Centralized vs Decentralized Exchanges
knowing the difference between the two
A cryptocurrency, (Bitcoin being the most well-known) is a virtual currency created and existing entirely in cyberspace that relies on sophisticated cryptography to prevent security breaches. Cryptocurrencies are not issued by any centralized organization or government and as such, are in theory anyway, immune to regulation or other types of government interference. But while cryptocurrencies are an increasingly viable option in an increasingly virtual world the fact that most transactions are made via centralized exchanges makes some uneasy about the potential for mischief or profiteering by those who control these platforms. The situation has set off a lively debate over the actual threat posed by centralized exchanges (if any) and whether or not decentralized exchanges are a better way to go. Below, we’ll look at both sides of the issue.
What's a Centralized Exchange?
A centralized exchange is an address in cyberspace which processes cryptocurrency transactions, facilitates the trading of cryptocurrencies and handles the conversion of cryptocurrencies into fiat or other cryptocurrencies. In a sense, the platform provides an interface between the virtual world of the cryptocurrency and the real economy.
While centralized exchanges are not technically a necessary component in the cryptocurrency equation, they do simplify things. For that reason, many people find them attractive and are willing to pay fees to those who run the trading platform in return for the convenience they provide.
Those with issues regarding centralized exchanges point to the fact that the company operating the exchange has complete power over all transactions that occur on the system. Dissenters tend to believe that ceding so much control to a third party is contrary to the rebellious spirit that gave birth to the cryptocurrency in the first place. And you can certainly see their point since the trading platforms establishes the transaction mechanisms, collects a fee for each transaction and, in the majority of cases, will only allow transactions to be made with "funds" held in an account they provide. It's all very big brother-ish, and some see the situation as a time bomb simply waiting to go off. That said here are some of the pros and cons of the system:
The third point in this bullet list is perhaps the most disconcerting one. In fact, recently disclosed data reveals that nearly 1/3 of all centralized exchanges have been hacked with losses totaling hundreds of millions of dollars in virtual currency. Aggressive hackers have forced the closure of almost half the centralized exchanges based in the West that existed just a couple of years ago. The problem is compounded by the fact that, although crypto exchanges tend to operate like banks, there's a significant difference: any money lost in a US bank robbery is insured up to $100,000 while virtual funds stolen from a trading platform are merely gone with the individual absorbing the entire loss. So while exchanges can offer convenience, there is little doubt they also represent a significant risk.
What's a Decentralized Exchange?
The decentralized exchange seeks to return control of cryptocurrency holdings and transactions to the user by providing mechanisms that enable peer to peer transactions. This is accomplished through the agency of software that matches buyers with sellers and then steps aside to let the two parties conduct the transaction themselves. A crude analogy would be that whereas a centralized exchange is like using a credit card a decentralized exchange is like using cash.
In the vast majority of cases, there are no transaction fees when using a decentralized exchange and no need to provide personal information to a vulnerable 3rd party. Because decentralized exchanges don't hold your crypto funds there is also no risk you'll lose them if servers are hacked.
In spite of these seeming advantages, decentralized exchanges have been slow to gain traction mainly because it is difficult to lure cryptocurrency users away from the convenience of the centralized platform. As a result of the comparatively small number of people who use decentralized exchanges, it can be challenging to find someone to trade with. It also takes longer to affect a transaction, and it can also be more difficult to liquidate your crypto into fiat cash. Still, decentralized exchanges are considered by many to be the future of the crypto economy and concerted efforts are being made as you read this to make the entire process more user-friendly. In a nutshell then here are the major pros and cons of the decentralized systems:
What the decentralized exchange concept needs right now is some time to iron out the kinks and attract more liquidity. There seems little doubt however that, as centralized exchanges experience more and more extensive hacks and impose more and larger fees, many people will finally decide that the downside of such trading platforms outweighs the convenience and seek an alternative. When they do, the decentralized exchanges will be there waiting for them.
People are attracted to the blockchain/cryptocurrency model because it represents a liberation of money from the claws of government. The notion of the centralized exchange, however - while no doubt providing a level of convenience - tends to run counter to the libertarian spirit of the cryptocurrency. Toss in a rash of large-scale hacks of centralized exchanges where investors have lost millions and the fact that governments are shutting down centralized exchanges (hello China) and you have a compelling argument for decentralized exchanges being the preferred way forward.