Exchanges: Centralized vs Decentralized
In a previous post, we dissected the different ways of storing crypto assets and highlighted the difference in wallets and exchange accounts. However, we did not go into detail about the two types of exchanges — centralized and decentralized. The following is a brief description meant to help readers understand the subtle differences that make these two exchange types distinguishably different and outline the pros and cons of each. Seeing as centralized exchanges have existed long before blockchain and decentralized exchanges, they will be easier to understand.
Centralized exchanges are exchanges owned and operated by a corporation: think eBay, Facebook Marketplace, Amazon, The New York Stock Exchange, Lloyds of London, etc.. These corporations facilitate an outlet for participants to exchange objects of value, often times for a small percentage fee on the derived value exchanged. Centralized exchanges run like a normal company with infrastructure and employee overhead. In the instance of cryptocurrencies, this is no different.
These exchanges are run by centralized companies that are profit-oriented, making money off of each exchange that takes place on their platform. This money comes in the form of trade fees. These fees vary from exchange to exchange, and often times are higher for the person taking the trade compared to the party who initially sets the value of the trade and places an open offering onto the exchange’s market order books (known as taker and maker fees). Another way centralized cryptocurrency exchanges have found profits is by making their own on-exchange currency. Holding these currencies come with benefits to the holder: reduced trading fees by paying the fee with the currency. This means that the currency is going back to the possession of the company who then places it back onto the market for it to be re-purchased by users of the exchange, creating a whole new revenue stream. Centralized exchanges include all of the most widely known exchanges that cryptocurrency investors use like — Binance, GDAX, Bittrex, Huobi, Bitfinex, Kucoin and many more.
Comparatively, centralized exchanges have many advantages over decentralized exchanges. First, they allow for the most simple entry to cryptocurrency investment. Their front-end is usually simple and fast for users to run. Additionally, centralized exchanges often allow users to trade from fiat to crypto, providing a solid on-ramp for new investors. Finally, centralized exchanges can be much better for active trading, as they have significantly better liquidity currently in the market.
However, there are definitely several risks and disadvantages that are inherently involved with centralized exchanges. First and foremost, they somewhat break the whole ideology of distributed technology as these exchanges run on centralized hardware and run by a centralized authority. Therefore, centralized exchanges are susceptible to hacks and even government seizure, both of which have already been witnessed. Finally, centralized exchanges typically require a user to KYC; thus, transactions are not anonymous on their exchanges.
Decentralized exchanges, also known as DEXs, are still a marketplace for the exchange of valued assets and can even still be owned by a profit-seeking company. The major difference that sets DEXs apart is the structure of the technical network that is supporting the exchange platform. Where centralized exchanges maintain the server infrastructure that host the exchange platform, a DEX is supported by multiple devices that are not all owned/maintained by a single source. This means that if the entity that builds the DEX is shut down or has their servers seized, then the DEX will still remain functional — a core concept of a decentralized system. This also exponentially reduces the threat of a direct denial of service, DDOS, attack or server being hacked.
How is this possible? Decentralized exchanges are simply a combination of smart contract templates that facilitate the exchange of assets for participating parties using blockchain to validate the transactions and provide back-end functionality for the platform. This means that once created the exchange will live as long as individuals are running nodes for the underlying blockchain supporting the platform. Currently, as Ethereum is the predominant tokenization platform, most DEX run on top of the ethereum blockchain providing an instant source of liquidity for “ERC” standard tokens. The two major examples at the time of writing are IDEX and Etherdelta.
While there were obvious advantages to using centralized exchanges, there are also obvious advantages to using DEXs. Besides the lack of centralized points of failure mentioned above, with DEXs user maintain ownership of the true assets and not just a digital representation that appears in the form of an exchange account balance page. Also, users maintain ownership of their private keys and are even able to use cold storage wallets to interact with the smart contracts as an added security measure. In keeping with one of the core concepts of decentralization, a DEX does not always require the user to provide identity information to complete a trade, providing another layer of privacy not attainable on centralized exchanges.
Just like with anything, you have to take the good with the bad. DEXs are not without disadvantages. Since there is not always a corporation behind these exchange platforms, they are not always properly maintained or upgraded for efficiency causing the user experience to seem a little clunky and oftentimes more difficult to use. With trade being facilitated through smart contracts and validated on the blockchain, they can take much longer to settle due to delay in confirmation and order matching that is not always perfect. Currently, liquidity is an issue on DEXs due to the lack of adoption in the infancy of the technology. Lastly, nothing is insured. If you make a mistake, lose your private keys, your wallet gets hacked, or you mistakenly forget or add an extra 0, it is your problem and there is no centralized authority to help you recover.
Everest does not take a position in regards to which exchange type is superior, nor do we recommend the use of any particular exchange over any other. We do recommend that you take all of the proper steps to ensure the security of your crypto assets and consider the above when deciding which model is best for your purposes.