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Exchanging crypto

Lesson in Course: Crypto (advanced, 8min )

We want to buy crypto, but what does a trade look like on CEXs and DEXs?

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, and the cash or crypto we want to use to buy it.

Below is a screenshot of converting $25 of USDC into ETH using Coinbase.

Here, Coinbase offers us 0.01052559 ETH (we can trade a small fraction of crypto) for 25 USDC. We should keep in mind that CEXs, like Coinbase, provide a service for us. They 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 look at Uniswap, a DEX, when we receive a quote from Coinbase. We see the following conversion ratio offered.

On this DEX, we can trade 25 USDC for 0.0112521 ETH. Placing our trade here would give us slightly 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 cost associated with acquiring the ETH. 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.

 
Examples of taxes from trades

Let's consider a straightforward transaction. Say we buy 0.01 Bitcoin (BTC) for $300 on January 1, 2021, and then sell the BTC for $500 on May 6, 2021. In that case, we have $200 of short-term taxable gains.

Let's consider a more complicated exchange. Like the example above, we bought 0.01 BTC for $300, and it is now worth $500. This time, we want to buy an NFT instead. We need ETH to purchase the NFT, so we need to trade our BTC for ETH first. In this case, we still face $200 of taxable income because we exchanged the property (BTC) for other property (ETH), which is considered a taxable transaction. The NFT will then be taxable if we sell it for a realized gain.

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!

 

Decentralized exchanges

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.

yield farming

Yield farming, also known as liquidity mining, is a method of earning crypto by temporarily lending crypto to DeFi platforms in a permissionless environment.

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.

Individual DeFi projects

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
  • Trajectory
  • Valuation propositions
  • Team & Founders
  • Technology
  • Tokennomics & token inflation rate

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.

Glossary

What is yield farming?

Yield farming, alternatively known as liquidity mining, is a method of earning crypto by temporarily lending crypto to DeFi platforms in a permissionless environment.

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