Centralized vs. Decentralized Exchanges: Do We Need Both?
June 14, 2018 7:04 pm
As the Bitcoin market matures, it will grow and change. Exchanges represent the forefront of this ongoing development. In their simplest form, exchanges are a venue for moving cryptocurrency between users. They also function as a way of converting the value stored in one cryptocurrency to another. Two main forms currently exist – centralized and decentralized exchanges. Each has its pros and cons. Here’s a brief overview of the market as it stands and what it might look like moving forward.
A centralized exchange routes all traffic through a trusted third party and acts as a matchmaker between peers in an open market system. These are the kinds of exchanges most new crypto players are familiar with, as they are similar to more traditional stock exchanges.
Centralized exchanges bring most of the advantages – and disadvantages – of traditional stock exchanges to the table. They are intuitive as they resemble more familiar systems. They usually offer a wider range of advanced trading features, such as the ability to create synthetic positions, set up limits, and even trade in derivatives.
Perhaps the most important benefit a centralized exchange boasts, however, is liquidity. Since transactions are not occurring directly from peer to peer, there is a large amount of free “cash” in the form of liquid crypto assets available to make trades quickly. This can, of course, vary by exchange and even by coin or token, but for the most part, centralized exchanges will usually have enough liquidity on hand to execute most non-whale trades.
The cons of a centralized exchange go hand in hand with the benefits. Like any centrally located system, centralized exchanges are vulnerable to hacking and phishing attempts. A substantial amount of cryptocurrency aggregated in a single location tends to make a tempting target. They are also prone to good old downtime as both software and hardware undergo maintenance. Since all the essential machinery of the exchange is in the same location, a hardware malfunction or a natural disaster, like a flood or hurricane, can shut down trading for vast numbers of investors at once.
Then there’s the issue of who actually controls your funds. Many exchanges keep crypto funds deposited to them in cold storage for safekeeping, with only a fraction available in a liquid form for trading purposes. This means that you often don’t have access to your private key. Basically, you have surrendered the right to your individual coins or tokens in exchange for the centralized exchange’s promise of safe storage. This is similar to how a bank operates. If you deposit a $100 bill with a certain serial number, there is a very slim chance that you will receive that exact bill back when you go to make a withdrawal. In the same way, you combine your crypto funds with other users’ funds. The actual funds themselves are no longer yours, so to speak. If the exchange goes down or even goes out of business, you will lose your funds unless you happen to be using one of the few exchanges that personally insure funds. It’s worth noting that you’ll likely pay a service fee for this, as well.
Anonymity might also be a concern for some crypto traders. Centralized exchanges must be mindful of who exactly is doing business via their platform for a variety of reasons – some regulatory, some security focused. As a result, it’s typically necessary to provide identifying information when you first begin trading on an exchange. This ranges from a simple identification card or photo to a full-fledged video identification.
- Good liquidity
- Familiar layout
- Single point of failure
- Not private
A decentralized exchange is perhaps truer to the cryptocurrency ethic of a peer-to-peer interface. The exchange simply acts as a platform for users to trade funds directly with one another.
Pros and Cons
Many of the benefits and drawbacks of a centralized exchange are mirror images of the benefits and drawbacks of a decentralized exchange. Low liquidity can be an issue as peers are trading cryptocurrencies directly instead of via a shared pool of funds curated by an exchange. Security is less of an issue at the exchange level, as there isn’t a single point to attack. That can be a double-edged sword, however. Since security is squarely in the hands of each individual trader, it is up to that trader to safeguard their private keys and devices from hacking and phishing attempts. Decentralized traders, therefore, operate in a much more caveat emptor fashion.
The flip side of that is that there is no central architecture to fail, go out of business, or suffer some kind of natural catastrophe. Peers deal directly with one another and do not deposit their coins with a third party, so they are exactly as safe as the individual traders make them.
That ties in with the idea of anonymity. Since peers are directly interacting with one another, there is no need for identifying documents. Peers make trades without any kind of know-your-customer standards applied. That’s certainly a big benefit if privacy is your first concern. On the other hand, it opens the door to potential regulatory scrutiny down the road.
- Safe from general attack
- Security up to a user
- Low liquidity
Can They Coexist?
The short answer is yes. The long answer is which kind of exchange you decide to use largely depends on your need to weigh privacy against security. Then you must weigh whether your funds are likely more secure with you or housed on a centralized exchange. There are other factors to consider, as well– particularly if you plan to move large sums around and need a ready source of liquidity. However, the market definitely has room for both platforms as the needs of the growing crypto community continue to diversify.