What is a CEX (centralized crypto exchange)?

Key Takeaways

If you want to buy your first crypto, there’s a high chance that you’ll make your first steps through a centralized exchange.

But what exactly is a centralized exchange? Let’s go over the concept of a centralized exchange (CEX). We’ll outline how it works, defining features, limitations and risks.

What is a CEX?

A centralized exchange is a cryptocurrency trading platform where you can buy and sell crypto, swap crypto, store your digital assets and trade between different cryptocurrencies. Increasingly, these platforms also offer users other crypto services, such as staking and advanced trading instruments.

CEXs are designed to work with both crypto and fiat currencies, making them a very common gateway into the blockchain ecosystem. They enable instant crypto purchases, thanks to high levels of trading liquidity.

Centralized exchanges are custodial, meaning they hold user funds in an exchange wallet and fully manage the private keys. 

Examples of Centralized Crypto Exchanges

Some of the biggest centralized exchanges in the world include

• Binance
• Coinbase
• Bybit
• Kraken
• KuCoin

There’s a good chance you’ve also heard of FTX, a former centralized trading platform that notoriously collapsed due to mismanagement. We’ll come back to that shortly.

How Does a CEX Work?

Centralized crypto exchanges have a few defining features that differentiate them from other types of crypto platforms.

KYC on Centralized Crypto Exchanges

Regulatory compliance on centralized exchanges means a CEX almost always includes a Know Your Customer process when onboarding new users. KYC requirements are part of a global anti money laundering initiative aimed at countering money laundering, cybercrime, terrorism and more.

With KYC, newly registered users have to provide personal details and verify their identity with a photo of themselves and a document (personal ID, driver’s license, passport, etc.).  This verification process can sometimes take a couple of days, something new users need to consider.

These requirements exist so the exchange can monitor any suspicious activity and tie it to a real world identity. Since all transactions on the blockchain are recorded on a ledger that’s publicly accessible, the entire history of a user can be fully traced. 

Custodial wallet

CEXs require you to use a custodial wallet, or exchange wallet. Once you register, the platform automatically creates a wallet within its interface. You can use this to send and deposit crypto. 

What you don’t get is a seed phrase. This means you have no direct access to the address on the blockchain linked with your crypto wallet. Instead, you can only access your assets via the exchange, and the exchange has full control over the assets in your wallet.

But it’s not all doom and gloom, centralized trading platforms comply with regulation. As such, some exchanges insure customers up to a certain amount, much like a bank.

Order book system

Many users visit a centralized exchange to trade fiat and crypto. But how exactly does it all work? 

The answer lies with the order book system, which lists buy and sell orders. The order book system displays all open orders for a specific trading pair like BTC/USD, allowing users to place market or limit orders. 

Let’s say John wants to sell half a Bitcoin for $30,000 and Jane wants to buy the same amount for the same price. The two orders would match and get executed on the order book. Market orders are executed at the current market price while limit orders are executed when the market reaches a pre-specified price. The price of cryptocurrencies is determined by the point where the lowest bid and the highest ask meet.

CEX vs DEX – what’s the difference?

Decentralized finance offers crypto users access to financial services that are run by protocols instead of human entities. The decentralized finance equivalent of a CEX is a DEX, or decentralized crypto exchange. DEXs offer similar services, but they are structured very differently, and it’s critical to understand the difference between these two types of trading platform. There are a few key distinctions between a CEX and a DEX, including:

• who manages the trading platform
• regulatory obligations
• pricing mechanism
• liquidity source
• custody of private keys
• Fiat trading options

Let’s take a closer look at each factor now.

Managing entity

Centralized exchanges are managed by traditional companies that exist and are registered in the real world. The company oversees the exchange’s operations, customer support, and overall maintenance. 

In contrast, decentralized trading platforms are governed by protocols, relying on smart contracts to facilitate exchanges. DEXs may even be owned  and controlled by their community, via their native tokens. Uniswap is a great example of this with its governance token UNI.

Regulatory obligations

As a traditional company, centralized crypto exchanges must to comply with domestic law. Generally, this means implementing KYC procedures to verify the identity of their users.

But it might also entail more stringent measures: for example, China has enforced an outright ban on crypto trading, resulting in Binance relocating its headquarters to Malta in 2018. So regulation can add extra risk for CEX users, since governments are free to ban, control and censor the trading platform as a regular business.

On the other hand, decentralized exchanges are not bound by KYC requirements or any other regulations because they’re not legal entities. There’s no need to go through registration or KYC, simply connect your wallet and start trading. 

Pricing mechanism

We’ve mentioned that centralized exchanges use the order book model, allowing traders to place market or limit orders. These orders determine the price of an asset by finding the point where the lowest bid meets the highest ask.

A DEX, on the other hand, often uses an automated market maker (AMM). With an AMM, the DEX relies on liquidity pools controlled by algorithms that facilitate swaps across pairs of tokens. Asset prices are based on the ratio of token pairs in each pool.

Liquidity source

The liquidity on a CEX is provided by a combination of professional market makers and the vast number of users creating orders. As a result, liquidity tends to be high on a CEX, enabling you to make fast trades.

In a DEX or AMM, liquidity comes from liquidity providers, who are rewarded for providing their crypto to the exchange. In an ecosystem supported entirely by users, trades sometimes take longer to execute because there is simply not enough liquidity in a pool to immediately complete a trade. This can lead to a well known issue called slippage, where the price of a trade changes between confirmation and execution.

Custody

On CEXs, the exchange holds your private keys, and you’ll store your digital assets in the custodial exchange wallet. All you need to worry about are your login credentials, which can be reset by the exchange if you ever lose them. This is a double-edged sword. 

