Cryptocurrency exchanges are keystones in the buildup of the Internet of Value; a crypto-exchange offers a literal gateway into a world of thousands of digital assets that can be traded peer to peer and utilized for accessing a multitude of payment networks and decentralized applications.
For many users, their first cryptocurrency purchase would have been conducted through an exchange and therefore, it is no surprise that some exchanges have become industry giants.
In an ironic twist of fate however, for an industry that emphasizes decentralization and the optionality to transact without an intermediary, centralized exchanges play a critical role in the growth of the overall market.
As centralized exchanges have accumulated great wealth and power over time, people have questioned whether the mission to ‘decentralize the world’ has been undermined by excessive centralization. Big, centralized exchanges carry the same security, privacy, and censorship flaws that come along with traditional financial institutions.
Decentralized exchanges are an alternative solution that aligns more with the original crypto ethos and values of security, privacy, and autonomy. Debates on the merits and importance of decentralization have drawn some attention and focus in recent times and in this article, we will explore and discuss the pros and cons of centralized vs. decentralized exchanges.
Breaking down what they each have to offer for this space, and where they can improve moving forward to help advance the growth, adoption, and expansion of cryptocurrencies and blockchain technology overall.
The Strengths of Centralized Exchanges (CEX):
- Regulatory Compliance
- Ease of Use and Liquidity
- Fiat to Crypto Gateway
The first strength of a centralized exchange (CEX) is the most obvious one, and that is its speed!
Centralized exchanges operate more efficiently during times of high load and stress as they run on centralized servers and architectures. This allows for quick execution of trade orders in a centralized order book, and reduces the time taken to process orders in times of high volume.
Conversely, a decentralized exchange application must synchronize order books across many nodes, a task that can be challenging when high volatility brings about lots of order creation and execution requests in a short period of time.
Centralized exchanges are usually open to disclosing information as their team members and public headquarters are disclosed to the public. Because CEXs also have a lot more users than their decentralized counterparts, they are generally under heavier scrutiny from the public as well as government officials and authorities.
This transparency may only extend to basic information that most would expect from a public facing company to disclose, however even such basic information isn’t always provided by actors and players in this space. Because the blockchain industry largely stands unregulated at this time, with its founding principles based on the values of privacy and anonymity, this has resulted in a lack of transparent practices.
If an exchange is known for their lack of transparency however, this may deter users from trading on their exchange due to a lack of trust. This could be argued as one of the reasons why centralized exchanges are currently more popular than decentralized exchanges, which can be less transparent at times due to the decentralized nature of the platform.
If auditors develop specific tools geared towards decentralized exchanges however, this ‘trust gap’ could be bridged over time.
#3 Regulatory Compliance
In addition to greater transparency, most centralized exchanges seek to remain compliant under governmental regulations and authorities. Exchanges such as Coinbase, Bittrex, and Gemini require all of their users to verify their identity with KYC procedures.
At Blockchain.io, we are working closely with French government authorities and regulators to ensure that we remain compliant at all times with the introduction of new cryptocurrency rules and regulations that are proposed.
#4 Ease of Use and Liquidity
As a result of the speed and ease of use in CEXs, users are attracted to a better trading experience and this also results in greater trading volumes and liquidity for everyone trading throughout the centralized platform.
In addition, when a user friendly interface is paired with the ability to quickly execute trades, this provides a great overall experience for new traders and veterans alike, and this helps to retain users within an exchange’s ecosystem.
#5 Fiat to Crypto Gateway
CEX that are compliant with regulations are able to more easily connect to the outside financial world to offer a fiat ramp to crypto because banking services are able to adhere to their own financial rules and regulations. This means CEX provide users with the ability to transfer money from their bank accounts directly into exchanges to buy cryptocurrencies, as well as withdraw cryptocurrencies back into fiat as they please.
Having gone over some of the strengths of centralized exchanges, here are now some of the strengths of decentralized exchanges we can consider:
- Censorship Resistance
- Less Potential for Manipulation
One of the primary offerings in decentralized exchanges is their emphasis on privacy and anonymity. These exchanges often don’t require anything more than a username, password, and crypto wallet to begin trading.
The ease with which people can sign up and begin trading without having to go through KYC is attractive to those who would prefer to remain anonymous, and who also want to be able to deposit, trade, and withdraw their funds quickly.
Depending on the type of decentralized exchange, they tend to offer greater security than centralized exchanges because they do not have centralized wallets for a hacker to target and steal all users’ funds.
As DEXs perform decentralized settlement for orders, this minimizes potential attack vectors for hackers to exploit, and in some instances the chances of a successful attack occurring is almost negligible.
Users are also able to maintain complete custody of their funds that are placed in escrow whilst they trade, offering users peace of mind in the security of their funds. Even if the DEX stopped functioning, a user could recover her funds after the escrow transaction has expired.
#3 Censorship Resistance
Since there is no central entity supervising the trades and orders conducted on a DEX, a decentralized exchange offers greater censorship resistance than centralized exchanges. Government officials, authorities, and even hackers are not able to directly interfere and stop trades from occurring.
As there is no central entity or party running the show, this also makes it much harder for DEXs to be shutdown and censored.
#4 Less Potential for Manipulation
Without a centralized entity or orderbook maintaining and executing on trades, this minimizes the potential for manipulation.
