Education Series: Decentralized vs Centralized Exchanges

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If you’re trading cryptocurrencies you’re either trading on a centralized or decentralized exchange. If you’re new to cryptocurrency you’re quickly graduating from entry point websites such as Coinbase and learning about exchanges. This post will define what each of these are and what you should consider when using these platforms. There is a place for both Centralized and Decentralized (DEX) exchanges in the current marketplace. Whether one supplants the other is a matter of market dynamics and innovation. Decide for yourself what makes sense for you.



Exchanges come in all shapes and forms

Centralized exchanges are platforms that enable traders to buy and sell cryptocurrencies against set trading pairs. Most exchanges set Bitcoin and Ethereum as the primary trading pairs. Exchanges such as Kucoin and Binance enable their own proprietary token as a trading pair (Kucoin Shares and Binance Coin respectively). Few exchanges such as GDAX enable fiat pairings. I use the term platforms above as an encompassing term to group websites and mobile applications together. Some exchanges have mobile applications to facilitate trading while others are web only interfacees.

Decentralized exchanges (DEX) are platforms that also enable traders to buy/sell/trade cryptocurrencies. Decentralized exchanges are called as such as there is not one owner of the platform but rather the platform and its underlying infrastructure are maintained by a cadre of people. Projects such as 0x, Kyber, NEX, EtherDelta, IDEX, and Waves are examples of decentralized exchanges. Traders remain in control of their funds because they are in control of their private keys. DEXs utilize the functions of the blockchain themselves to enable more secure and transparent transactions. The most appealing aspect of a DEX is the opportunity for equal access regardless of jurisdiction, personal custodianship, and increased security. With that said, most, if not all DEXs are not purely decentralized. In fact, most of them are hybrid exchanges.

Hybrid exchanges are also listed in the table below due to the fact most DEXs have centralized components to it. Order books, for example, are hosted on centralized servers. Other features such as history records, charting, and chat boxes are also likely housed on third party servers. Like DEXs, hybrids do not hold private keys.



Comparing The Two

Topic Centralized Decentralized Hybrid
Security Failure points: employees, servers, client terminals (employee laptops) Centralized portions of a DEX can be compromised, such as the DNS (i.e. domain swap) Centralized portions of a DEX can be compromised, such as the DNS (i.e. domain swap)
Custodian Risk Private keys held by exchange. A minority of these exchanges enable users to own their private key Trader owns private keys Depends on configuration of the exchange.
KYC / AML Exchanges follow accords of domicile No KYC/AML needed. Potential risk of money laundering. Mix and mash of both. May follow accords of domicile.
Transparency Transactions not recorded onchain but on exchange’s database instead Transactions conducted via Smart Contract. Paper trail on public ledger. Transactions conducted via Smart Contract. Paper trail on public ledger.
User Experience Fast. Familiar to equity traders. Slow. Clunky to log in. Typically lacking auto order matching. Slow. Clunky to log in. Typically lacking auto order matching.
Liquidity 99% of trading volume is on centralized exchanges Less than 1% of trading volume Less than 1% of trading volume
Dividends / Hard Forks Not every exchange accommodates hard forks Not every exchange accommodates hard forks Not every exchange accommodates hard forks
Token Listing Process Apply online. Relationship based at times. Fee based at times. Tokens often listed before centralize exchanges. Apply online. Relationship based at times. Fee based at times. Tokens often listed before centralize exchanges. Apply online. Relationship based at times. Fee based at times.
Fees and Withdrawals Fees per trade and withdrawal. Limits may be placed for withdrawals. Depends on exchange but fees per trade. May have minimum limits for withdrawals. Depends on exchange but fees per trade. May have minimum limits for withdrawals.



Long Term Trends in the Exchange Industry

User experience

Centralized exchanges are likely to to hold sway over established markets as they increase their security and as insurance services are offered. Fast and convenient experiences will strengthen their grip over the market. Today, 99% of trades are conducted on centralized exchanges. Decentralized and Hybrid exchange face an uphill climb in offering a fast and convenient experience. While solutions are currently underway, liquidity (mentioned below) remains a huge adoption hurdle for DEXs.

Insurance

Over the long run, centralized exchanges are likely to invent or acquire insurance services with the trade fees they generate. This additional blanket of coverage will assure traders that a portion of their funds can be restored if verifiably stolen.

Transparency and Audit Trails

Transactions on decentralized are recorded onchain on the blockchain. Depending if the blockchain is public the transactions are recorded as a smart contract transaction and withdrawals from the Dex as a deposit into your onchain address. This benefits tax preparers, governments, and businesses that require a clear paper trail. Over the long run, governmental frameworks are likely to apply pressure to centralized exchanges to provide information. Given enough time, the transparency and audit trail is likely to reach parity.

Liquidity and Consolidation

The market is becoming more fragmented by the week. New exchanges are popping up due to the attractive profits existing exchanges are raking in. With the increasing numbers of exchanges, liquidity is sitting at a global level will become trapped in closed systems. The likely trends in the long term will feature:

  • Competitive offers to list best-in-class projects between exchanges
  • Consolidation between best-in-class operators. The best exchanges will outmaneuver exchanges lacking relationships with project owners. Defensive acquisitions are likely to increase to remove players off the board.
  • Exchanges may become server-to-server services operating in the background unbeknownst to the end user

Security

Centralized exchanges represent an evergreen honeypot for thieves. With 99% of trading volume, centralized exchanges are a tempting target. With increased fees funding operations, exchanges are likely to hire top tier talent, provide insurance benefits, and enable best in class security features. While no system is 100% secure, centralized exchanges are in stronger position than DEXs to fund security innovation.



Buy beware. Scams and hacks abound.

A list of hacks for exchanges.

  • [Centralized] Bitfloor (Sep. 2012) – 24,000 BTC stolen
  • [Centralized] Mt. Gox (Feb 2014) – 850,000 BTC stolen
  • [Centralized] Bitsy (Jul 2014) – 13,000 BTC and 300,000 LTC stolen
  • [Centralized] Mintpal (Dec 2014) – 3,894 BTC stolen
  • [Centralized] Bitstamp (Jan 2015) – 19,000 BTC stolen
  • [Centralized] Bter (Feb 2015) – 7,000 BTC stolen
  • [Centralized] Bitfinex (Aug 2016) – 120,000 BTC stolen
  • [Centralized] Coincheck (January 2018) – 523,000,000 NEM stolen
  • [Centralized] BitGrail (February 2018) – 17,000,000 NANO stolen
  • [Decentralized] EthereDelta (March 2018) – 305 or 308 ETH stolen
  • [Centralized] CoinSecure (April 2018) – 438 BTC stolen


Try out both for yourself

Now that you’re sufficiently freaked out with the list above you can now tell yourself that you are wading into risky waters. Buying crypto is an exercise in trust. Right size your expectations before jumping in.

Most crypto traders have interacted with a centralized exchange such as Binance or GDAX. Beginners often start out with Coinbase. Eventually, traders become curious and search for diamonds in the rough. DEXs are an ideal place to find these hidden gems prior to a tokens listing on a major centralized exchange. Do what works for you but educate yourself before wading into the deep end of the swimming pool.



Other Resources:

  1. List of DEXs
  2. Solutions to DEX liquidity issues


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