Decentralized vs. Centralized Exchanges
Decentralized digital asset exchanges are increasing in popularity due to the long list of issues that cryptocurrency users have been faced with when trading on centralized exchanges.
Exchange hacks, lengthy KYC processes, and unmerited account closures are some of the challenges that crypto traders have had to deal with on centralized exchanges, which is resulting in more and more investors are moving towards the decentralized alternative to execute their trades.
The Failures of Centralized Exchanges
The decentralized nature of cryptocurrency networks is one of their main advantages over fiat currency. Decentralization eliminates third-party risk and the need for a financial intermediary. It also increases security and transparency as there is no single point of failure in the network and all financial transactions can be viewed on a public ledger.
Most cryptocurrency exchanges, however, are centralized operations. That means they carry a range of risks for users that could lead to a loss of funds such as an exchange hacks, financial mismanagement of the exchange operators that results in bankruptcy, operational errors by employees, and unexpected account closures or freezes. Unfortunately, these are not just theoretical risk but issues that have occurred for thousands of crypto investors in the past.
Exchange hacks are probably the most prominent concern when dealing on centralized exchanges. According to a study funded by the U.S. Department of Homeland Security and published by Reuters, one in three bitcoin exchanges have been hacked from the period of 2009 to March 2013, and since then, cybersecurity measures of centralized exchanges have still not managed to prevent cybercriminals from stealing funds.
Perhaps the most prolific bitcoin exchange hack happened in 2014, when the then largest bitcoin exchange in the world, Mt.Gox, lost an estimated $460 million due to a cyber attack. The hack resulted in the Japanese exchange’s bankruptcy and its bankruptcy proceedings are still underway today.
Since then, leading digital currency exchanges Poloniex, Bitstamp, LocalBitcoins, and Bitfinex have all been hacked while the largest hack of a centralized cryptocurrency exchange took place in January 2018 when Coincheck had $530 million worth of NEM (XEM) stolen from its platform.
Needless to say, this long list of exchange hacks does not bestow much confidence in the current centralized exchange model.
As a result, every experienced crypto asset investor knows not to hold large amounts of crypto on their exchange accounts as you do not hold the private keys for these wallets. Having said that, transferring funds in and out of exchanges can often take time, which could mean losing out on a trading opportunity. Hence, the constant transfer of funds from cold wallets onto exchanges and back is another issue traders have to deal with.
Furthermore, with increasing scrutiny on cryptocurrency exchanges by financial regulators, KYC/AML procedures have become more stringent and it can often take a substantial amount of time to set up and verify a new trading account.
While centralized exchanges provide a relatively easy-to-use solution for cryptocurrency investors, their high number of drawbacks suggests that decentralized exchanges be the future of cryptocurrency trading.
Are Decentralized Exchanges the Solution?
A decentralized cryptocurrency exchange, also known as a DEX, is a trading platform that does not hold investor funds. Instead, digital asset trades occur directly between the two transacting parties on a peer-to-peer basis and are settled on the blockchain.
Decentralized exchanges provide a degree of anonymity and personal financial sovereignty to traders as transactions are executed on a distributed ledger directly and there is no need for sign up documentation or identity authentication to use the platform.
Furthermore, decentralized exchanges can provide faster and cheaper transactions as no third-party is involved in the trading process. They are also much more difficult to hack as the potential attack vectors of decentralized exchanges are much less than for centralized exchanges.
Finally, several decentralized exchanges can also be easily integrated with hardware wallets such as the Nano Ledger S or Trezor for increased security. Users can send the cryptocurrency they want to trade directly from their hardware wallets to the smart contracts used to conduct the trade. That means that investors are always in control of their private keys and the risk of phishing attacks is significantly reduced.
Having said that, decentralized exchanges are not (yet) everyone’s cup of tea. Firstly, the majority of decentralized exchanges today are difficult to use. Having to trade using smart contracts can even be challenging for tech-savvy investors , let alone for beginners. Centralized exchanges, on the other hand, are set up in the same way as online stock brokerages, which most investors are already used to and comfortable with.
Secondly, decentralized exchanges currently come with limited features. For the most part, decentralized exchange only offer conversion from one digital token to another. Margin trading, stop-loss limits, and other useful functions are not available on today’s DEXs.
Thirdly, liquidity on decentralized exchanges is still much lower than on their centralized counterparts, which is perhaps the biggest deterrent for large investors to start trading on a DEX.
Probably the most popular decentralized exchange today is EtherDelta. EtherDelta uses Ethereum smart contracts to enable investors to buy and sell ether (ETH) and ERC20 tokens. The exchange has become particularly popular for ICO investors who want to trade ER20 tokens that are not listed on major cryptocurrency exchanges.
While decentralized exchanges are on the rise, it is unlikely that centralized exchanges such as Binance, GDAX, and Kraken will disappear. For the time being, crypto investors are still content with taking on the risks of dealing on centralized exchanges in exchange for ease-of-use, liquidity, and convenience.