Centralized Exchange (CEX)
A centralized crypto exchange (CEX) is where users buy, sell or trade their cryptocurrencies. It’s custodial in nature, holding the funds or digital currencies of users in a digital wallet before authenticating transactions centrally. CEXs generally charge trading fees by a specific percentage, regardless of the trade volume. You can either purchase cryptocurrency with fiat currency, or choose to trade one crypto for another through the exchange. To facilitate payments, a CEX may work with commercial banks to allow direct bank transfers or payment through credit cards.
CEXs may also work with a central authority to ensure the transactions on the platform are not malicious or illegal, for example, money laundering activities. Being centralized, a CEX is able to provide security with cryptocurrencies and to improve user experience with a wide range of services. These services make transactions more reliable, efficient and secure for users. They’re also the main reasons why CEXs are more commonly used among crypto users as compared to decentralized or hybrid exchanges.
Despite CEXs being centralized, the cryptocurrency used in transactions is still decentralized, which means that the CEX doesn’t control the network or operations for any given crypto asset. The CEX is simply a third-party platform, operated by a central entity that serves to facilitate transactions between buyers and sellers.
How Does a Centralized Exchange Work?
As a third-party platform, a CEX offers impartiality, security and efficiency in the transaction of crypto assets between users. Therefore, instead of exchanging the crypto assets among themselves, users may choose to deposit their funds into a digital wallet on the exchange. Upon taking custody of the funds, the CEX will issue a corresponding amount of IOUs or credits to the users. These IOUs or credits are tracked by the CEX whenever transactions are being performed, and it will convert them to actual fiat currency at the point of withdrawal. This is done through the maintenance of an order book that records the buy and sell orders among traders.
These buy and sell orders are essentially requests by users to purchase or sell cryptocurrencies at a certain price. This is aggregated by the CEXs, whose platform is able to calculate, match and execute buy and sell orders between users. The ability of a CEX to process transactions in a speedy and efficient manner makes it convenient for crypto users to buy and sell crypto assets on the platform.
Limitations of a Centralized Exchange
Despite ensuring stability and convenience for transactions on a CEX, the percentage taken from each transaction as a trading fee can add up, depending on the trading volume. This may deter users from considering a CEX as a trading platform for their crypto assets.
In addition, CEXs generally do not present their internal operations openly to users. This lack of transparency may enable malicious price and market manipulation. For a community of users who value decentralization and transparency of transactions that cannot be affected by a single entity, a CEX’s central control of funds and its ability to freeze or block them at will may be a cause for concern among users.
Being custodians of crypto assets for users who wish to trade on the platform, CEXs are also widely targeted by attackers — whether internally or externally — causing a loss of over $292 million in 2019. CEXs may be easily targeted by government organizations as well, forcing the central platform to freeze or seize the funds of their users and even forcing them to reveal the users’ personal information under legal pressure. Such coordinated attacks and technical disruptions can lead to downtime in CEX services, resulting in a loss of trade opportunities for users.