Are you interested in cryptocurrency? Then you’re probably wondering where the best place to make a purchase is. As you research crypto exchanges, you’ll notice the terms centralized vs decentralized.
These are the main types of crypto exchanges, and they are fundamentally very different.
Centralized crypto exchanges are heavily regulated, and are often the starting point for most people as they buy their first cryptocurrencies. But decentralized exchanges often have many more cryptocurrency purchasing options.
What type of cryptocurrency exchange should you be using? Keep reading to discover the differences and benefits of each.
Crypto Exchange; Centralized Definition
Centralized exchanges (CEXs) are online cryptocurrency trading platforms. They allow users to create an account, transfer US dollars (or their native currency) to their account, and swap those dollars for crypto.
What makes it a centralized exchange? CEXs take control of your crypto assets. They hold onto them on your behalf and link a balance to your account.
When you trade crypto on a CEX, transactions aren’t actually occurring on the blockchain. They are simply occurring within the CEXs database. So all of the cryptos are staying within the exchange unless you move them to a wallet outside of the exchange.
On top of that, CEXs are financial institutions. They are regulated just like banks are in the US. That means there are certain requirements for the CEX and for its customers.
In order to use it, you need to verify your identity, as a means of preventing financial crimes such as money laundering. This process can often take days to complete.
Crypto is an asset class, and gains on your crypto are taxable. CEXs do you a favor by letting the IRS know that you used their platform.
This means the IRS will know that you have been trading crypto and will expect to see this reported on your tax return so that they can collect any eligible capital gains tax. To reduce your tax liability, make sure to check out these helpful tax strategies.
Benefits of a Centralized Exchange
CEXs are where most people start their crypto investing journey. But why do people trust the most much?
CEXs Support Fiat Currency
In order to buy a cryptocurrency for the first time, you need to be able to convert fiat currency to cryptocurrency. CEXs allow you to do this with relative ease.
Once your account is verified, you can link a funding method, such as a bank account or debit card. Then, you can purchase your desired crypto using your fiat.
CEXs are User Friendly
CEXs are much more user-friendly than decentralized exchanges. They’re geared towards beginners and make the process of buying crypto simple.
If you’ve used a stockbroker to purchase stocks before, then you can use a CEX to purchase crypto.
Security and Support
When you use a CEX, the exchange holds your crypto. Many people find this comforting, while also fearing this.
For newcomers, however, storing your crypto in a CEX is safe. While hacking is a threat, it’s unlikely that a reputable CEX will fall prey to hackers and lose funds.
Even if they do, they may offer support to their customers and return lost funds.
With a decentralized exchange, it’s a different story. There isn’t any support, and it’s up to you to keep your investments safe and secure.
Popular Centralized Exchanges
Binance is the most popular exchange globally. It was founded in China and was initially geared toward non-American users. However, they have created a separate exchange called Binance.us specifically for US users, though it offers fewer cryptocurrencies to Americans.
Coinbase is the world’s second most popular exchange and the most popular in the US. It launched back in 2012, making it one of the oldest exchanges still around.
FTX is another popular option for many countries around the globe. It also has a US-specific version of the exchange.
Crypto.com has been growing by leaps and bounds in recent months, though it was founded in Hong Kong. And exchanges Gemini and Kraken are both US-based exchanges that are quite popular as well.
Decentralized exchanges (DEXs) offer you the ability to trade one cryptocurrency for another, just like a CEX. But it does so in a completely different manner.
DEXs never take custody of your crypto. Unlike CEXs like Coinbase, you never send your funds to the exchange, to be held in their vaults. With a DEX, you always retain control and self-custody of your crypto.
Second, DEXs provide true peer-to-peer trading. There is no intermediary, like a broker, to manage transactions.
Rather, most DEXs use liquidity pools to allow for quick and easy swapping of one cryptocurrency to another. Users are incentivized to hold their crypto in these liquidity pools in exchange for interest payments.
This allows anyone wanting to swap one crypto for another to deposit their crypto in the pool and withdraw the other, at the current going rate.
DEXs and the liquidity pools that they create are automatically run by smart contracts, making them efficient, requiring very little overhead to maintain.
Benefits of a Decentralized Exchange
So why would someone want to use a DEX, rather than a government-regulated centralized exchange? Here are a few of the main reasons.
KYC stands for Know Your Customer. CEXs are financial institutions. As such, they are regulated by the government in the same way that banks are.
In order to use their services, you will have to verify your identity by submitting your photo ID along with your social security number and current address.
But DEXs don’t require KYC. They are completely private, and no personal information is required in order to use them. All you need is a crypto wallet.
DEXs do not take control of your funds. Because of this, they don’t fall under the same regulations as CEXs.
Access Thousands of Cryptocurrencies
CEXs are very selective about the cryptocurrencies they offer on their platform. They often claim that they limit access to various cryptocurrencies in order to protect their customers from high-risk currencies.
So CEXs like Coinbase might offer around 100 different coins. But DEXs can provide you access to thousands of different cryptocurrencies, letting you invest in up-and-coming coins early on, hoping to capture big gains as the coins grow.
