Chapter 1: Core Concepts of Exchanges
1. Centralized Exchanges (CEX)
1.1 Definition & System Architecture
Definition: A custodial trading platform operated by a single corporate entity. Matching, risk control, and clearing/settlement occur off-chain; blockchains are used mainly for deposits and withdrawals.
Core modules:
Accounts & Custody
Hot/Cold wallet system (hot wallets serve liquidity and small, frequent flows; cold wallets keep most funds offline long-term).
Multisig / MPC key management to reduce single-point key-exposure risk.
Matching Engine
Price–time priority matching with nano–millisecond latency; supports batch matching and in-memory/on-disk snapshots of the matching core.
Order types: market, limit, stop-loss (SL), take-profit (TP), IOC/FOK, post-only, hidden/iceberg, reduce-only, etc.
Risk & Clearing
Spot: T+0 real-time settlement; rollback strategies for abnormal matches.
Perpetuals/Derivatives:
Margin modes: isolated vs. cross; initial/maintenance margin curves;
Risk engine: stepwise deleveraging tiers, liquidation flows, insurance fund and ADL (auto-deleveraging);
Funding rate: periodic fee balancing longs vs. shorts;
Mark price / index price: prevents unreasonable liquidations due to manipulation.
Fiat On/Off-Ramps
Banking rails, card schemes, payment processors, compliant stablecoin rails (mint/redeem).
Risk & Compliance
KYC/AML/sanctions screening, on-chain tracing/monitoring, suspicious activity reports (SARs), Travel Rule support, geo-fencing;
Monitoring for AML, wash-trading, market manipulation (layering, pump-and-dump, wash trades).
1.2 Advantages & User Experience
High performance & deep liquidity: Centralized matching and a unified order book lower spreads and market-impact costs.
Rich product suite: Fiat rails, margin/derivatives, options, OTC/block trades, lending, staking, Earn, copy trading, etc.
Friendly UX: One-click orders, unified settlement currency, customer support—newcomer-friendly.
1.3 Key Risks & Mitigations
Counterparty risk
Funds are custodied by the platform—Not your keys, not your coins.
Mitigations:
PoR (Proof of Reserves): on-chain reserve addresses + Merkle-proofed liabilities + third-party attestation;
Limits: point-in-time only; blind to external borrowing/off-balance-sheet liabilities; trust in auditor/process; rehypothecation risk.
Opacity
Matching and settlement occur in a black box; information asymmetry/insider-risk (e.g., potential pre-trading, internalization).
Mitigations: trade surveillance, access-log retention, matching-engine isolation, bandwidth isolation, regulatory sandboxes/licensing constraints.
Operational & compliance risk
Regulatory shifts, licensing hurdles, regional restrictions, service pauses and withdrawal throttling.
Security risk
Hot-wallet compromise, privilege abuse, social engineering, supply-chain attacks;
Mitigations: MPC, multisig, withdrawal allowlists, withdrawal delays, risk thresholds, SOC 2/ISO 27001, bug bounties, incident drills.
1.4 Engineering & Data Metrics to Assess a CEX
Market quality
Depth (e.g., executable size within ±10 bps), realized market-impact, slippage distribution, spread, order-gateway latency, reject rate, matching lag / queue-jump incidence.
Reliability
Peak QPS, matching jitter, availability (>99.9%), circuit breakers and rollback, active-active across regions.
Risk robustness
Liquidation incident rate, ADL trigger rate, insurance fund size, continuity during extreme volatility.
Compliance & transparency
Licensed jurisdictions, Travel Rule coverage, PoR disclosure cadence/method, availability of audit reports.
2. Decentralized Exchanges (DEX)
2.1 Definition & Ecosystem Components
Definition: Non-custodial trading protocols on blockchains. Assets remain in users’ wallets; smart contracts handle quoting, matching, and settlement.