On one hand, it simplifies the experience, especially for new users. You’ll never need to worry about storing a seed phrase and you can always rely on the exchange’s support team if you become locked out.

On the other hand, it also introduces some risks: since you have no direct link with your blockchain address, you’re reliant on the exchange to remain secure and properly manage your funds. 

By contrast, a DEX allows you to retain full control of your private keys at all times. The only way you can interact with a decentralized exchange is through your own personal crypto wallets. This means you’re always in sole charge of your crypto as you trade.

Fiat trading

One of the significant advantages of a CEX is its ability to handle fiat trades, enabling users to buy cryptocurrency with Fiat (on-ramping) and vice versa (off-ramping). This makes it easy for users to quickly enter and exit the crypto market. 

DEXs, however, don’t support fiat exchanges. They operate solely with cryptocurrencies and require traders to use other means to convert fiat to crypto before they start trading.

Limitations of using a CEX

As you’ve seen from the comparison above, a centralized exchange is far from perfect. It has its upsides but also certain limitations.

Custodial wallets

A centralized exchange uses custodial wallets, meaning it has full control over user assets. The CEX holds and manages a user’s private keys so traders must trust the exchange to keep their assets secure.

Selective fiat options

Centralized exchanges enable fiat trading, but that doesn’t mean they support all types of Fiat. Most exchanges can work with Euros and Dollars, but less widely used currencies may not be accepted by the platform. In short – do your research and make sure your exchange supports the Fiat currency you’re trading with before signing up.

Data sharing

As part of their regulatory compliance, most centralized exchanges require users to complete a KYC process. Going through KYC involves providing personal information and documentation such as a government ID, driver’s license, passport or proof of address. Anyone who values their privacy can have a problem with this procedure. 

Risks of using a CEX

Trusting a third party to take care of your private keys comes with a risk – your crypto is only as secure as the exchange itself. The primary risks associated with that are:

• Bankruptcy or Mismanagement
• Hacks of the Exchange
• Censorship or Government Bans

Bankruptcy and Mismanagement

The possibility of mismanagement and bankruptcy is always there and it can cause the total loss of user assets. There’s no brighter example of this than the not-so-recent collapse of FTX. With millions of users, the FTX exchange was once the third-biggest in the world. Customers, all keeping their crypto on the platform’s custodial wallet,suffered a combined loss of nearly $9.7 billion. To this day, many of the affected users are still waiting on the return of their lost funds.

Hacks of the Exchange

While CEX security has improved over the years, the risk of a hack is ever-existent. Back in 2013, Mt. Gox handled over 70% of all Bitcoin transactions. The exchange suffered a security breach two years earlier in 2011, resulting in the loss of 25,000 Bitcoins. But that wasn’t the end. In 2014, hackers managed to steal 740,000 BTC from Mt. Gox customers and another 100,000 from the exchange itself, making it one of the biggest heists in the world. The price of the stolen assets was roughly $460 million at the time but today it would be nearly $48.8 billion.

Censorship or government bans

When it comes to regulation, not all countries are pro-crypto. China is a great example as the country has banned Bitcoin too many times to count. Depending on government regulation, certain exchanges can stop their operations in an entire region. This can affect their users’ access to funds. One of the most recent examples was India’s ban issued to nine centralized exchanges that were operating within the country.

How To Start Using a CEX – Step by Step

How can you pick the right CEX?

Beforer you begin, it’s important to define your own trading strategy. Are you looking to day trade your crypto? Do you prefer to hold long-term and use the platform for crypto savings accounts? Pick your priority and then compare the fees offered by each of the available exchanges. After that, follow these steps:

1. Choose a CEX

Ensure the centralized exchange supports the digital assets and fiat currencies you’ll be using. Bitcoin, Ethereum and the top 10 are usually found everywhere. If you want to trade more niche currencies, it’s worth checking out whether they’re available on a CEX.

2. Create an account

Sign up on the exchange’s website or do it through the app. Simply use your email address to create an account and set a password.

3. Verify your identity

Complete the KYC process by providing personal information and documents. This will most likely include you taking a picture of your ID, driver’s license, passport or another document. Plus a selfie.

4. Activate 2FA

This step is optional but highly recommended to step up your account security. With 2FA, you’ll always be asked to enter the code from your phone authenticator.

5. Deposit funds

Transfer fiat or cryptocurrencies into your exchange wallet. If you have no crypto, your sole option would be to buy some directly with a credit/debit card or a bank transfer.

6. Start Trading

Use the exchange to buy, sell, or trade cryptocurrencies. Depending on the exchange, you might also have access to different advanced tools such as margin trading, derivatives trading, trading bots, staking and more.

Closing thoughts

Centralized exchanges play an important role in the crypto ecosystem. They provide a bridge between traditional fiat and cryptocurrencies, allowing users of all experience levels to easily on and off-ramp within a regulated environment.

However, the convenience of a centralized exchange comes at the cost of users not having full control over their digital assets and the requirement to share personal details through KYC procedures. By better understanding the risks associated with using a CEX, you can define your own trading stragegy and make informed decisions about your digital assets.

FAQs about Centralized Exchanges

What are the risks of a centralized crypto exchange?

Using a centralized crypto exchange involves multiple risks such as bankruptcy or mismanagement, hacks, censorship and government bans. Since the trading platform controls your private keys, your crypto is only as safe as the exchange itself.

Should I use a centralized or decentralized crypto exchange?

It depends on your priorities. Centralized exchanges have a more user-friendly UI, fiat on-ramping, and regulatory compliance. Decentralized exchanges don’t utilize custodial wallets and allow you to retain full control over your private keys while also providing a more anonymous, decentralized trading environment.