Anyone buying cryptocurrency will invariably end up needing to use an exchange. As Bitcoin and other cryptocurrencies have become more mainstream over recent years, hundreds of trading platforms have popped up to service the growing population of crypto users. At the time of writing, CoinMarketCap lists over 250; however, there are many more when all of the local and institutional exchanges are factored in.
Over the years, users of crypto exchanges have faced ongoing issues with exchanges, including hacks, lost funds, and irresponsible owners. In the first six months of 2019, there were seven large-scale attacks on exchanges, resulting in tens of millions of dollars being stolen from users. In many cases, these funds will never be recovered.
Issues like this have led to the increased popularity of decentralized exchanges (DEXs), which offer various advantages over the traditional centralized exchange. So, what is a DEX, and why should you choose one over a centralized exchange?
Decentralized vs. Centralized Exchanges
A centralized exchange operates in a similar way to a bank. You deposit your tokens, and the exchange serves as a custodian. It’s up to the exchange to safeguard the funds and ensure it can make good on any withdrawal requests.
If you keep your funds in a cryptocurrency wallet, then you have your own private keys, and your digital assets are recorded on the blockchain as belonging to you. Users of an exchange don’t have private keys. The blockchain record will show the exchange as the owner of the funds, and the exchange keeps records of which tokens belong to each user.
A DEX works differently, in that the exchange never takes custody of funds. Although the underlying mechanisms for a DEX can vary, in general, there is an order matching protocol and funds are transferred between individual wallets using smart contracts to execute trades automatically.
DEXs are often developed as a decentralized application on a particular blockchain platform, which determines the tokens that can be traded on it. For example, the Binance DEX is developed on the Binance blockchain. This means that users transact using the Binance token (BNB) as the base currency, and only tokens based on the Binance blockchain can be traded. The Waves DEX on the Waves platform, or IDEX on the Ethereum platform, are other examples of DEXs that function in this way.
Why Use a Decentralized Crypto Exchange?
There are four main reasons to consider using a decentralized crypto exchange over a centralized one.
Centralized exchanges hold large amounts of funds from investors, making them a prime target for hackers.
In 2015, Bitstamp, a Slovenia-based exchange, was hacked by an anonymous hacker who was able to gain access to the exchange’s operational hot wallet and steal 19,000 Bitcoins (worth $5 million at the time). The most famous bitcoin hack in history was Mt. Gox, a cryptocurrency exchange which no longer exists. It was hacked twice in 2011 and 2014, resulting in more than 750,000 Bitcoins being lost. Investors had no way of retrieving their funds and maintain the loss to this day.
With the increasing trading volume of cryptocurrencies, centralized exchanges are becoming more attractive to hackers. Decentralized exchanges are becoming more and more user-friendly and common, simultaneously providing better security for investors.
2. Control over your funds
Hacking is not the only issue with centralized exchanges; in such environments, users do not have complete control over their funds, but the centralized exchanges do. This can impose many constraints and even financial losses on investors.
In January this year, crypto exchange HitBTC started freezing user accounts, purportedly ahead of a planned event by users to withdraw all their funds from centralized crypto exchanges in a single day. The event, called “Proof of Keys”, was an attempt by the crypto community to ensure that exchanges could make good on deposits, similar to a bank run.
Another example from earlier this year was when it emerged that the owner of Canadian cryptocurrency exchange QuadrigaCX had died, and he was the only person who had the private keys to the exchange’s storage wallets, leaving debts worth $200 million. It also later transpired that the owner had been deeply irresponsible with user funds.
Once again, the non-custodial nature of DEXs means that funds are under your own control, and no central authorities can freeze or lose your access to them. If the exchange goes down tomorrow, your funds will be unaffected as you’ve retained possession of them.
Centralized exchanges are classed as money service providers (MSPs) in many jurisdictions, meaning that customers are required to undergo mandatory know-your-customer (KYC) and anti-money laundering (AML) checks. In many cases, however, people are reluctant to provide their private information to third party entities, because they have no control over what happens with their data and to which authorities — domestic or foreign — gain insight.
Decentralized exchanges, on the other hand, aren’t under any central control; therefore, there are often no registration requirements for using the exchange beyond having a wallet address.
4. Financial inclusiveness
In response to increasing regulatory pressure, many centralized exchanges have restricted access to users in particular countries. Most recently, exchanges have begun withdrawing from providing services to US users, due to the risks of being seen to offer unregulated trading of securities. In June, Binance announced that it would be geo-blocking US users from its platform ahead of rolling out its plans for a US-specific compliant exchange. Other exchanges such as Bittrex have delisted a number of tokens from US users.
Decentralized exchanges offer a way for individuals in any location to trade cryptocurrencies, as they aren’t run by a centralized authority that can be subjected to a shutdown order. Investors can invest as little as they want to benefit from trading activities, and the peer-to-peer transaction costs are much lower than those on traditional exchanges.
The concept of the DEX is still gaining traction, as the cryptocurrency community recognizes their benefits amid ongoing hacks and incidents involving centralized exchanges. However, overall, the DEX is a closer fit with the decentralized ideology of cryptocurrency and blockchain. Perhaps it’s only a matter of time before the rise of the DEX consigns centralized exchanges to the history books.
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