Ecosystem components:
Market-making mechanisms
AMMs: Constant product
x*y=k(Uniswap V2); stable-swap curves (near-constant-sum, Curve); concentrated liquidity (Uniswap V3—price-range LPing for capital efficiency).Order-book DEXs: on-chain/off-chain order books with on-chain settlement (common on some L2s/specific chains).
RFQ / Intent: Users submit intents; solvers/market makers compete to fill, often via batch auctions to reduce MEV (the auction/solver route).
Routing & aggregation: multi-pool paths, cross-protocol aggregation, best-path search, some support split fills and RFQ hybrids.
Oracles: TWAP/in-pool pricing; external decentralized oracles with manipulation-resistance.
Governance & fees: protocol fees, LP fees (static/dynamic), buybacks & treasury, incentive tokens.
2.2 Trading Flow (typical AMM)
Approve: User
approves tokens (or uses Permit/EIP-2612 for gasless approval).Quote: Front-end/aggregator reads pool reserves & fee, estimates slippage and minimum out.
Submit: User signs and sends the tx (L1 or L2); it enters the mempool awaiting inclusion.
Settle: Contract updates reserves per curve, swaps tokens, and emits logs.
2.3 Advantages
Asset sovereignty: Users keep their keys—no custodial counterparty risk.
Verifiable transparency: Rules are in code; on-chain and auditable.
Censorship resistance: Any address can interact with minimal permission (subject to base-chain/front-end constraints).
2.4 Challenges & Technical Considerations
Performance & cost
Constrained by L1 TPS/gas;
L2 rollups cut costs and latency; EIP-4844/blobs further reduce DA costs.
MEV & execution fairness
Sandwiching, front-/back-running, liquidation races, arbitrage crowd-outs;
Mitigations: private mempools/protected RPC, frequent batch auctions (FBA), intents+solvers, threshold encryption/delayed reveal, dark auctions, randomized routing, ZK-private transactions.
Smart-contract & oracle risk
Reentrancy, price manipulation, flash-loan coupling, privilege misconfig, init-defects, arithmetic bugs, etc.;
Mitigations: multiple audits, formal verification, bug bounties, split privileges/timelocks, parameter caps, multi-source oracle aggregation.
LP risk & incentives
Impermanent loss (IL), adverse selection / toxic flow, LVR (loss vs. rebalancing / price-update lag);
Mitigations: stable-swap curves, dynamic fees, tight-range CLMM management, hedging, MM-as-a-Service (MMaaS).
User experience
Approvals/signing, gas settings, slippage tolerance, revert handling;
Account abstraction (AA), batching, paymasters, social recovery improve usability.
Compliance pathways
Whitelisted pools/restricted front-ends, compliant routing, on-chain credentials (VCs) and optional KYC scenarios.
2.5 Engineering & Data Metrics to Assess a DEX
Liquidity & execution quality: pool TVL, 30D/7D/24H volume, unit-size market impact, time-of-day slippage profiles.
Efficiency & cost: average confirmation time, failure rate, average gas cost, L2 fees and withdrawal latency.
Security: audit count/depth, bounty ceiling, incident history, proxy/upgrade permissions, oracle protections.
Sustainability: LP APY (net of IL), protocol fee capture, incentive inflation, governance participation.
3. CEX vs. DEX: Dimensional Comparison
Asset custody
Platform custody (hot/cold/MPC)
Self-custody (user wallet signatures)
Matching
Off-chain order book; millisecond latency
AMM / order book / intent; constrained by base-chain performance
Transparency
Low (black box); PoR helps but limited
High (contracts and transactions auditable on-chain)
Perf/Cost
High performance; low unit execution cost
L1-limited; L2s can approach CEX-like UX
Product breadth
Fiat, margin/derivatives, options, Earn, etc.
Mostly spot; derivatives/options maturing
Key risks
Custody / operations / compliance
Contract / oracle / MEV / IL
Compliance
Strong KYC/AML/licensing
Optional compliance modules / front-end gating
Listing bar
Centralized reviews & MM arrangements
Any contract can deploy; trust via community/audits
Composability
Weak (platform walled garden)
Strong (composable with other DeFi protocols)
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