When you use a CEX, your crypto is held in custody by the exchange, not you. With a DEX, you always retain control over your private keys. You never have to give your crypto over to anyone else.
For people who are comfortable managing their crypto holdings, this is much more secure than trusting a third party to hold coins on your behalf.
How to Use a Decentralized Exchange
Decentralized exchanges are a type of decentralized application (DAPP) that is built on the blockchain. These are crypto-native tools.
And while the exchange was founded by, and is currently run by a team of people, they are decentralized in that the exchange uses smart contracts to empower peer-to-peer transactions, rather than taking custody of the funds of its users.
Unlike CEXs, DEXs do not offer support to fiat currency. You can’t transfer your US dollars to a DEX. They only offer support to cryptocurrency.
So that’s the caveat. You first have to acquire crypto, most likely through a CEX. Once you have crypto in your wallet, you can use decentralized applications like a DEX
To use exchange crypto on a DEX, you’ll need a software wallet installed on your internet browser. DEXs do not offer accounts or wallets. They do not take custody of your funds.
So a software wallet allows you to make trades directly from your own wallet, without having to first transfer the funds to the exchange, as you would do on a CEX.
Here’s how you would use a DEX for the first time.
Buy Crypto on a CEX
We’ve already covered the process of purchasing crypto on a CEX. You’ll need to have an account with at least one CEX before you can explore the wide world of cryptocurrency and decentralized finance (Defi). CEXs make it possible to convert fiat to crypto, and crypto to fiat, whenever you need to cash out.
Setup a Browser Extension Wallet
Next up, you’ll want to set up a browser extension crypto wallet. The most widely used, and most trusted wallet for this purpose, is MetaMask.
You can install it in your web browser for free. You can use it with Google Chrome, Safari, and a few other popular browsers.
You don’t need to create an account to use the wallet. But you will want to write down your seed phrase, which is the phrase that controls your wallet’s private keys. Keep this safe and never share it with anyone.
It only takes a minute or two to launch your wallet.
Send Crypto From the CEX to Your Wallet
Once your browser wallet is set up, you can transfer crypto from your CEX wallet to your browser wallet. To do this, you’ll want to copy the wallet address on your new wallet.
This is a long string of characters. If you’re using an Ethereum-based cryptocurrency, the address will start with “0x” followed by 62 more characters.
Then, in your CEX, click withdraw, and choose the cryptocurrency you want to send to your browser wallet. Paste your new wallet address in the recipient field, and initiate the transfer.
You may need to pay a transaction fee. And it may take a few minutes to go through.
Connect Wallet to a DEX
Once you’ve chosen the DEX you would like to use, you just need to connect your browser wallet to the exchange. To do this, click the “connect” button on the website. Your wallet should pop up and ask you to confirm the connection.
Once you do this, you can begin trading cryptocurrencies on the website. The transaction takes place directly in your wallet, simplifying the process for you.
Popular Decentralized Exchanges
So what are the DEXs you should consider using? As mentioned earlier, Uniswap is one of the most popular. And it’s the most popular on the Ethereum network.
Uniswap is one of the oldest DEXs in the space, having got its start in 2017. It reached a cumulative trading volume of $500 billion in just three years. It lists thousands of different cryptocurrencies, which you can contrast to a CEX which may offer just over 100 if you’re lucky.
Sushiswap is another popular DEX, having cloned Uniswaps open-source code. It’s gone through some tumultuous times, as the pseudonymous founded, Chef Nomi, removed funds from the exchange, presumably for personal gain.
He later returned the crypto and handed the DEX over to successful crypto entrepreneur, Sam Bankman-Fried. Sushiswap also supports Ethereum-based cryptocurrencies, with over 1,000 different tokens on the exchange.
PancakeSwap also copied Uniswaps source code. But this DEX is based on the Binance Smart Chain, not Ethereum.
Trader Joe is a popular DEX for coins that live on the Avalanche blockchain.
And Curve Finance is particularly focused on stable coin swapping.
Centralized vs. Decentralized Crypto Exchanges
So which type of cryptocurrency exchange should you be using? If you’re a new crypto investor, you’ll want to start with a centralized exchange. CEXs offer you the ability to buy crypto using fiat currency, which you cannot do on a DEX.
Plus, they are much more user-friendly and will allow you to buy the most reputable cryptocurrencies.
Decentralized exchanges offer access to a much wider variety of cryptocurrencies. But they aren’t especially user-friendly. Using a DEX requires extensive knowledge of software wallets, blockchain compatibility, and crypto-security since you’re always in control of your funds.
Advanced crypto investors regularly use both types of exchanges. Typically, they use a CEX for adding funds to their crypto portfolio or cashing out when necessary. But they’ll do the bulk of their trading with a DEX as they trade, invest, and build a portfolio both for short-term gains as well as retirement planning.
Building Wealth With Crypto
Centralized vs. decentralized crypto exchanges, now you know the difference. The cryptocurrency industry is huge and it’s evolving daily. There’s a lot to learn if you want to master this asset class and use it to build wealth.
Just don’t forget that regardless of which type of exchange you use, you do need to track your trades, as almost every transaction is a taxable event.
If you need help figuring out what your tax liability is for your crypto investments, make sure to read up on how a CPA can help you out.