem. And this kind of ownership structure is the same as stock brokerages. They own your shares and portion your purchases to your account.

It’s important to pick a major exchange that you can trust to hold onto your investments.

A few reputable centralized exchanges we use are::

  • Gemini
  • Coinbase
  • Binance.us
  • Kucoin
  • Kraken
  • FTX.us

What are Decentralized Exchanges

Decentralized exchanges, or DEXs, allow you to transact one coin for another. But there is no single entity that controls the exchange. That means anyone from anywhere can use these exchanges.

No KYC, no verification, no customer service.

DEXs have no central authority acting as an overlord. And because of that, you get to control and custody your coins.

The trades on these are made possible by the community using the DEX. Community members will put their coins into liquidity pools (LPs). These LPs generally consist of two coins like BTC-ETH.

When someone wants to transfer their bitcoin to ethereum they will use the pool. And the members of the LP are incentivized by being able to keep a portion of the bid-ask spread in the trades. People putting coins into the LPs act the same as market makers do in the stock market.

There are a lot of nuances to picking the right LP. [We will talk about this in more detail in the future].

These LP providers and the algorithms that control the pools enable a smooth trading experience on DEXs.

But we have to be careful when placing a trade on a DEX. The LP may not be deep – meaning there may not be a lot of money in the LP. If that’s the case, even a small transaction can  change the price of the smaller coin. So when placing a trade, watch the estimated price impact to the cryptos.

Using a DEX

To use a DEX, you must transfer coins from a centralized exchange to a wallet. One common wallet in the crypto community is called MetaMask. We have a guide to setting up a MetaMask wallet here [link].

Once you get the coins on the MetaMask wallet you can connect the wallet to the DEX and start trading. We have instructions for how to do that here [link once we do that]. It’s simple.

This is a simple and easy process. And once we connect our wallet to a DEX like Uniswap, we have the ability to trade thousands of different cryptocurrencies… Allowing us to get in on the ground floor of the most exciting new projects.

But just like Centralized Exchanges, Decentralized Exchanges have drawbacks…

Having access to thousands of cryptocurrencies is amazing, but it also opens us up to investing in a scam. Before exchanging a quality crypto for a small new project, make sure you do your research.

As mentioned above, you must be aware of the impact your transaction will have on the price. For smaller, less liquid cryptos, even a $500 transaction can  impact the price. That can  impact your potential for profit on your investment.

Speaking of profits, you also must be aware of the fees the DEX charges. Typically the DEX will give you the best fill on the price of crypto. But Decentralized exchanges charge a fee in the way of gas.

We talked about Uniswap earlier. This DEX is on the Ethereum network. And when the GWEI (fees to transact on the Ethereum network) is high, transactions cost a lot. We’ve seen transactions cost over $100. That is rare, but even the norm is around $25 a trade.

The gas fee makes it less compelling to do small transactions on a DEX like Uniswap. Anything less than $5,000 is not worth the fee in our opinion. 

The crypto community is working on solutions to this. You can use a Layer 2 solution like Polygon or Arbitrum which is built on top of Ethereum. Or other blockchains like Solana and Fantom. Transactions there typically cost about 1 cent. But it is still difficult to get to these chains.

But if you’re transacting in large amounts, it makes sense to do so on any DEX. The gas fee is the same whether your trade is for 0.01 ETH or 10,000 ETH.

Security is another drawback for some people. There is no one to complain to if something goes wrong. Or if someone hacks your wallet, it’s like they picked your pocket in real life. Your money is gone. So you must be careful.

But once you know what you’re doing with the security in your wallet, and therefore with the DEX, it’s greater than using a centralized exchange. That’s because with a crypto wallet like MetaMask, you can secure it with a hardware device like a Trezor or Ledger. We have a guide on how to secure your wallet with a Ledger here [link to future article or YouTube video].

Some of our favorite Decentralized Exchanges are:

  • Uniswap
  • SushiSwap
  • PancakeSwap
  • SpookySwap
  • Raydium
  • TraderJoe

The Bottom Line

Both Centralizeds and Decentralized exchangess make it possible to trade cryptos. We start with a CEX to get our fiat dollars converted into crypto. And from there we can continue using the CEX or transfer our coins to a wallet and start using DEXs.

Centralized exchanges typically are more user friendly… They have someone to talk to if there’s a problem. Like if you forget your password to a CEX, you can contact them and have it reset. But if you lose your passphrase to set up a wallet… Well, good luck getting those coins back.

If you want the best crypto experience, it’s worth learning how to navigate the Decentralized exchanges out there. That’s where you can find the smaller, more explosive projects.

And if you want to trade on some up and coming blockchains like Fantom and Solana, you have to use a DEX. No CEX handles those blockchains yet.

To learn more about how to navigate the complex world of Decentralized exchanges click here to sign up for our paid membership where our experts will help answer your questions in real-time.

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