In the past, several exchanges have been accused of wash trading to create fake volume, and cutting off deposits and withdrawals on tokens at key trading times, or manipulating the trade order and price of tokens.
As there is no controlled order book for decentralized exchanges, this means there is less potential for such manipulative behavior to take place.
Now having gone over the strengths for both centralized and decentralized exchanges, let’s switch gears to dive into some of their weaknesses…
The Weaknesses of Centralized Exchanges:
- Lack of Censorship Resistance and Transparency
- Monopolistic Environment
Centralized exchanges tend to operate with a single point of failure, whether that is a central database, wallet, or server, and this means one hack could result in the loss of millions of dollars.
Mt. Gox is the prime example of this, being an exchange hacked back in 2014 that resulted in the loss of $450 million. These incidents have been all too common throughout the lifetime of cryptocurrencies and usually results in a significant decline in price due to the fear from the public and in people withdrawing their funds.
A consequence of centralization is the increased potential for systems failures. CEX exchanges can face severe downtimes due to technical issues or even persistent DDoS attacks.
It is also possible for government agencies or authorities to order exchanges to stop their operations for a period of time. The CEX itself may also choose to halt trading for any handful of reasons, such as upgrading infrastructure, in times of hacks, or to ensure regulatory compliance.
#3 Lack of Censorship Resistance and Transparency
Centralized exchanges are more vulnerable to government censorship. Exchanges can easily have their operating licenses revoked, their funds seized, and may even be coerced into revealing sensitive information about their users and their funds.
There have been several instances in the past where governments have banned and forced exchanges to shut down, such as in India and China.
Although centralized exchanges may seem more transparent on the surface, due to the lack of regulations in this space, some exchanges can and do undertake questionable activities and behavior, unbeknownst to the public. Some exchanges participate in wash trading activities to superficially boost their trading volumes, whilst others have mismanaged and misused their user’s funds that were kept under their custody.
#4 Monopolistic Environment
The lack of competitive DEXs has created a market where a handful of centralized exchanges have taken up the majority share of the market. This has allowed some exchanges to charge projects millions of dollars in order for them to have their tokens listed on the exchange.
Some see this as a sign that centralized exchanges are accumulating too much power and are effectively limiting the potential growth and adoption of cryptocurrencies.
To consider how a shift towards more users favoring DEXs may eventuate, we have to take a look at the current weaknesses of DEXs to see where potential improvements can be made!
The Weaknesses of Decentralized Exchanges:
- Speed and Efficiency
- Crypto to Crypto Only
#1 Speed and Efficiency
As decentralized exchanges operate primarily on-chain with the use of smart contracts, achieving consensus and executing trade orders can take more time than on a centralized off-chain transaction platform.
The same can be said for making and confirming deposits and withdrawals. In times of high volume and traffic, congestion in blockchain networks can effectively render DEXs unusable as it becomes impossible to escrow, cash out, or even execute on trades in a timely manner.
Currently, blockchains are plagued by a problem known as the “Scalability Trilemma”. This trilemma addresses the issue of how blockchains are incapable of achieving scalability, decentralization, and security, without compromising for one of these attributes.
The trilemma explains why scalability solutions now entail multi-layered protocols, combining on-chain and off-chain transaction flows.
Typically, centralized exchanges execute trades off-chain in a traditional, high performance database while utilizing on-chain transactions only for deposits and withdrawals.
As decentralized exchanges operate on-chain, facing the scalability trilemma, they are generally slower and less efficient than centralized exchanges. For greater adoption of DEXs, scalability will have to be addressed as one of the primary bottlenecks.
Customer support is a highly valued service and almost a necessity for any online service or product these days. When it comes to decentralized exchanges however, customer support is sorely lacking. On DEXs, traders are usually left to their own to diagnose technical trading issues or problems they experience.
DEXs tend to attract users who are more experienced when it comes to using cryptocurrencies, and so they also usually understand how to overcome common user experience problems, such as transferring funds to and from a crypto wallet, and executing trades in a decentralized trustless manner.
#4 Only Crypto to Crypto
A big barrier to entry for DEX is their lack of support for fiat to crypto offerings. This missing feature results from the lack of having a centralized entity, as well as the regulatory uncertainty that surrounds the space.
As a crypto to crypto exchange, decentralized exchanges can operate completely detached from the traditional finance system, however this comes at the cost of users needing to familiarize themselves with centralized exchanges first that offer fiat to crypto trading pairs, who may also offer crypto to crypto trading, meaning users may never have to leave their platform.
After it’s all said and done…
Currently, the free market economy favors centralized exchanges due to their ease of use, efficiency, and higher trading volumes. This has allowed some exchanges to exploit the supply and demand imbalance by charging blockchain projects exorbitant fees for listing their tokens.
This trend will hopefully fade over time as more decentralized exchanges come online, proving their value and taking up some of the market share. In the meantime, customers will naturally gravitate to the exchange best suited to their temperament and what they are looking for in trading when it comes to safety, privacy, speed, and transparency.
Blockchain.io has strongly taken these pros and cons into account to provide a solution that offers the best of both worlds. Through the combination of a centralized order book with a decentralized settlement, we offer users a quick, safe, and reliable crypto to crypto exchange to provide new traders and veterans alike with a seamless trading experience.
We welcome you to sign up and trade on our exchange at Blockchain.io!