We need to use an exchange to trade our cash or crypto for any other crypto. Both a CEX or a DEX can help us do so, but we want to be mindful of the differences of using each.
Trading on a centralized exchange
CEXs offer a convenient way for us to find a buyer or seller to trade with while also acting as a custodian of our crypto wallet. To make a trade:
- We queue up a transaction
- Select the crypto we wish to buy
- Choose the cash or crypto we want to use to buy it
We should keep in mind that CEXs, like Coinbase, provide a service for us. The exchanges make money by finding us a buyer for our USDC and a seller for the ETH we want. Rather than charging us directly, Coinbase will include the service fee in the exchange rate.
The service fee becomes more apparent if we compare the exchange rates at Uniswap, a DEX, when we receive a quote from Coinbase.
Placing our trade through Uniswap would give us more ETH for the same amount of USDC! While the difference between 0.01052559 and 0.0112521 seems small, the convenience fee that Coinbase charges is about 7% of the transaction value. These fees pay for the additional services that Coinbase provides, like tax documents and tracking for us.
The moment we exchange our USDC for ETH, we have a known cost of acquiring the ETH. Future taxes are calculated against this cost.
Let's assume ETH increased 30% in value, and we decide to swap back to USDC. The trade is considered a realized gain on our ETH and is, therefore, a taxable event. Coinbase tracks all of these transactions and prepares a tax document for us at the end of the year.
We might find that this fee is worth the convenience. However, using a DEX may make more sense if we invest large amounts of money or make frequent transactions...these fees will add up!
A DEX is another way for us to trade crypto. One of the major advantages of using a DEX is the lower transaction fees and access to more cryptocurrencies.
In the example above, Uniswap is only taking 0.164% of the transaction value. The most popular DEXs are Uniswap (built on Ethereum), Pancakeswap (built on Binance), and Sushiswap (also built on Binance).
For convenience, many crypto investors also use a DEX aggregator like 1inch. 1inch will search all DEXs for an exchange we want and show the best option. It also allows us to exchange our crypto with the aggregator.
Cost savings only scratch the surface of what DEXs provide. With a DEX, we can loan our own crypto and earn interest through yield-farming.
Yield farming allows us to earn passive income with our crypto investments, much like receiving dividends from stocks or interest from bonds. However, yields in crypto are much higher because they are riskier investments. Depending on the risk, rates are as high as 400% APY (annual percent yield).
DEXs also allow investors to invest in the tokens of individual DeFi projects. We can think of investing in tokens as being similar to investing in the stock of a startup. When we buy tokens in a DeFi project, we provide the team with money to continue building its business. If the team succeeds and the project is successful, we could see the value of our token rise significantly; however, the tokens could also be worthless if the project fails.
Before buying tokens for DeFi projects, we need to do proper due diligence. To do that, we should look at the following aspects of a DeFi project:
- Revenue streams
- Social growth
- Valuation propositions
- Team & Founders
- Tokennomics & token inflation rate
We've only just begun to scratch the surface of the possibilities with decentralized finance. We'll cover how to do everything mentioned above in future lessons.
We may find crypto trades on a CEX to be more than sufficient for investing in crypto. However, using a CEX is not mutually exclusive to using a DEX; we can use both. Despite higher fees, we still use CEXs because they allow us to convert crypto back into cash so we can pay for most things like bills. We should make our trades on CEXs until we set up our own digital wallet and are ready to go deeper into the decentralized world.