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Centralized Exchanges (CEXs): A Complete Guide to How They Work

Centralized Exchanges (CEXs): A Complete Guide to How They Work

tl;dr

  • First crypto exchange, New Liberty Standard, launched in 2009, set the initial BTC-to-USD rate.

  • Mt. Gox dominated BTC trading but collapsed in 2014 due to a massive hack.

  • CEXs remain the most popular platforms for trading due to ease of use and liquidity.

  • CEXs offer a variety of trading pairs and periodically list or delist assets.

A Brief Introduction to Centralized Exchanges (CEXs)

Crypto exchanges are platforms that allow users to buy, sell, and trade cryptocurrencies. The first-ever exchange, New Liberty Standard, launched on October 5, 2009, shortly after the release of the Bitcoin whitepaper. It set the first Bitcoin-to-fiat exchange rate based on electricity costs and recorded the first BTC-to-USD sale: 5,050 BTC for $5.02 via PayPal. Though it eventually faded into obscurity, New Liberty Standard laid the groundwork for the crypto trading ecosystem.

The landscape changed dramatically with the launch of Mt. Gox on July 18, 2010. Originally a trading site for "Magic: The Gathering" cards, it quickly became the dominant Bitcoin exchange, handling over 70% of global BTC trades at its peak. However, its collapse in 2014 after losing 850,000 BTC highlighted the importance of security.

Today, CEXs remain the most popular choice for crypto traders and investors due to their user-friendly interfaces, liquidity, and robust trading features.

How Centralized Exchanges Function

Different exchanges operate in different ways. There is some common ground that nearly all CEXs share. Here’s a peek.

Account Creation and Verification (KYC/AML)

To use a centralized exchange, users must first create an account by providing basic information such as email and password. Most CEXs require Know Your Customer (KYC) and Anti-Money Laundering (AML) verification, which involves submitting ID documents and proof of address. These procedures may help prevent fraud, identity theft, and illegal financial activities to some extent, but are invasive. Additionally, there were hacks or leaks of KYC documents like the Binance KYC hack.

Order Books and Matching Engines

CEXs use order books to display buy and sell offers for different trading pairs. Traders can place market, limit, or stop orders depending on their strategies. A matching engine continuously scans the order book to match buy and sell orders in real time, ensuring efficient and fair trade execution.

Trading Pairs and Asset Listings

CEXs offer a wide range of trading pairs, such as BTC/USD or ETH/BTC, enabling users to exchange one asset for another. New assets are listed after meeting internal criteria like liquidity, compliance, and project credibility. Assets can also be delisted if they become inactive or fail to meet regulatory or security standards.

Custodial Services and Wallet Management

CEXs hold user funds in custodial wallets, meaning the platform controls the private keys. While this setup offers convenience, it also carries risks like hacks or platform insolvency. Some CEXs now offer optional non-custodial features for added security.

Key Features and Services Offered by CEXs

In modern times, CEXs have a nearly never-ending list of features and functionalities for users to enjoy. At their core, however, centralized exchanges are all about trading. Here are a few key features nearly every CEX offers.

Spot Trading

Spot trading is the most common form of crypto trading on centralized exchanges. It involves buying or selling cryptocurrencies for immediate delivery. Users trade directly using available funds at current market prices or through limit orders. Spot markets are highly liquid and support a wide variety of trading pairs.

Margin Trading and Leverage

Margin trading allows users to borrow funds to trade larger positions than their actual balance. CEXs offer leverage, often ranging from 2x to 100x, enabling traders to amplify potential gains. However, this also increases risk, as market fluctuations can lead to liquidations and significant losses.

Futures and Derivatives Trading

CEXs provide futures contracts and other derivatives that allow traders to speculate on the future price of cryptocurrencies without owning the underlying asset. These products support hedging strategies and high-leverage opportunities, but require advanced understanding due to their complexity and volatility.

Staking and Lending Services

Many CEXs now offer staking and crypto lending, allowing users to earn passive income. By locking up tokens or lending them to other users, participants can earn interest or rewards, typically in the form of additional tokens.

API Access and Integration

CEXs offer API access for developers and traders, enabling them to automate trades, integrate analytics tools, or build custom platforms. APIs provide real-time data and trading functionality, crucial for algorithmic strategies and institutional access.

Advantages and Disadvantages of Using CEXs

CEXs offer a user-friendly experience, making them ideal for beginners. They provide high liquidity, fast order execution, and access to a wide range of trading pairs and services, including customer support. 

However, CEXs come with downsides. Their centralized nature creates single points of failure, increasing vulnerability to hacks or internal mismanagement. Additionally, users must complete invasive KYC/AML procedures, raising privacy concerns. While convenient and efficient, CEXs require trust in the platform’s security and leadership.

Security Considerations and Best Practices

As the gateway to crypto trading and investment, centralized exchanges are frequent targets for cyber threats. To safeguard your funds and data, it's essential to follow security best practices and remain vigilant when using any CEX.

Two-Factor Authentication (2FA) and Multi-Factor Authentication (MFA)

Enabling 2FA or MFA adds an extra layer of protection by requiring a second form of verification before accessing your account. The code can be an SMS, email, or uniquely generated key. While far from being a bulletproof solution, 2FA can reduce the risk of unauthorized access.

Cold Storage and Security Protocols

Reputable CEXs store the majority of user funds in cold wallets, which are offline and inaccessible to hackers. CEXs should also implement strict internal security policies, encryption, fund segregation, and regular audits to protect assets.

Due Diligence and Research

Always research the exchange’s background, security history, and user reviews. Stick to well-established platforms with a transparent track record and clear operational practices.

Avoiding Phishing and Scams

Beware of fake websites, email scams, and malicious links mimicking popular exchanges. Always double-check URLs, never share credentials, and consider using browser bookmarks to access trusted CEXs safely.

The Role of CEXs in the Crypto Ecosystem

CEXs are among the richest and most influential players in the Web3 ecosystem. When a major CEX collapses, whether due to mismanagement, like FTX, or a hack, like Cryptopia, it sends shockwaves throughout the crypto industry, eroding trust and stalling adoption.

CEXs serve as vital on-ramps and off-ramps, allowing users to convert fiat currencies into crypto and vice versa. They play a pivotal role in price discovery and market liquidity, often setting the tone for broader market sentiment.

Despite their centralized nature, CEXs coexist with decentralized finance (DeFi), often acting as gateways that funnel users toward DeFi protocols. Some even integrate DeFi-like services such as staking and yield products.

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