CEX needs DEX.

TLDR;

  • CEXs and DEXs are often viewed as competitors, but they can work together with a CEX running a decentralized backend to ensure security, transparency, and permissionless transactions.
  • Centralized frontends are necessary for users who cannot or will not self-custody. Not everyone will use a DEX.
  • On-chain transparency prevents shady issues related to misuse or commingling of funds, including outright fraud.
  • A CEX allows frontends to implement KYC/AML, filter tokens, and take other compliance measures applicable to their jurisdictions and principles.
  • A DEX is a backend that is always permissionless and cannot be stopped or censored by governments, whether for benign or malicious reasons.
  • Infrastructure improvements mean DEXs can support assets from multiple chains, a key differentiator for CEXs in the past.

It is evident that centralized exchanges (CEXs) can no longer support the growth of cryptocurrency.

Sergey Gorbunov, co-founder and CEO of Axelar and leader of the cryptography group that built Algorand.

CEXs have lost billions in successive waves of attacks: external hacks (Mt. Gox), internal misuse of funds (FTX), and regulatory crackdowns (Binance and Coinbase). Their decentralized counterparts, DEXs, are a defense against all three.

However, CEXs remain vital for users who do not want self-custody and for operators who require jurisdictional compliance. To meet these needs and defend against the threats they face, CEXs now require a hybrid solution that integrates DEX technology. Specifically, they need layers of smart contracts that can be put on-chain as the backend to a centralized frontend.

This need is emerging just as new interoperability infrastructure makes this kind of integration possible. And it’s why I say every CEX needs a DEX.

Background on DEXs & CEXs

The first DEXs emerged within months of the Mt. Gox hack being made public. They gained popularity as a way to stay safe and clear of CEXs, which were seen as “honey pots”: pools of money that are attractive to hackers.

Outside attackers have stolen over $15 billion from Mt. Gox and successive generations of CEXs, according to data through 2020. However, the successors matured, and the threat of such CEX “hacks” has greatly diminished. Today, CEXs handle 10 to 100 times the notional volume that DEXs traffic.

Of course, there are other threats besides “hacks.” FTX imploded after a cadre of managers commingled and seemingly lost billions worth of customer funds on an affiliated hedge fund. Binance and Coinbase, the two largest exchanges, face existential threats from the world’s most powerful financial regulator.

DEXs provide strong safeguards against all three of these threats: hacks, fraud, and regulatory overreach. And for the first time, they can compete on a feature that until now has set CEXs apart: the ability to trade any token from any chain.

Binance realized this early and built its own decentralized blockchain and DEX. OKX followed soon after. Now, Coinbase has announced it is launching a layer-2 blockchain called Base. The fact that the largest CEXs are developing decentralized systems is telling: DEXs are not necessarily competitors to centralized exchanges; they are complements.

Here’s why every CEX needs a DEX (and vice versa):

DEXs are secure

Decentralization improves robustness against failure and attack. That’s the principle that drove the creation of the internet’s earliest iterations, in an effort to make computer systems resilient against nuclear attack.

The longevity and system reliability demonstrated by Bitcoin and Ethereum are also a testament to the robustness of decentralized approaches.

Decentralized approaches are the best way to protect systems against attack and failure.

CEXs are easy to use

In general, DEXs are more robust than CEXs, but historically they haven’t been able to compete on features, like trading tokens issued on separate blockchains. Interchain infrastructure improvements mean DEXs can now do that and handle transactions faster by scaling horizontally.

However, some users may be deterred by the core feature of DEXs – their decentralization – as not everyone wants to manage their own private keys. Mass adoption of DEXs will not be feasible without custodial (centralized) onramps, whether measured in terms of users or dollars.

One of the most successful custodial onramps is FTX, which was an astonishing success before its catastrophic failure. However, users had no way to verify how FTX was using their money, which was gambled and lost.

On a DEX, transactions are published on-chain, allowing users to verify the integrity of their deposits and see where they are being used. Although funds can still be commingled, it is harder to hide that fact from users. A DEX running on the backend can provide periodic visibility into where funds are stored and how they are being used, which users can verify using a block explorer.

On the other hand, integrating off-chain information can be difficult on a DEX, requiring complex and fragile “oracles.” Centralized exchanges, or CEXs, can easily handle know-your-customer (KYC) and anti-money laundering (AML) processes, limit what tokens they list, and apply other filters required by regulation applicable to their jurisdictions.

Since its inception, cryptocurrency has been identified as a way to protect against governments that abuse or overuse their power. Any backend that inherits bitcoin’s properties can never be stopped, and the use of such a system will always be permissionless, without gatekeepers. For centralized exchanges, a decentralized backend serves the same function: a guarantee to users that no matter what action a government may take against the exchange operator itself, the pipes used to handle transactions are proof against overreach.

For many true believers, decentralized exchanges have always been the dream, as cryptocurrencies are decentralized and should run over decentralized systems. However, in every wave of enthusiasm for cryptocurrency, CEXs have served as the onramps and primary interaction experiences for the majority of user traffic due to their greater and faster throughput, and their ability to list pairs across various blockchains. Improvements in blockchain interoperability have changed the game for DEXs on both factors, allowing them to offer cross-chain swaps and scale horizontally while avoiding congestion.

See also: Osmosis Labs’ Sunny Aggarwal: Why Appchains Are DeFi’s Future

The ability to interoperate between different blockchain technologies allows for continued horizontal scaling. This means that applications can move onto newer and faster blockchain technologies as they emerge, without requiring their users to switch over.

Additionally, a decentralized exchange (DEX) backend allows a centralized exchange (CEX) to collaborate with other builders, integrating features and network effects into new “super-app” products. Overall, blockchain infrastructure is rapidly approaching a point where building decentralized applications is no longer just a matter of principle, but also a matter of competitive advantage and ultimately, survival.