What Are Decentralized, Nested And Centralized Exchanges?

Cryptocurrency trading is increasingly gaining momentum and almost everyone wants to join the bandwagon. However, not knowing where to start or which exchange to trade on is a major pain point for new investors. Here is a list of the different types of exchanges along with their merits and demerits to help you make a safer and informed choice for trading.

What is a cryptocurrency exchange?

A cryptocurrency exchange is a platform that helps one buy and sell cryptocurrencies efficiently. It is similar to a traditional stock exchange but instead of stocks, cryptocurrency is traded on the platform. The price of cryptocurrency follows a 24-hour cycle and may go up or down, the crypto market is highly volatile. There are several such exchanges with Binance being the world's biggest cryptocurrency exchange in terms of trading volume, followed by Coinbase, the biggest exchange in the U.S.

There are multiple types of cryptocurrency exchanges, each having a specific purpose and features for the investor. The three major types of cryptocurrency exchanges one will most often come across are centralized exchanges, decentralized exchanges and nested exchanges.

All three work on the basic principle of making cryptocurrency trade easier and profitable; however, their approach to doing so and treatment toward the identity of a user makes them different.

Centralized exchanges (CEX)

The most popular and commonly used cryptocurrency exchanges are centralized exchanges (CEXs). To start trading on such an exchange, one will have to submit their documents and complete a Know-Your-Customer (KYC) process.

CEXs work along with the regulatory authorities to improve users' experience while trading crypto, and provide a secure approach to the user. Such exchanges comply with the governments' rules and work as a firm that is not decentralized in nature, i.e., there is a CEO and a board of directors in control of the entire exchange.

"Centralized exchanges are platforms which facilitate the buying and selling of cryptocurrency, either for fiat currencies, like the U.S. dollar, or between digital assets, like BTC and ETH. They function as trusted intermediaries in trades, and often act as custodians by storing and protecting your funds," Gemini, a CEX, wrote in its blog.

Before onboarding, multiple levels of checks are performed on an individual's account to prevent money laundering and terror financing activities via cryptocurrencies. Individuals can use debit cards, credit cards, wire transfers, etc to trade on these exchanges. Examples of CEXs are Binance, Coinbase, etc.

Decentralized exchanges

Decentralized cryptocurrency exchanges (DEXs) are those that do not have any authority looking after the day-to-day activities of the platform, so there is no CEO, employees nor board of directors. The exchange is not answerable to regulatory authorities and may or may not comply with the government rules. This makes such platforms risky and should be avoided by new investors.

DEXs offer anonymity to the users and hence, users don't need to complete security-related processes like KYC. The absence of a centralized authority allows such exchanges to support peer-to-peer transactions. These exchanges are best for experienced traders who can secure their funds in case of a hack. For any loss or theft of crypto on such an exchange, there is no authority to complain or hold responsible.

Another notable feature of DEXs is that they are comparatively cheaper because CEXs charge more service fees for setting up secure infrastructure for traders. DEXs work on automated smart contracts and do not need any interference. Examples of DEXs are Uniswap (V2) and 0x Protocol.

Nested Exchanges

Nested Exchanges operate solely with the purpose to hide the identity of the user. These exchanges act as middlemen between a trader and a CEX. Experts usually advise avoiding such exchanges altogether.

Nested exchanges open an account with popular crypto exchanges, like Binance. Thereafter, if a user, say, Mr. X, wants to buy some Terra (LUNA), which has been the 'latest shiny thing' in crypto, in exchange for Ethereum (ETH), which is known for its high gas fee, they will have to raise an order with the nested exchange.

The nested exchange will take Mr. X's Ethereum (ETH) and change it for Terra (LUNA) on Binance, acting as the middleman in the process, hiding the identity of the user who has raised the order.

The reason to void such exchanges is that regulatory authorities might shut them down anytime, and users will lose all their crypto in that case.

"The best way to avoid these is not to use nested crypto exchanges. Spotting them can be tricky as it's not always obvious," said a Binance blog.

Difference between DEXs and Nested Exchanges

Although they sound similar, DEXs and nested exchanges differ in their approach. Nested exchanges take the users' crypto into their custody and as a result, trade on their behalf. Most often, these exchanges will also hide the source or platform where the trade was done on behalf of the user.

On the other hand, DEXs won't ever take control of your crypto but, connect buyers with sellers and vice versa. DEXs use smart contracts to complete a trade that is not controlled by any human while nested exchanges make trades on their own, keeping a part of the transaction as commission.