Crypto Exchanges: Custodial vs. Non-Custodial vs. Decentralized
Innovative and experimental tech is what the crypto space is all about. This innovation drives the space forward and makes it an exciting place to be. It’s true that not every project has merit or that every ICO deserves your money but some strides are being made. How assets are traded is an example of this.
Many people bought their first chunk of crypto from Coinbase (myself included). Coinbase is an example of a custodial exchange. Most of the trade volume in the cryptocurrency space is still through traditional custodial exchanges. Non-custodial exchanges like Switchain, Shapeshift or Changelly are also an option and have become quite popular. We also have decentralized exchanges, like EtherDelta and IDEX. Decentralized exchanges haven’t reached full technological maturity yet but they hold the interest of many avid community members.
GDAX, Coinbase, Binance, Kraken, Bitfinex, Poloniex. These are all examples of custodial exchanges. They are well known and have massive amounts of crypto moving through their platforms.
They are called custodial because they are the ones in possession of your crypto; they are the custodians of your private keys. Trading is done off-chain, meaning that trading is tracked on their balance sheet instead of being verified by the blockchain. This allows transactions to be done quickly and cheaply but leads to a lack of transparency.
Account registration and identity verification are also trademarks for these kinds of exchanges. This not only slows the trading process but also forces you to trust the exchange with sensitive information such as your Social Security Number.
Trading your altcoins for other altcoins can also be annoying. For example, maybe you have Monero and you want to buy Dash. You would have to first sell your Monero for something like Bitcoin and then use your Bitcoin to buy Dash (spending more time and paying more fees).
There are some advantages to using these kinds of exchanges, like being able to deposit and withdrawal fiat currency, high trade volume, and often higher limits. They have a long history and they work, especially for moving a large sum of funds in and out of the exchange.
Although these exchanges are widely used many people feel like things could be better. Especially when you factor in the amount of customer funds lost on these exchanges due to hacks, seizures, or closure of the platform. Even the most reputable names like Coinbase experience periods of time where access to funds is unavailable (website crashes or maintenance). You may be unable to access your money when you need it the most. People still make the mistake of leaving there money on an exchange instead of moving it into cold storage or to a secure multi-coin wallet like Coinfy.
There is a slew of other reasons why people are working hard to explore alternatives to this kind of exchange. From allegations of market manipulation and insider trading to forks not being recognized. They are seen by some as being the “big banks” of the crypto space and causing a centralized effect. Many people feel like the cons outweigh the pros which is why some have been laboring tirelessly to create a new era of trading. Custodial exchanges are indeed dominant in the crypto space. Their trade volume is unmatched, but their dominance has faded some due to alternative solutions being introduced.
How can trading occur in a way that ensures liquidity and security while maintaining convenience and a user-friendly interface? The non-custodial or “instant” exchange! No account is needed and they make altcoin-to-altcoin trading a breeze. The process is simple enough for even the most inexperienced traders to complete a transaction.
The fact that no account is needed for trading makes this model perfect for people who just want to complete a quick trade. It’s also good for individuals who don’t want to commit to an exchange or who are hesitant to entrust an exchange with personal information. The environment allows for a higher degree of anonymity and security.
A trade is made instantly on your behalf, a non-custodial exchange does not hold your money as a custodial one does. After a short period of time, the crypto is automatically deposited back into your possession.
Although Shapeshift is the most well-known example of a non-custodial exchange, a few noteworthy competitors exist. Changelly and Evercoin are also viable options. But another option known as Switchain provides an even better trading experience. What sets Switchain apart is the fact that it not only has its own trade pairs available, but it compares rates across exchanges to make sure you always get the best deal. This makes non-custodial exchanges even more enticing as low-cost trading combined with privacy and convenience offer a superior trading alternative.
A third option to transact some crypto would be using a decentralized exchange. This type of exchange still has a relatively small trade volume but it’s growing, despite still being in its developmental stages.
The idea is to have an open-source, permissionless on-chain platform for trades to take place. There is no need to trust a third party with your private keys. Although speed bumps are slowing progress(scalability and fees for example), the demand for such an exchange is still strong. Etherdelta and IDEX are two well-known examples.
Trading is completed utilizing smart contracts on the Ethereum network instead of being done on a centralized platform. Ethereum tokens are traded on these exchanges (Ethereum isn’t the only platform supporting decentralized exchanges but it’s the most prevalent).
Although trusting a third party isn’t necessary, a lot of faith is put on the smart contract itself. Money can and has been stolen from decentralized exchanges despite the fact that many community members considered them unhackable.
There is also a concept called cross-chain atomic swapping which would allow cryptocurrencies on different blockchains to be traded in a decentralized fashion. Successful atomic swaps have occurred but there’re restrictions and a product that allows this kind of trading hasn’t fully manifested yet.
Which is the Best?
So, after having used these kinds of exchanges, what do I think offers the superior trading experience? What is best is determined by the circumstances of your trade. I may use either of these options depending on exactly what I’m hoping to achieve.
If I want some obscure ERC20 token than a decentralized exchange is where I go. I recommend IDEX.
If I want to purchase cryptocurrency with fiat currency or trade a crypto not found on non-custodial or decentralized exchanges (something like IOTA) than I use a custodial exchange. I prefer Binance although they don’t have fiat trade pairs.
For most trading, I use a non-custodial exchange. This is my preferred method after factoring in the benefits and drawbacks of the options available. Switchain is your best bet for most everyday trades.
The potential future paved by cryptocurrency and blockchain technology rely upon its usability and adoption. How do we facilitate this growth? Digital assets are heavily dependent upon people’s ability to easily and freely trade these assets. Advancements have been made to make sure that the space continues to grow. New tools have emerged from the space and I recommend giving them a try to see what works for you.